By Nick Mustoe
The drive to reduce perceived risk has the potential to bring about the single biggest actual risk to a pension fund investor: the risk that future liabilities won’t be met.
What began in the late 1990s with legislation to restore some balance after pension funds had too much exposure to equities, has been replaced with what seems to be an irrational drive to continue to lower pension schemes’ allocation to equities. We believe the balance has tipped too far now in the direction away from equities, with long-term implications for pension contributions and the solvency of the savings system.
The combination of the growing regulation of pension funds and risk aversion has seen trustees and savers focus on short-term market movements despite the fundamental objective for them to deliver long-term pension savings. The imbalance in perception today between equities and bonds appears to be the reverse of behaviour witnessed at the peak of the equity bubble in 2000, when money flowed with abundance from bonds to equities, with little regard for long-term valuation. Restoring confidence in the equity markets is vital for long-term investors. Their confidence is key to economic confidence and growth as equity capital is crucial to the health of capital markets which underpin growth and innovation across the economy.
The asset-class winner over the last decade has certainly been the bond market. The big question now is whether we are seeing the last stages of what has been a very long bond-market rally driven by rising bond allocation paired with the downward trend in interest rates and inflation over the past 30 years. Added to this, we have seen unnaturally strong bond market rallies during the past five years in particular, due to the printing of money artificially driving down yields. It is an obvious irony that it is the downward force on interest rates which has increased pension scheme liabilities and fuelled the de-risking trend.
The result of more stringent funding requirements pushing schemes to invest largely in bonds has relevance for all of us. It is widely assumed that bonds more closely match the benefit payments due, but it remains uncertain how this could be achieved given where bond yields are today. After all, equities have historically outperformed bonds 80% of the time in consecutive 10 year periods.
As long as the strong demand continues for bonds, prices will be driven up and yields down. This reduction in yields places even higher value on pension liabilities with schemes chasing their tails, becoming more risk averse and further compounding the problem. As market observers we have been concerned by this unrelenting march from equities. It is a perversity that today, the debt of the very companies that pension schemes are disinvesting from in equity terms is being so aggressively sought by these same schemes. It is not dissimilar to the perversity of much of the 2000s, where public equities were disinvested in favour of private equity and hedge funds. Private equity funds, which rely on the public equity markets for secondary and primary issuance, have billions in frozen assets, while many hedge funds, which promised uncorrelated equity returns, failed.
Nick Mustoe is chief investment officer at Invesco Perpetual
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