Pension schemes have endured a volatile few months. Scott Edmunds looks at how this can be dealt with
- Investment volatility over the summer was the worst seen since 2008
- Many pension schemes are still reluctant to de-risk their investment strategy given the historically low level of gilt yields
- Trustees should jettison the classic “static, asset-only” approach and embrace strategies that are dynamic and that reflect the particular characteristics of their schemes’ liabilities
The summer months of 2015 could best be described as tumultuous, with market volatility on a scale not seen since 2008. China was the trigger, with concerns over slowing economic growth and the subsequent monetary policy decisions taken reverberating through global financial markets.
The US Federal Reserve's decision to leave interest rates unchanged in September provided a second bone of contention. For short-term investors, volatility can ravage portfolios; but for long-term investors it is often a storm that is weathered with time.
When faced with volatility, investors typically become polarised by risk appetite, with 'bulls' relishing the perceived buying opportunities and 'bears' fleeing for safety. This was especially evident within retail markets this summer. However pension schemes, which have the luxury of long-term perspectives, have been much more sanguine.
Nevertheless, interest rate uncertainty has resulted in the deferral of certain decisions, particularly those concerning de-risking measures. Many pension schemes are still reluctant to de-risk their investment strategy given the historically low level of gilt yields. Deferral may yet prove to be a 'rewarded risk', but trustees need to acknowledge the increased funding level volatility such a strategy implies.
Recent volatility has also given rise to an increase in questions about the merits of multi-asset funds. While multi-asset funds afford a degree of protection, through efficient diversification, during highly volatile periods asset class correlations often rise and the diversification can become insufficient to stem losses completely.
As volatility is increasingly introduced into markets, by geopolitical concerns and central bank policy, this may become a more prevalent feature of multi-asset investing and dynamic asset allocation might become yet more important.
Given that volatility, and the macro drivers behind it, show no sign of abating, the question remains, "what can schemes do to weather the storms?" The answer has two parts. Firstly, pension trustees and sponsors must ensure their investment approach is 'fit-for-purpose' in a strategic sense.
A balance should be struck between targeting enough return to achieve the funding objective and protecting the funding level from excessive risk. Investment portfolios should be spread across a range of return-seeking assets and liability-matching assets, in the relevant and scheme-specific proportions.
Secondly, they must ensure the strategy acknowledges and responds to changing market conditions. In order to achieve this, trustees should jettison the classic 'static, asset-only' approach and embrace strategies that are dynamic and that reflect the particular characteristics of their schemes' liabilities.
This change of mind-set calls for a nimble governance framework and a higher frequency of monitoring; both of which allow trustees to capitalise on changing market conditions in support of improved performance.
The premise is simple: as the risks faced by pension schemes change, so too should the investment strategy, and schemes should face only those risks necessary to achieve their ultimate goals.
This realisation has become starker following the volatile summer months, with some trustees being shocked by the speed with which the financial dynamics of a pension scheme can change. Pension schemes that already implement such a strategy, however, will likely have benefitted from rising gilt yields (and the subsequent improvement in funding level) to December 2013, while minimising the impact of: (i) falling gilt yields from December 2013; and (ii) periods of increased asset market volatility.
The adoption of a dynamic approach, which calls for greater awareness of how all aspects of the investment strategy interplay, can raise concerns for pension schemes with smaller governance budgets.
The solution might lie in providing increased delegation to fiduciary managers or fiduciary-minded consultants. The increased competition in this market has dramatically improved the value for money on offer; so long as a sensible framework is set to hold that party to account.
In summary, increased volatility is likely to continue to play a pivotal role in investment strategy planning; presenting new risks and opportunities. Never has the time old adage "timing is everything" been more applicable to pension schemes.
The adoption of a well thought through dynamic approach to managing the funding level will allow trustees to better manage these risks/opportunities as they present themselves; maximising the potential for long-term success.
Scott Edmunds is investment consultant at Quantum Advisory
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