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DB shift to bonds highlights yield risks

30 Jan 2020

Defined benefit (DB) schemes are continuing to shift asset allocation from equities to fixed income but investment risk remains a key concern, particularly for schemes with higher deficits, Pension Protection Fund (PPF) data revealed.

While the overall deficit in the PPF’s universe has declined to £160bn, from £188bn last year, partly due to the updated s179 valuation guidance, funding ratios of smaller schemes have declined. In the event of a further fall in gilt yields, this could leave schemes at risk of a double whammy of declining funding ratios and falling returns.

Stephen Wilcox, chief risk officer at the PPF, commented: “While many schemes have reduced their investment risk, the deficit of schemes in deficit is more than double what it was in 2006 and the economic circumstances much less favourable. The funding ratio of schemes in deficit is particularly vulnerable to economic shock.

“Although the PPF is much better equipped to manage that risk than we have ever been – our own funding ratio is stable, we have years of experience under our belt and we have a healthy reserve to fund future claims – the potential claims of underfunded schemes pose a significant risk, which is beyond our control,” he warned.

Of the remaining 5422 DB schemes in the PPF’s universe, the average equity allocation fell from 27% to 24% while the proportion invested in bonds rose to 62.8% from 59%. In 2006 the proportion invested in fixed income was 28%.

This picture is supported by data from Aon’s annual Global Pension Risk Survey, which found that 40% of respondents anticipated further reductions in their equity allocations in the next 12 months.

Index-linked bonds made up the largest proportion of fixed income allocations by DB schemes at 46.2%, a figure little changed from the previous year, suggesting that investors continue to anticipate an uptake in inflation. This is despite the fact that the latest Office for National Statistics data shows a decline of CPI inflation to 1.4% in January, down from 1.8% a year earlier.

Meanwhile, 28.4% of schemes were invested in corporate bonds and just over a quarter in government issued fixed-interest bonds. The PPF said that smaller schemes were more likely to have higher proportions in government and fixed interest bonds than index-linked bonds.

Within equities, the UK-quoted proportion fell to 16.6% from 18.6%, while the proportions of overseas-quoted and unquoted/private equities increased slightly to 69.7% and 13.7%, respectively.

Smaller schemes tend to hold higher proportions in UK equities with smaller proportions in overseas and unquoted/private equities, according to the Purple Book.

According to the PPF, the best funded schemes tend to have the greatest proportion of their assets invested in bonds and a smaller proportion invested in equities.

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