Pension Funds Online

Trustees Need to Watch their Assett Allocation

The calculation of deficits

All too many pension funds have large deficits. Their actuaries think that they do not currently have enough money in them to pay all the future pension bills. They may be right about that, but you cannot be sure. Their calculations have to make assumptions. How long will every member of the pension fund live?  What will happen to salaries and wages before members retire? How high will inflation go over all the years people will be drawing their pensions? How well will the investments perform?

There is no single right answer. It’s all a question of estimating, forecasting and judgement. If we are lucky, investment returns will go up and inflation will fall back and stay low. If funds are lucky but people less so, there would be no further increase in how long people live, and wage and salary awards would be at the mean end. In these conditions pension funds might get through without further increases in the amounts of money their employers put in.

If inflation doesn’t plunge and then stay down, and if things get better for members with good pay awards and longer lives, then companies will have to put more money into their funds.

The one thing everyone agrees about in this debate is that the best answer is for the investments to perform better. Members are happy if the extra pension is paid for through the fund making more money. Company management are delighted if the investment managers bring in big surpluses so the company can put in less and the members take out more.

Looked at from the perspective of the noughties, this sounds like cloud cuckoo land. Yet that is exactly the position many funds thought they were in during the 1990s. We had lived through a good period for investment returns. Trustees sat down with companies to discuss what extra benefits the members should enjoy to help spend the surplus. Finance Directors sharpened their spreadsheets and pressed for contribution holidays. The law of the land required that the surpluses be reduced, as the favourable tax treatment of pension contributions and investment is only permissible if the money is needed to pay the pensions.

What can we expect from pension investment over the next decade?

Are we at the start of another great ten years, when investments will grow rapidly, taking funds out of deficit without the need for large increases in funding? Or are we in a new era of austerity, when investments will do badly, increasing the strain on funds. Is there any danger funds may not even earn the returns their actuaries forecast, meaning that company contributions will have to be even bigger than current deficit reduction plans envisage?

The danger in the current situation is that investment returns will disappoint. There is one main reason for this. That is the current fashion to invest pension funds in so called matching assets, or UK government securities. There is also the questionable performance of UK shares.

Government bond investment

It is misleading to say that a government fixed-income bond is a matching asset for a pension fund. As we have seen, the future liabilities of a pension fund are unknown, increasing in line with a mixture of wages, prices, and the longevity of pension fund members. In contrast, a government bond pays a fixed and constant amount of income twice yearly over the length of the bond, and then repays the capital at the end of its term. Today a typical £1million bond would pay the pension fund £20,000 each half year for ten years, and then repay the £1million at the end. Over that time period if inflation is 2% a year in line with the government’s targets, the pound has lost around one fifth of its value, so the fund receives back devalued money. Meanwhile the cost of pensions has gone up, usually by more than price inflation.

If UK government bonds were offering a much higher running income than the rate of inflation, then things would work out better. If you could be sure you could reinvest the income from the bonds at a higher income, that would help, though it would also mean that the value of your existing government bonds at current market prices would fall. Bonds yielding 4% are only going to work if you are sure wage and price inflation is going to be extremely low for many years ahead.

Even then, you also need to be sure that you can hold all your bonds to maturity. If you might not be able to, then the value of the bonds in the market matters more. If people lose confidence in the UK government’s financial management, and demand more interest on UK government debt, then a pension fund owning gilts will lose money on its holdings as interest rates rise. If a UK government decides that in order to control inflation it needs to increase interest rates from their current rather low level, that too could cause losses on existing holdings of gilts in pension fund portfolios. If this happens and your fund holds lots of bonds, your deficit will appear to go up if you use market values to look at the situation. You will also have lost real money!

The actuaries are only correct in saying fixed income government bonds can be matching assets for a mature fund with no current employee members, where the pensions in payment are fixed and do not go up in line with prices, and where the actuary correctly predicts how long pensioner members will live.

From the investment point of view I see UK government bonds today as a high risk asset, not the low risk asset that some actuaries describe. I am not expecting the UK to renege on its obligations to pay the interest and repay the capital. I am expecting some more inflation to erode the value of the payments the government makes. I am also expecting interest rates to rise in due course, which normally means bond prices falling. There is a chance of a UK government funding and bond crisis. We have just seen how painful that can be to holders of government debt in the case of the Greek crisis, where Greek government bonds fell sharply. Similar events have occurred with Icelandic and Irish debt in the last couple of years.

Equities

Buying shares is a higher risk thing to do. In a way, however, shares are closer to being a matching asset for a pension fund than a fixed income bond. A portfolio of shares should over time bring rising income to the owner. Most of the time economies grow. In such circumstances most companies can increase their turnover and profits. As they do so they can increase the dividends they pay. The value of companies also rises over time as the host economies grow. As companies increase turnover and profit, so the value of the companies’ assets increases. As companies grow, they in turn invest more, increasing the worth of the business.

If we could be sure that company share prices would more than keep pace with inflation, and sure that dividends would grow by enough to take care of rising salaries and pensions, a share portfolio would be the natural asset for a pension fund. Shares, however, have two worrying characteristics that can cause havoc during bad times. Dividends can go down as well as up, and they can even disappear for large numbers of companies if an economy is put through a credit crunch or recession. Share values can also go down and stay down for worryingly long periods if economies perform badly, or if profits get squeezed by wage inflation, falling turnover or higher taxation.

Many investment experts used to tell pension trustees that if they bought UK or US shares they would be fine on anything other than a short-term view. It would be possible to buy shares that had a bad year or two, losing the fund money. If they held on, the theory went over a ten year period and probably over a five year period they would make money.

There have been two shocks to this theory in recent years. Japanese shares, which did so stunningly well for much of the post war period, have now done badly overall since 1990. They are currently standing at less than one quarter of their collective value in 1990 as measured by the index. It has reminded people that if shares get overvalued and the host economy then moves to slow growth or no growth, share investment can be a disaster.

UK and US shares have now lived through a whole ten year period when their owners made no return from them. Ten years ago there was bubble in the western share markets. Today shares have recovered somewhat from the hammering of the 2008 Credit Crunch, but still have not regained the index levels of previous peaks.

So what should we make of the future prospects? The good news is that US and UK shares are not currently expensive when comparing their current values with past values. They are not obviously at the top of a bubble as Japanese shares proved to be in 1990. There may well be some dividend growth resuming, after the sharp falls in dividends experienced at the height of the banking crisis.

The bad news is we should expect slower growth, especially in the UK. The huge debt overhangs in the public, private and banking sectors have to be tackled. As people, banks and governments move towards cutting spending and repaying borrowing, so the economy will experience a slower growth rate than in the debt-swollen years.

The reliable performances of shares in the post-war world may be a thing of the past for the richer developed countries. All of them, from Japan to the UK and from Euroland to the USA, have their own economic problems to wrestle with. I would not myself put large sums of pension fund money at risk on a portfolio of UK-based company shares.

The world economy is likely to grow faster and do better than the economies of the advanced and heavily indebted nations. Whilst emerging economies, such as China and India, will have their performances affected by weaker demand in the West and by the current vogue for competitive devaluations, nonetheless they are likely to perform better. The equity part of any pension portfolio should be global rather than narrowly UK- or US-focused. It should have exposure to the faster growing parts of the world. Returns there have been much better over the last ten years. They could be so again over the next years, given the likely degree of outperformance of the underlying economies. China is currently growing at around 10% per annum. The UK will be lucky to grow at 2% per annum over the decade ahead.

Property

A third asset class that sits between shares and bonds is property. It has the advantage over shares that rent is paid ahead of the dividend, so the income is a bit safer. If the tenant goes under, the property owner might find a new one. Like shares the income usually grows, though rents can be driven down by a bad recession. This asset class in the UK did extremely well until the Credit Crunch hit. Now there are concerns about the volume of empty properties, and the decline in rents.

These worries do not apply in some of the faster growing parts of the world. Yields are still higher than the income on shares. This asset category is one to look at seriously.

Conclusion

This is going to be a difficult decade ahead for pension investment. Funds do need to lift the returns compared to the money they have earned 2007-10. The best way to do this is to think globally, and to consider liquid and relatively safe ways to invest in property as well as shares and bonds. At Evercore Pan we specialise in helping funds with those big picture asset allocation decisions that make all the difference. We usually recommend index products that have relatively low costs and are easy to buy and sell. We don’t like complexity, high cost and lock-ups. You do need to keep your asset allocation under continuous review. If you set your strategy in June 2007 and did not reconsider it again for a couple of years you might now be regretting your failure to rethink as the world changed dramatically.

Biography of John Redwood

John Redwood is Chairman of the Investment Committee of Evercore Pan Asset (EPA). EPA offers advice on whether to be in shares or bonds or property or some mixture of the different asset classes, and runs portfolios of passive ETFs that can implement the strategy. John says "Big Picture investing concentrates on the crucial decisions that make most difference to portfolio performance. Keeping it simple and keeping the costs down are central to our approach. You can't avoid having an asset allocation so we help you concentrate on that decision, and then we manage it for you every day the markets trade." For more information please visit www.pan-asset.co.uk.