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Defined benefit scheme shift to bonds highlights yield risk

4 Mar 2020

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

While the overall deficit in the PPF’s universe fell 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, the PPF’s chief risk officer, said: “While many schemes have reduced their investment risk, the number 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 5,422 DB schemes in the PPF’s universe, the average equity allocation fell to 24% from 27% while the proportion invested in bonds rose to 62.8% from 59%. In 2006, the allocation to 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 DB schemes’ fixed income allocations at 46.2%, a figure little changed from the previous year, suggesting that investors continue to anticipate an uptake in inflation. This is despite Office for National Statistics data showing a decline in 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 private companies 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 private companies, according to the Purple Book.

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

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