The effects of Coronavirus have sent global stock markets tumbling and are eerily reminiscent of the last recession. As long-term investors, pension schemes should, in theory, be relatively resilient to short-term market movements. In practice, a crisis that has already wiped billions of dollars off the value of stock markets around the world could trigger severe cash-flow and liability challenges.
Economic outlook
Markets had been anticipating another downturn for some time. By the end of last year, around 80% of institutional investors believed that there would be a recession within five years.
Nevertheless, when stock markets started sliding at the end of February there was still an element of surprise. Unlike the 2008 financial crisis, which was sparked by a securitised debt bubble in the US mortgage market, the triggers for the current crisis are firmly rooted in the real economy.
Coronavirus, or Covid-19, has thrown a spanner in the works of global capitalism, causing fundamental changes to the lives of ordinary people across the globe. Unlike its predecessor, SARS 1, which broke out in China in the early 2000s; it’s younger sibling, Covid-19 or SARS 2, is much more lethal and is spreading with lightning speed from Asia across the Western World.
At the time of writing, 188 countries have closed their schools, affecting more than 91% of all pupils worldwide; the majority of Schengen countries and the US have closed their borders and many countries, including the UK, have entered an almost total lockdown.
“What was initially thought to be a supply side event that was disrupting global trade emanating from the Chinese manufacturing hub, is now turning out to be a demand shock as consumers and corporates grind to a consumption halt,” warns Gavin Corr, director, manager selection services at Morningstar.
In a desperate attempt to prevent a temporary liquidity crunch from turning into a solvency crisis, central banks and governments have attempted to mitigate the effects of the crisis with large scale cash injections. In just a single day, the US Federal Reserve injected $500bn (£423.9bn) of overnight repo funding into markets while the Chancellor of the Exchequer, Rishi Sunak, has made £350bn of loans available to cash-strapped businesses.
But as the number of victims rises and millions of people are unable to enter their workplace, it appears inescapable that the virus will hit the financial sector. Despite large scale cash injections, US stock futures hit limit down levels while oil prices hit a 17-year low. What will be the scale of repercussions across markets and how will it affect pension schemes?
Effect on DB schemes
Defined benefit (DB) pension schemes will be hit by the recession from at least three angles: a drop in investment returns, a spike in liabilities and risks to their sponsor’s covenant. Falling investment returns combined with potentially lower gilt yields could present a double whammy for their balance sheets.
Most DB schemes have been reducing risk in their portfolios in recent years by cutting back on their equity exposure and increasing investments in fixed income. The average equity allocation for final salary schemes has more than halved during the past 10 years, to 24% from 46.4%, according to the PPF’s Purple Book.
Having said that, there are still schemes with a higher allocation to equities, due to a relatively higher proportion of active members and higher return requirements. Examples include local government pension schemes, which tend to have higher than average allocations to equities and a relatively younger membership.
Border to Coast, for example, has some £9.58bn invested in equities, which is a significant majority of its pooled assets. Only a third of the pool’s members are pensioners, which leaves room for a higher risk orientation. Similarly, out of Local Pensions Partnership’s (LPP) £12bn of assets that are already pooled, more than half, £6.7bn, are invested in equities. Richard Tomlinson, recently appointed LPP’s chief investment officer, says that a long-term focus remains crucial. “We continue to monitor the government’s current advice and are reviewing our position daily via a tactical working group.
“We are in regular touch with our key suppliers on their ability to maintain their services and continue to take all reasonable steps to maintain current business as usual service. Our aim is to do our best to keep disruption to a minimum,” he adds.
With stock markets reporting the sharpest sustained decline since 2008’s financial crisis, a focus on equities can be painful, particularly if the scheme in question is also in the process of completing its valuation, as is the case for the country’s biggest final salary scheme, the £69.4bn Universities Superannuation Scheme (USS). In line with FRS102 guidance, the scheme’s asset values will be based on a snapshot of asset prices at a set date, in this case 31 March. While results are yet to be determined at the time of writing, they are unlikely to be flattering; 60% of the assets in the scheme’s Retirement Income Builder fund are held in equities.
Shortly after launching its valuation process, USS announced that it had reported itself to the regulator after breaching its internal self-sufficiency measure on five consecutive days this month. USS uses the self-sufficiency measure to estimate the level of low risk “self-sufficiency” deficit at the current levels of 10% employer contributions annually during the next 30 years.
With the referral to the regulator, USS’ board is likely to make the case for an increase in deficit contributions because of falling investment returns combined with rising gilt yields.
Bond volatility
Having said that, questions are being raised over whether gilts should still be a benchmark of investment returns and if they are the risk-free assets they are believed to be.
Throughout March, gilt yields were characterised by sharp volatility. Earlier that month, yields on long-dated assets fell sharply, causing warnings that liabilities could spike by between 15% and 20%, according to River & Mercantile.
But just weeks later, gilts, like other sovereign bonds, faced sudden selling pressures in response to the Coronavirus crisis. On 19 March, UK bonds had been on course for their biggest sustained fall since 1998, which was only halted by the Bank of England cutting rates to 0.01%. After a decade of record low returns, 10-year gilt yields suddenly surged by 70 basis points.
Robin Ellison, a consultant at law firm Pinsent Mason, has a warning despite the rise in the return on the risk-free rate. “Regardless of the volatility and the price, dealing in bonds has become difficult. With traditional liquidity providers like investment banks no longer in the market, the standard advice that bonds are a safe haven has been slightly tarnished.
“In theory bonds should be less volatile but that has not been the case and there are times when bonds are less marketable than equities,” he adds.
The reason for the falling confidence in UK sovereign debt is only partially related to the Coronavirus crisis. One the face of it, this suggests that investors are starting to ask questions about the sustainability of the government’s latest borrowing spree aimed at tackling the crisis. While the Chancellor has pledged hundreds of billions in loans and tax breaks to support businesses, the Bank of England committed to buying £200bn of UK government and investment-grade corporate debt, bringing the total volume of its quantitative easing measures to £645bn. So why the concerns about liquidity?
A more complex underlying factor might be the structural change in the nature of bond market liquidity providers that took place in the aftermath of the global financial crisis. With banks having retreated as the main liquidity providers to the bond markets, principal trading firms have increasingly emerged as market makers. But unlike banks, they tend to have small balance sheets and trade large quantities of securities by hedging the relevant assets, therefore, keeping a zero-net exposure.
Investors are now raising concerns that in the event of sharp volatility, they might be more reluctant to hold opposing positions and simply sell the assets that are easiest to liquidate to meet margin calls.
Another factor complicating risks in bond markets are potential liquidity mismatches in bond funds. Fund managers for supposedly liquid bond funds have gradually edged up the risk curve to improve returns, a move that could now come back to bite them.
The flipside of a potential rise in gilt yields is that it could have short term beneficial effects on liabilities, which tend to be calculated in reference to long-dated debt yields. In November last year, a marginal increase in bond yields wiped off more than £20bn from the FTSE350 pension scheme deficit within a month. However, with volatility of gilt yields remaining a constant factor due to the changing nature of liquidity providers, it is uncertain whether these benign effects will be long lasting.
Having said that, the crucial element for many DB schemes should now be a focus on immediate cash-flow requirements, rather than worrying about deficit figures in the abstract, according to Ellison. “Most pension schemes I work with are desperate for a buyout in the next year or so and we’re looking at a six-year project.
“So if the stock market collapses for a year or two it’s not the end of the world,” he adds. “Unless they need the cash, and some schemes do need the cash.”
For defined benefit schemes, the main elephant in the room will be the strength of the employer covenant. Risks are particularly high for some of the biggest final salary schemes in the country, where pension scheme assets exceed the sponsor’s market capitalisation. Examples include the retirement schemes for BT, Centrica and British Airways. The latter is, of course, particularly affected by the travel restrictions due to the Coronavirus. Early reports suggest that some sponsors are attempting to mitigate cash constraints by appealing to trustees for a temporary suspension of pension contributions, a policy which could free up much needed cash in the short term.
DC schemes – Riding the volatility
The short-term effects of stock market volatility will be even more severe for DC schemes’ investment returns as they are predominantly invested in passive equities. DC schemes for FTSE250 firms had on average 70% of their assets invested in equities, according to the Investment Association. The overwhelming share of these assets continues to be invested in passive funds although in recent years some larger master trusts have been able to venture into alternative asset classes.
At the same time, policy makers appear less concerned about the losses in DC funds, partly because the average membership for DC schemes is still young and partially because losses will be borne by individuals.
For example, only 5% of Nest’s members are 60 years or older while 30-year-olds account for nearly a third of its savers. Mark Fawcett, Nest’s chief investment officer, warns members against sudden withdrawals in the current environment and urges patience. “Most Nest members are unlikely to experience a long-term impact from shorter term market falls either because they’re young enough to comfortably ride them out or because, if they’re closer to retirement, we’ll have taken steps to move their money out of the stock markets,” he stresses.
One of the initial effects of the Coronavirus crisis could be that a further increase of automatic enrolment contributions is put on hold. Speaking in March at the PLSA conference in Edinburgh, pensions minister Guy Opperman suggested that automatic enrolment contribution levels should be kept at 5% for employees and 3% for employers to help businesses and households deal with the effects of the crisis. While The Pensions Regulator has so far stressed that employers are expected to “meet their automatic enrolment duties” despite the ongoing crisis, the government has neither confirmed nor denied a potential deferral of contributions.
The way forward
The long-term impact of the Coronavirus crisis on the global economy and concomitantly its impact on UK pension schemes is still uncertain and depends on the ability of Western governments to curtail the spread of the virus.
While former Bank of England governor Mark Carney and European Central Bank president Christine Lagarde were careful to describe the events initially as a shock, rather than a recession, four former top officials at the IMF have already warned that global economy is now in a recession.
According to Ellison, remaining optimistic is now a necessity for investors. “There is a Monty Python sketch about no one expecting the Spanish inquisition. Similarly, no one expects the Black Swan, no one expected a pandemic. And to prepare for such an event is expensive. So quite rightly, no pension fund did that.
“I wouldn’t blame anybody for not preparing for this event because it would have been too expensive and the risk would have been outweighed by the cost,” he adds. “The worst case scenario could be a lot worse, markets could halve again, the lockdown could last for a year, we might not find a cure, but we have to work on the assumption that things will get better, you can’t live your life on a worst case scenario.”
Gerard Lyons, an economist, predicts that China’s provisional success in limiting the spread of the virus bodes well for the global economic outlook. “If China is past the worst, then in Q2 the economy might start to recover, but we need to be convinced of that,” he said in a speech at the PLSA conference.
But since his speech, infection rates across major Western economies have dramatically exceeded those in China. The British government has joined many other countries in implementing major containment measures.
As the pace of infection rates in the UK overtakes those in Italy, it appears unlikely that this gamble will play off.
