Sponsor covenant strength will be key in determining 2014 asset allocation for UK pension schemes approaching the decision of investing for growth or moving towards bulk annuities, BlackRock has said.

Pension schemes in the UK are currently mulling asset allocations after 2013 proved to be an exceptional year for growth asset returns.

However, the yield on government bonds also rose, after the downward pressure imposed by quantitative easing began to ease, lowering the value of Gilt holdings.

Inverse performance from equity and fixed income assets has left underfunded pension schemes with something of an allocation dilemma.

Schemes wanting to increase their funding level via asset increases are again being encouraged to move into riskier assets, such as equities.

Simultaneously, schemes are also being encouraged to look towards bulk annuity markets to pass on obligations to the insurance industry, thus reducing liabilities.

In order for the latter option to be commercially viable, schemes would need to invest in assets easily transferable, and preferable, to the insurance sector.

Bulk annuity insurers have a preference for fixed income assets, and price insurance contracts depending on the spread between Gilts and corporate bonds.

Arno Kitts, head of institutional business at BlackRock, said the decision within pension schemes should be based on two factors.

One would be the scheme’s distance from achieving 100% funding on a buyout basis, thus allowing it to pass on all obligations to an insurance company.

More important, however, would be the scheme’s support structure, such as its sponsor covenant, Kitts said.

“Mainly, it is the strength of the covenant, which does dictate the amount of risk a pension fund can afford to take,” he said.

“If you’re underfunded, a strong covenant affords you the ability to take growth risk, as someone can back you, if you really need to make up the ground on funding.”

However, the move for growth assets to plug funding gaps may prove detrimental should the pricing for bulk annuities further improve, as is expected.

Consultants at LCP, in a recent report, said 2013 was a record year, but 2014 could dwarf this, given that pensioner buy-in pricing remains attractive.

Aon Hewitt, in its monthly bulk annuity market report, also found that volatility in growth assets was affecting schemes planning to transact with insurers, and highlighted the conflicting aims for schemes.

At the end of January, schemes planning to price up an insurance contract could have seen the affordability fall by 5% in a week, solely due to equity movements.

“This highlights the importance of considering when risk settlement would be desirable and what changes to the operation of the scheme may be made – perhaps including asset switches – in preparation,” Aon Hewitt said.

Kitts said schemes, once set on a strategy, needed to think tactically about asset allocation.

He suggested discussing with insurers which assets were more attractive to them, given the constant movement in pricing markets.

Kitts pointed out that schemes allocating for bulk annuities could not follow calls to move into illiquid growth assets, which are long term and index-linked, and potentially provide equity-like returns.

He said insurers would have admissible limits over illiquid assets and further capital requirements for volatility, resulting in higher pricing for bulk annuity deals.

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