Liability-driven investing as a way of structuring a portfolio has been a theme for over a decade, tightening the link between assets and liabilities with explicit acceptance that the risks being taking should all be measured relative to your liability. Ultimately the desire is often to completely outsource any pension risk, which, judging by the record volumes of buy-ins and buy-outs recently in the UK, is an option chosen by many schemes. Good asset returns plus a competitive and expanding insurance market have given a tailwind to this trend over recent years.
While full buy-outs may become the norm in 5-10 years’ time, not all schemes are able to transfer their liabilities to an insurer just yet. For schemes where funding levels are still insufficient to make the transaction appropriate they need to consider how best to maintain the value of their assets while planning – and hoping – to reach the necessary funding level through contributions and further asset returns or reductions in liabilities. The latter would require an upward movement in the yield curve which currently seems unlikely (if anything, the mood music from Central Banks is that rates are predicted to be stable or declining, not increasing).
Further, the availability of attractive buyout terms remains conditional on the insurance industry being able to source sufficient assets at favourable yields - pushing providers into more unusual assets like private debt or equity release mortgages. The latter have in turn attracted some regulatory capital scrutiny linked to features like guaranteeing “no negative equity” to the homeowner.
Where the scheme has a strong covenant, and a sponsor willing to make up any shortfall (rather than invest those sums back into the business), the scheme could in the meantime retain a tilt towards riskier assets, but with an eye on capital preservation. The balance between risk (relative to liabilities) and potential return becomes the primary driver of the preferred solution.
“Diversification of risk” may be more appropriate than traditional de-risking, especially income generating assets with a somewhat predictable return stream. Infrastructure – like toll roads or wind farms – continues to prove popular, offering both some opportunity for growth (income streams are often inflation-linked) and capital preservation features if the asset can later be sold. Private equity scores favourably from a return perspective but is not really de-risking since underneath is an early stage equity investment, potentially showing dampened volatility because it is illiquid.
Property has been another popular choice due to the comparatively steady income stream and the bonus of potential capital appreciation again making it not unlike index-linked gilts (though without any of the guarantees). But property can be very cyclical and affected by local economic factors: not least in the UK where well-documented problems in the retail sector have seen (chains of) shops go out of business and often led to rent reductions. These reduce landlords’ regular income and cause a fall in property values as the market adjusts to lower demand from future tenants. For example, UK-listed Intu plc (formerly Capital Shopping Centres plc), a favourite among investors in our home market of South Africa seeking offshore exposure, reported a decline in like-for-like net rental income of 8% for the first half of the year. This is largely due to its exposure to the struggling UK retail sector, where major players have been declared insolvent and struck deals to keep them afloat. Intu’s share price has slumped, losing over 75% for the year to October.
Finally there is (multi asset) credit which combines interest income from a range of credit markets, adding for example emerging market debt, asset-backed securities or secured loans to investment-grade corporate bonds. However, the quest for yield has produced substantial excess demand in this area, with some practitioners now cautioning that the yield achievable simply doesn’t justify the underlying risk to capital from lower quality debt.
Nevertheless, the quest to de-risk pension portfolios continues. The OECD reports that firms are increasingly allocating pension investments to alternative high-yield asset classes such as real estate, private equities or hedge funds. The share of alternative investments has increased by 12.8% between 2004 and 2014 in the UK (OECD, 2015).
An interesting future dynamic will be to see what approach the UK local government pension schemes take to de-risking. Thanks to having maintained exposure to growth assets, including emerging market equities, their deficits have been falling with more schemes attaining fully-funded status. Will there now be pressure to take some risk off the table? De-risking, all else equal, means that future expected returns would be lower, meaning potentially higher future contributions – not good news for cash-strapped councils. They may decide for now that, on balance, the rewards of growth assets exceed the risk of potential valuation shortfalls if markets did decline.
Lars Hagenbuch, Consultant at RisCura
