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Last updated: April 29, 2013 12:19 am
As interest rates remain low, traditionally risk-averse investors, such as pension funds, have increasingly been turning to unconventional classes of assets like property, commodities and high-yield bonds in a relentless search for yield, driven by pressure on the target returns needed to cover liabilities.
In its 2013 Global Pension Assets study, Towers Watson, the professional services company, found that in the seven largest pension markets, equities, bonds and cash allocations had been reduced to varying degrees. Assets in alternatives such as property had grown from 5 per cent to 19 per cent since 1995.
John Ralfe, an independent pensions consultant, says that, traditionally, the UK and US defined benefit pension funds held about 80 per cent of quoted equities, and the balance in bonds and property.
“This seemed to work well in the bull market of the 1980s and 1990s, with company sponsors able to make modest annual contributions to pay for new pension promises, which invested in equities, then magically grew in value,” he adds.
“But, the end of the dotcom boom in 2000, coinciding with the introduction of the new UK accounting standard, FRS17, bringing pension deficits on to company balance sheets for the first time, showed this was no more than a ‘magic money tree’.”
He adds that since then there has been a desperate hunt for the “next new big thing” to plug pension deficits. “Including hedge funds, private equity, commodities, foreign currency and property – made more desperate by the low interest rates of the last couple of years. This hunt diverts from the real issue – deficits can be plugged only if the company gets out its cheque book and puts more money into the scheme.”
Last year research published by Pyramis Global Advisors, the asset manager, suggested that pension funds were gloomy about achieving the target returns they need to cover their liabilities over the next five years. This was driving more than half of global investors to rethink their asset allocation, with 38 per cent planning to increase their use of illiquid asset classes such as real estate and infrastructure.
Andy Green, partner and chief investment officer of Hymans Robertson, the independent pensions consultancy, said many pension schemes have sold down gilts and invested in corporate bonds, high yield and emerging market debt where, until recently, yields had been more attractive. More recently floating rate loans had also become attractive. He says: “The rotation has been from gilts to corporate bonds and now from short-dated corporate bonds to floating rate loans where you get better yield and are immunised if interest rates rise, as the coupon rises as well.”
But the change in asset allocation brings risks.
While investing in property, for example, provides diversification of a fund’s assets and can help reduce risk in a portfolio, it is intrinsically illiquid, and owning property requires large amounts of capital to have a diversified portfolio.
Infrastructure projects are being seen as attractive but opportunities can be difficult to come by.
“Pension funds also like the regular inflation-linked income stream provided by infrastructure but it can be harder to access this without buying the underlying equity of the companies, which is still equity and behaves like equity,” says Mr Green.
Other assets carry risks and the UK government’s actuary’s department issued a note of caution on high-yield bonds last year.
Mr Green says diversification still carries risks. “There is a broader risk of illiquidity and whether assets can be sold if the markets freeze up as they did in 2008, although most pension funds can actually benefit from extra yield in return for this illiquidity, and there can also be concentration risk as many strategies necessarily involve active management.”
Alasdair Macdonald, head of investment strategy UK at Towers Watson, says as funds take more investment risk, they have ways of helping manage that risk. “They can take out risk elsewhere by reducing longevity risk for example. Or, if they are better funded, then this may offset some of the downside risk from investing in riskier assets.
“They can purchase options so if, for example, they buy equities they can buy put options to protect against equities falling to offset any downward risk.”
Many believe risk can be managed by using trigger points so a pension fund can sell positions if a certain market price is reached.
Mr Ralfe says companies continue to take financial risks in their pension schemes which they would not dream of taking on in their treasury departments.
“They need to be able to answer three simple questions ‘What can go wrong? How quickly can it go wrong? What do we do if it does go wrong?’”.
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