Equities are a better option than index-linked bonds for pensions seeking to reduce shortfall risk and close existing deficits—despite present volatility—according to a study by Fathom Consulting and Pension Insurance Corporation.
Yields on index-linked UK government bonds are likely to remain low for a significant period, argued Fathom’s Andrew Brigden and Danny Gabay in a report. As a result, these reputed “safe havens” could pose major problems for pension fund investors.
“Underfunded schemes have been running hard, and yet they have been unable even to keep still.”UK private-sector funds have been increasing allocations to these assets for several years, despite yields turning negative four years ago. This approach has led to defined benefit (DB) pensions becoming “too defensive,” the authors argued.
“We find that the barriers to a full normalization of UK index-linked gilts are substantial,” Brigden and Gabay wrote. “It would require that policymakers in a number of countries, including China, take appropriate action. And that is not going to happen overnight. Indeed, we see a sizeable risk that it does not happen at all within a timeframe that is relevant to the UK defined benefit sector.”
Inflation shocks pose a minor risk, the authors continued, due in part to the Bank of England’s reasonable success in maintaining its inflation target. With pensions in less need of hedging, equity risk is a more attractive proposition for pensions seeking to close deficits, they argued.
“Whether index-linked gilts return to their long-run average of around 2% or whether they stay low, a reallocation out of fixed income into equities would confer a number of benefits,” Brigden and Gabay said. “Understandably, the probability that any given scheme became fully funded would increase, but surprisingly, funding uncertainty would reduce beyond the very near term.”
The authors concluded that poorly-funded pensions and those with weak sponsors would particularly benefit, as it would reduce the need for large deficit-cutting capital infusions.
A survey published last summer by CREATE-Research found that pensions were increasingly incorporating equities into their liability-driven investment strategies due to the low yields on fixed-income assets.
Related: The Great Inflation Conundrum & The DB Market Collapse for Asset Managers in Numbers