Pension funds are feeling pressure on both sides of their balance sheets as a result of the sustained period of low rates. Squeezed yields have undermined returns and, perhaps more importantly, low rates are pushing liabilities higher by altering the discount rate used to calculate them, exacerbating the asset liability mismatch. And there is little prospect of any respite: unlike homeowners and people struggling with maxed-out credit cards, pension funds don’t vote.
Much of the pressure being piled on pension funds originates from the quantitative easing (QE) that forms the cornerstone of the global economic rescue plan. On the positive side, inflating equity and bond valuations have helped plans, but for debt products the effect has been largely limited to the short and medium end of the curve. For pension funds, among the biggest purchasers of long-dated paper to match their investment horizons, this limits the benefits.
While supply has struggled to keep pace with demand for index-linked gilts or inflation-linked assets, QE has depressed yields, and therefore the discount rate, which is typically 0.5% to 1.5% over gilts.
The result has been an anxious debate about discount rate calculations, with some calling for rates to be smoothed, using an average rate to weaken the link with short-term rates. However, critics warn this only hides the problem. The National Association of Pension Funds has advocated that a margin be added to the discount rate, while others suggest a floor, meaning the rate cannot fall any further, regardless of rate movements.
“We advise clients to actively manage their discount rate so it properly reflects the investment strategy they have at any given moment,” says Jeremy May, pensions partner at PwC. The risk level of the fund should determine the discount rate at any given time, with the rate adjusted as the risk associated with the fund rises and falls.
“It is a question of timing but it makes a considerable material difference to the calculations over the life of the fund,” he adds.
Regulation is not helping. “Solvency II will increase pressure to reduce funding risk in our view at the wrong time,” says Ross Pepperell, risk consultant at CheckRisk, a provider of risk consulting services. “It will increase pressure on employers’ contributions and mandate greater exposure to bonds to de-risk portfolios at a time when the risk within that asset class has increased significantly.”
When market conditions eventually normalize, there is a risk that “members of DB [defined benefit] schemes will ultimately pay the price of this misguided regulation, as inflation wipes out valuations,” he adds.
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| Phil Irvine, director at PiRho |
Perhaps a quarter of funds have liability-driven investment (LDI) strategies in place, which typically use swaps to leverage portfolios and hedge interest rate and inflation risk, and these funds have typically performed better than their peers, says Phil Irvine, director at PiRho Investment Consulting, an advisory firm to the investment management industry. However, with rates continuing to edge downwards, some investors are loath to lock in today’s rates, encouraging them to put off implementing LDI strategies, he adds.
Funds typically keep a close eye on asset performance, reviewing on a quarterly basis, but many liabilities are assessed less frequently, perhaps every three years, which is helping mismatches to grow, says Irvine.
Pepperell adds: “With inflation likely to persist over the medium term, and debt write-offs a possibility, pensions might consider increasing allocations to inflation-protected assets such as equities, property, infrastructure and resources.
“An investor is being forced to ask the question of how much interest rate risk they are willing to bear by holding a bond, versus whether they will take the risk on the capital of equities. On a 10-year view, you are being paid to take the risk of the equity versus the bond. This is the point of quantitative easing, to force risk-taking by penalizing the price of cash.”
However, increasing allocations to equities brings a different set of problems, says Irvine, further accentuating the asset-liability mismatch that funds are wrestling with. “Instead, funds will ultimately be looking to invest in longer-duration bond assets. “Currently many feel they cannot afford to do so,” he says.
The pressure is being felt by pension funds everywhere, and of all sizes. Calpers, one of the world’s largest pension funds, is struggling to meet its treasuries plus 5% returns target, and is reportedly already shaking up its $5 billion absolute-return strategies portfolio to achieve this.
Having seen the portfolio miss its target return by about 200 basis points annually since its inception in 2002, it is halving hedge funds-of-funds exposure to 5% of overall absolute-return assets, while adding a 5% allocation to event-driven strategies. Global macro-allocations have been radically increased to 10% from 2%.
Extreme financial repression and fears that central bankers are blowing fixed-income bubbles are daily gripes for pension fund consultants, adding to fears about the health of western financial systems.