Defined benefit (DB) pension schemes should move away from index-linked gilts and increase exposure to risk assets in order to plug deficits, according to research by Fathom Consulting.
It questioned trustees' "too defensive" investment strategy of continuing to de-risk away from equities in favour of gilts which are still generating historically low yields.
The Investing in a time of negative real yields: when ‘re-risking' can be ‘de-risking' report was written by Fathom and commissioned by Pension Insurance Corporation (PIC).
Fathom warned that negative index-linked gilt yields are doubly harmful to scheme funding because not only is real value of scheme assets eroded, but also under accounting rules liabilities are higher than in a more normal yield environment. So deficits are close to a record high despite substantial deficit reduction contributions from scheme sponsors.
Schemes' asset allocation had become too defensive due to a vast majority of underfunded schemes doubling their exposure to index-linked gilts.
It also questioned the "curious response" of trustees to the decline in index-linked yields by almost doubling the share of index-linked gilts in their portfolio, and that this should be investigated further.
Fathom evaluated an alternative, return-seeking strategy under two different macro-economic and financial market scenarios. It recommended increasing the share of risk-seeking assets in the portfolio - something that would be particularly advantageous to poorly funded schemes and those with weak sponsors.
It found even if index-linked gilt yields return to their long-run average of around 2%, or remain at low levels, a reallocation out of fixed income into equities would raise the likelihood of schemes reaching full funding. It would also mean fewer schemes transfer to the Pension Protection Fund, which means fewer members would suffer a cut in their benefits.
Many schemes have been banking on a UK rate raise to reduce their liabilities, but the report pointed out there were substantial barriers to index-linked yields fully returning to normal levels.
It predicted there could be a "sizeable risk" if appropriate action were not taken at all within a timeframe relevant to the maturing UK defined-benefit sector.
PIC head of origination Jay Shah said: "The question that the research poses is should pension schemes instead of continuing to move towards an increasingly low-risk asset profile investing in gilts and selling equities, should they be looking to move into riskier assets.
He added this clearly bucks the trend that pension schemes, trustees, advisors and companies have been following.
One barrier to schemes re-risking is the short-term pressures sponsors are under.
Shah said: "PIC's view is that while one can take a 30-year macroeconomic view, what the paper doesn't cover is some of the shorter-term pressures. For example one thing that company directors are worried about is the volatility of the pension deficit on their balance sheet. So while you may take a 30-year view that equities might out-perform bonds, if they have peaked that might make an even bigger dent in the sponsor's balance sheet," he added.
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