Are Large Equities Allocations Holding Back Pension Funds?

Closing funding gaps will require fewer liquid investments and more private assets, according to Cambridge Associates.

Pension funds will “struggle to close their funding gap” if they continue to rely on liquid assets like public equities, Cambridge Associates has argued.

In a report focusing on UK pension funds, the consultant said that a switch from public equities to illiquid private assets could “improve their chances of closing the funding gap and reduce the likelihood of requiring additional capital injections to honor their commitments to pension fund members.”

Currently, the average UK pension fund has 90% to 95% of its portfolio in liquid assets—a “staggering” amount representing “far more than they need in order to be able to pay pension fund members,” the consultant said.

“Many schemes do not need to set aside more than 5% to 10% of assets for benefit payments in any given year for the next 20 years,” said Alex Koriath, head of Cambridge Associates’ European pension practice. “By having such liquid portfolios, they are giving up return opportunities and face having to deal with the risk of a widening funding gap.”

As of October, UK pensions were 77.5% funded on average, according to the Pension Protection Fund. This funding gap has widened over the last five years despite rising stock prices, as a “dramatic” fall in interest rates increased the value of liabilities, Cambridge Associates said.

Most funds have implemented liability-driven investing (LDI) strategies to a limited degree, with the typical pension scheme investing 40% of its portfolio in liability-matching assets like gilts. The rest was held in growth assets like equities and credit. Just 5% to 10% of the growth portfolio is invested in illiquid assets like real estate, private equity, private credit, and venture capital.

This strategy, however, still leaves pension funds susceptible to market volatility. According to Cambridge Associates, a scheme hedging just 40% of its liabilities faces more than a one-in-three chance of seeing its funding level fall by 10% at least once in the next 20 years.

“In our view, even a growth portfolio purely focused on public equities, typically the highest expected return option available in public markets, will not close the funding gap fast enough for most schemes,” said Himanshu Chaturvedi, a senior investment director at Cambridge Associates’ London office.

To better close the funding gap, the consultant suggested what it termed a “barbell approach”: investing a small part of the portfolio—roughly 20%—in private investments targeting “substantially higher” returns, while putting as much as 80% into liability-matching assets to reduce liability risk.

“This approach to pension investing can deliver a hat-trick of benefits,” said Chaturvedi. “Plenty of liquidity, reduced volatility, and appropriate rates of return to close the current funding gap.”

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