Written By: Kevin McCreadie
Kevin McCreadie of AGF Investments discusses a range of de-risking strategies available to pension scheme sponsors and emphasises the importance of considering all the tools they have at their disposal
Markets traded unpredictably throughout most of the year as a number of events weighed on investor sentiment, and uncertainty and volatility remained elevated. Weakening commodity prices continued to weigh heavily on resource-rich financial markets and economies, and dampen inflation and bond yields globally. Policy rhetoric and statements from the US Federal Reserve Board (Fed) kept market participants guessing as to when the Fed would initially raise interest rates, though the Fed finally hiked rates at their December meeting.
The Greek election in August ended a long-lasting political uncertainty, and default and contagion concerns finally abated. The emerging markets were under considerable pressure during the year as a stronger US dollar, the threat of a Fed rate hike, and persistent economic weakness resulted in their significant underperformance relative to developed markets.
After a significant run-up in Chinese equities earlier in the year, equity markets in China entered a bear market after falling more than 20% from their peak. Over the balance of the year, they remained range-bound as economic growth deteriorated. Authorities in China implemented a number of policy measures to help support economic growth, but caused concern in August when they surprised markets by devaluing the renminbi.
Looking forward, while some of the aforementioned risks have dissipated, we expect market volatility to continue into next year. While bond yields remain at low levels and have remained largely range-bound for most of the year, we expect yields will gradually move higher into next year as economic growth shows modest improvement and the Fed potentially raises rates.
In an environment of higher volatility and low interest rates, achieving a sufficient level of return on fixed income assets is somewhat dubious. Market volatility can also have a significant impact on the funding ratio of pension schemes as we have seen in 2015; the decline in equity markets in combination with substantially lower interest rates has resulted in the deterioration of funding levels for defined benefit (DB) schemes. This is in stark contrast to 2013 when strong global equity markets coupled with rising interest rates resulted in funded ratios reaching multi-year highs. Despite the fact that the median solvency deficit has improved in recent years, many DB schemes still have weak solvency positions.
Given that a significant number of conversions from DB to defined contribution and plan closures have already occurred, consideration of plan design and investment decisions, together with employee cost-sharing to better manage both costs and risks to plans, will continue in the private sector. Sponsors are increasingly recognising the importance of focusing on pension risk management. Annuity buy-outs, buy-ins, and longevity risk transfers are de-risking strategies that have become more popular. The benefits include more effective management of pension risk, greater attention on a company’s core competencies, enhanced benefit security for scheme members, and improved consistency in financial reporting results.
Liability-driven investing (LDI) will continue to be a viable de-risking strategy. However, in an environment of low interest rates, careful consideration must be made to balancing sufficient investment return objectives with de-risking strategies. If rates do rise, this would serve to decrease scheme liabilities, but will negatively impact the scheme’s current bond portfolio, which would result in a deterioration in the funded status. LDI can help achieve long-term plan sustainability; however, in the current environment, it is essential that pension scheme sponsors look at additional diversification strategies to manage pension scheme risks.
Diversification is an important strategy for navigating through market uncertainty and volatility, especially in the limited opportunity set available domestically. This means continuing to decrease the “home bias” inherent within many DB schemes. Despite a decline in domestic equity allocations in DB schemes over the last decade, there is still room for improvement. Over the past 10 years, US pension plans maintained the highest level of “home bias” and even increased their domestic allocation over the last few years to 67% in 2014. While UK pension schemes have halved their allocation to domestic equities since 1998, to 36% in 2014, Canadian and Swiss funds maintain the lowest level of “home bias”, with domestic equity allocations at 33% and 34%, respectively in 2014.¹
Another potential de-risking solution in an environment where we expect market volatility to remain elevated is low volatility equity solutions and incorporating “smart beta” techniques that can help achieve portfolio risk management and diversification at the same time as enhancing risk-adjusted returns. These strategies are likely to outperform traditional fixed income investments over an investment cycle, while maintaining significantly lower volatility than traditional cap-weighted equities.
Diversification into alternatives
Diversification into alternative asset classes such as infrastructure, private equity, and real estate is also a trend that we expect to continue. Within the context of a low and potentially increasing yield environment where rich bond valuations are coupled with volatile equity markets, infrastructure can be appealing. The asset class tends to be more resilient to economic cycles and can improve diversification through lower correlation with traditional asset classes, provide some inflation protection, and deliver current yield.
As pension scheme sponsors continue to deploy de-risking strategies, it is important to consider all available tools within their disposal as higher volatility, the low yield environment and reduced expectations for all asset classes going forward can have an impact on funding levels. Fortunately, there are many options available to scheme sponsors that can help ensure a scheme’s sustainability over the long term.
1. Towers Watson, February 2015