Schemes need to act now to get out of a pension deficits black hole, reports Jenna Gadhavi
There seems to be a paradox in UK pension scheme investments – deficits have grown, gilts and bonds have become more expensive, yet schemes are allocating more and more to low risk assets. Is it time for a rethink?
October 2016 saw record pension deficits in the UK of around £350b and Goldman Sachs Asset Management (GSAM) believes this was largely due to schemes focusing too heavily on hedging which came with an opportunity cost for generating returns.
LDI is unlikely to improve funding position
David Curtis, their head of UK institutional business explains: “A huge amount of time was spent on liability matching and LDI implementation – the strategic issues in pensions. We question whether the amount of governance time spent dealing with those issues has meant that there has been less time spent on generating returns.”
The problem is that LDI is unlikely to improve funding position - its job is to match liabilities - so the funding gap challenge needs to be addressed by generating returns.
GSAM believes that schemes are missing a trick and more of their return generating portfolio should be in better performing assets such as Emerging Markets. And they may be on to something, in 2016, the average return generating contribution for FTSE 350 companies was a mere 3.0%. If you compared this with Emerging Market equities for the same period, the returns stood at a much healthier 16.7%.
Curtis highlights: “The best performing equity market in 2016 in US dollar terms was Brazil, closely followed by Russia. So these opportunities were out there but pension schemes didn’t capture them.”
So it’s safe to say that the return prospects for traditional equity and fixed income assets are low and alternative sources of return may offer more opportunity.
What are the alternatives?
GSAM continues to be broadly supportive of risk assets, but believes that adapting by identifying opportunities in emerging markets and deploying more dynamic asset allocation strategies, rather than sticking to more traditional stocks is key.
They are placing their focus on alternative investment strategies and alternative risk premia, for example lower-beta strategies within equity long/short and macro strategies that look for opportunities across multiple asset classes. These exposures could improve diversification and act as useful tools in the pursuit of attractive risk-adjusted returns.
Alternatives These are investments outside the mainstream (e.g. equities and bonds). Commodities, hedge funds and private equity are the most well-known types of alternative investment. Infrastructure is another alternative investment.
A macro strategy is a hedge fund or mutual fund strategy that bases its holdings, such as long and short positions in various equity, fixed income, currency, commodities and futures markets rather than one specific asset class.
Emerging markets are countries which are still developing, but have fast-growing economies, offering promising growth prospects to investors. Investors can either buy emerging market equities (shares in companies which appear to offer promising returns) or debt (bonds).
Emerging markets can also offer diversification through their varied economic models - importers versus exporters, consumption-driven versus investment-driven economies, state-owned versus private companies and local currency versus external currency fixed income.
Javier Rodríguez-Alarcón, head of the quantitative investment strategies group at GSAM is a strong advocate. He says: “Pension schemes need to be allocating more to alternatives.”
He does however think that the percentage allocated to alternatives is very much dependent on the individual scheme and their funding status and objectives.
So maybe it’s time for schemes to take a little more risk? It seems that conservatism comes with an opportunity cost that pension schemes can’t afford.