By Ian Barnes
Less than a decade ago, meeting liabilities appeared to be relatively simple. Strong bond yields and positive equity returns saw many schemes emerge with healthy funding ratios and enabled schemes to enter programmes to systematically match their liabilities. However, liabilities were in most cases only partially hedged and funding levels remained vulnerable to interest rate and inflation risk.
Furthermore, the low interest rate environment and its impact on bond yields have left many trustees wondering where they can go to find yield.
Many schemes are now considering expanding the range of asset classes within their liability-hedged portfolios to achieve greater choice and flexibility in plugging deficits. Schemes have been looking at high yield bonds, leveraged loans, bank loans, real estate debt and infrastructure debt – all of which provide diversification away from traditional asset classes.
Nonetheless, there is still a role for traditional asset classes and indeed, domestic bonds remain a cornerstone of liability-hedging strategies. By 2013, the average UK DB scheme held 17% in UK fixed income, 13% in index-linked gilts and 5% in overseas bonds – a total of 35%. This was slightly down from 37% in 2012, but still high relative to previous periods. We anticipate that bond allocations will increase very gradually, as the need to match liabilities grows due to changes in funding philosophy and accounting standards.
Just as important as matching liabilities is achieving a sustainable level of growth, which is central to reducing the scheme funding gap.
The 2008 global financial crisis and more recent threat of the withdrawal of central bank stimulus have put pay to the myth that equities and bonds offer real diversification benefits. In fact, a range of asset classes which showed little or no correlations during normal market volatility actually became highly correlated during the crisis. The downside protection expected from hedge funds also went unrealised, save for a few specific strategies.
Subsequently, investors are increasingly looking to exploit alternative investments to further diversify and reduce risk. Data from WM shows that the average UK pension scheme allocated just 0.7% to alternatives in 1999, increasing to 9.1% by the end of 2013.
Extending asset class choice within the growth portfolio can also help to provide greater levels of income and real returns. Strategies pension funds are considering include student accommodation, social housing, direct real estate, long lease property, direct infrastructure and ground rents.
A consequence of expanding the range of asset classes is the increased governance burden placed upon trustees. Not only will trustees have to contend with a potentially greater number of managers to select and monitor, but they will also be required to ensure these managers are making a positive contribution to their schemes’ overall objectives. Trustees also need to be cognisant of the introduction of additional risks. Clearly, many alternatives entail a degree of illiquidity; trustees should assess whether the premium provides an adequate trade-off for long maturity horizons.
Ian Barnes is head of UK & Ireland at UBS Global Asset Management
Trends and data have been taken from UBS’s Pension Fund Indicators 2014 research publication.
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