Trustees and sponsors of UK defined benefit (DB) schemes should consider diversifying their growth portfolios to protect against the possibility of a market crash, according to Cambridge Associates.
In a report published yesterday (28 August), the firm warned that, with the prospect of a recession "on the horizon", alternative assets - such as private credit, private equity, and real assets - could "significantly outperform" a traditional growth portfolio on a risk-adjusted basis.
The report said that the traditional growth engine of schemes still contains a large allocation to publically listed equities, and with global stock market valuations so stretched, "prospects over the near term seem bleaker".
Based on a sample portfolio as at 31 December 2018, the firm found that for a closed scheme with a 75% funding level, by replacing a portfolio of 60% global equities and 40% bonds with 60% diversified growth assets and 40% in physical gilts, trustees could maintain the expected beta while reducing funding level risk.
It also argued that the impact of a shock to global markets may be "significantly reduced" through a small allocation to hedge funds. The firm's report argued that careful selection is key when it comes to selection, as only 5% of the approximately 8,000 hedge funds worldwide merit investment by pension schemes.
Furthermore, Cambridge Associates recommended schemes should consider how they are making best use of fixed income investments to generate income, while looking to alternative markets such as high-yield private credit, royalties and long-term leasing.
Head of European pensions practice Alex Koriath said: "UK pension schemes have dramatically improved their financial position over the last decade but if they want to defend that progress they may have to examine how their growth portfolios are set up to withstand the future market environment."
He also noted that generating excess returns relative to liabilities is beneficial for even those schemes which are better funded, as investment return can help to protect against unexpected increases to liabilities due to demographic changes and to cover ongoing expenses.
Koriath added: "Trustees should be extremely selective when investing in hedge funds as so many charge high fees, employ excessive leverage and provide little transparency.
"At this point in the cycle, trustees need to reassess their growth portfolio to ensure their investments are structured to help meet their long-term objectives."
The recommendations follow warnings that pension schemes that have not hedged their liabilities could face funding issues as long-dated bond yields plummeted earlier this month, causing the curve for yields on some UK gilts and US treasuries to invert.
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