‘The Boots decision was daft.” This was one of the blunter replies we received to this month’s Off The Record survey, in which we sought your views about the place of fixed income within pension fund portfolios.
We did not actually mention Boots, the UK company whose pension fund caused a flutter last autumn when it announced that it had shifted its entire portfolio out of equities and into fixed income.
However, we were curious as to whether other European pension funds were thinking along the same lines. We are informed that at least one Swiss pension fund was planning to follow the example of Boots until an ALM study by its consultants suggested that such a course would be disastrous.
We decided to find out whether there really has been a change in the way pension fund managers see their role and responsibilities. Are bonds the only proper match for pension fund liabilities? Should pension funds be in the equity markets at all?
From what you tell us there seems to be no Gadarene rush towards fixed income. Less than half of you (45%) have altered your exposure to fixed income in the past six months, while only a quarter (27%) have increased exposure.
This decision was imposed on some. “An increase in fixed income investment automatically happened because the value of the equities have been reduced,” one pension fund manager points out.
Most of this investment is in the government bonds (92% ) and investment grade corporate bonds (18%). Only a small minority (17%) have ventured into junk bonds. There is some interest in index-linked bonds. Just over half of you (54%) invest in index-linked bonds, or say you would if they were available.
You show even less interest in increasing your exposure to fixed income in the future. Only 27% of you are considering a change to your fixed income allocation and only 9% are considering increasing it. Twice as many – 18% – plan to reduce exposure.
The chief reason for switching into bonds is to seek calmer waters. Two thirds (63%) of those who have increased or plan to increase their exposure to fixed income say the main reason was to reduce volatility. Only 37% are making the move to match liabilities.
One of the arguments for pension funds going back into bonds is that because equity values are not driven by interest rates, there is likely to be a mismatch between assets and liabilities in funds that invest in equities. We asked you whether this was an argument for moving out of equities and into fixed income.
A small minority – 18% – agreed. “It would depend on the size of mismatch and available surplus,” one manager points out. “It depends on the scheme’s funding position. A scheme with a large surplus is likely to be able to tolerate the volatility that comes with a mismatch through equity investment.”
However, most of you disagreed – some strongly. “Nominal interest rates are a very poor match for pension liabilities,” is a common view. Some feel that neither equity values nor liabilities are driven by interest rates: “Liabilities are driven more by economic conditions – for example, salary inflation – than purely interest rates,” one respondent points out. “Equities are a far better match for economic growth than fixed interest.”
Others feel that, with interest rates so low, the argument in favour of fixed income has weakened. Interest rates are low nowadays, and there is a big risk to increase duration in fixed income,” one manager says.
Much depends on time horizons. Pension funds often have plenty of time to offset equity risk. One manager suggests that “the most important thing to consider is the duration of your liabilities, and you should look at that when determining how much equity exposure you can or cannot take. Obviously, a long duration on the liability side enables you to take more equity exposure.”
The chief reason you give for not supporting a move into bonds is that bonds simply cannot produce the growth in values needed to pay tomorrow’s pensioners. “The expected return on fixed income would be insufficient, especially if a large number of pension funds were to move to fixed income,” is a typical view.
A continuing low inflation, low interest rate environment will not help. “How can liabilities be met in the long run, supposing there is a lasting situation of low interest rates on the international capital markets, if pension funds lack the growth potential of equities?”
The growth potential of equities, properly managed, wins strong support. “As long as it stays within a defined corridor there is a ‘superiority’ of long-term extra return versus 100% matching,” says one manager. But perhaps one speaks for all when he says: “In the long term equities will always outperform bonds.”
We asked whether there were other ways of reducing volatility besides increasing fixed income allocation. You came up with a whole raft of alternatives including manager and portfolio diversification, currency overlay programmes and convertible bonds. Other suggestions include “equities managed to obtain a nominal return rather than to beat a benchmark” and, of course, real estate. “Direct property is an ideal investment that all pension funds should have,” says one manager.
Reducing volatility is not the same the same as reducing risk, however. We asked whether you thought holding equities in a pension fund inevitably increases financial risk. Almost 60% say that it does not. “It depends what you mean by financial risk,” one respondent points out. “It is likely to increase volatility. However it may reduce the risk over the long term of having to pay higher contributions.”
Many of you feel that, far from increasing risk, equity investment helps to lower it. “In the long run it reduces risk since equities, like pension liabilities, are real assets,” says one.
Your confidence in the performance of equities is reflected in your faith in the global equity markets. We asked if you thought that volatility in the equity markets had curbed pension funds’ enthusiasm for foreign equities. Here there is a near-unanimous belief that there can be no turning back. Only 29% of you think that the move into foreign equities has been halted and less than 5% think it will be reversed.
Much has also been made of the impact of the new employee benefits accounting standards on company balance sheets and, ultimately, on the asset allocation strategies of company pension funds. In a falling equity market, a company pension fund that has invested in equities can affect the value, and possibly the share price, of its parent company.
Yet opinion about the impact of standards is evenly divided, with a slight majority (54%) agreeing that it could encourage pension finds to switch assets from equities to fixed income
Finally we asked whether you thought the move back into fixed income by some pension funds is likely to be temporary or permanent. Most of you (89%) believe this will be only temporary. However, this may to be not be as true for the whole of Europe. One UK manager suggests that “it will be permanent in US and UK, but the other way in Europe. We are now really seeing convergence across the world.”
Perhaps what the current interest in fixed income really reflects is a renewed interest in balanced funds?