Underfunded defined benefit (DB) pension schemes in the UK are over-dependent on historically improbable equity returns, analysis by Willis Towers Watson reveals.
The consulting firm's research found the average underfunded UK DB scheme requires equities to return 9% above cash rates on an annual basis for the whole of the next decade, or face significant deficits continuing into the 2030s.
It said comparing this requirement with historic returns from equities reveals how unlikely current allocations are to lead to full funding before the 2030s - noting the required rates of return for equities are almost three times the historic equivalent.
Willis Towers Watson said UK equities have averaged just 3.1% per annum above cash rates since comparable records started in 1704. Throughout that time, UK equities have only matched the required 9% annual rate of return over cash in 1-in-20 previous rolling decades.
Other international comparators also suggested low odds of full funding by 2030. It said with equivalent data from US equities available from 1946, average ten-year returns still amount to just 6.2% per annum relative to cash, and 9% per annum returns have only been achieved by US equities in a quarter (27%) of rolling ten-year periods since 1946.
Head of multi-asset growth solutions Katie Sims explained: "Underfunded DB schemes are effectively counting on a once-a-century equity performance if they're to wipe out deficits this decade.
"Simply putting all your eggs in one basket and hoping for unlikely events will not be enough to solve the funding gap. Pension schemes need to look outside of listed equities and adopt the mindset of an endowment investor, embracing a broad range of assets including private markets, to improve their return profile."
Sims added: "While caution is partly understandable, year by year this problem gets worse as returns will on average disappoint. Allocations that have such a low chance of delivering the right outcomes might also be seen as a form of denial. Trustees need to reimagine allocations.
"Many pension schemes and other institutional investors need to massively rethink how they anticipate creating the necessary long-term wealth to fund their future obligations. A much greater portion of portfolios need to be invested in practical real-world projects that are actively building the economy of the future. Listed equity certainly has a place in the investment mix, but schemes need to think beyond traditional allocations in order to meet the returns they need."
Methodology
Willis Towers Watson's analysis is based on the PPF 7800 index funding ratios of underfunded UK defined-benefit pension schemes as at 31 July 2020. The funding ratio was adjusted for and assumes that schemes are targeting full funding on a gilts-flat liability basis (a proxy for targeting buyout). The analysis also assumed fixed income and liability returns are in line with the UK nominal yield curve at 31 July 2020 and that schemes are fully hedging their liabilities.
The findings additionally assumed further unbroken contributions averaging 2% of assets per annum for seven years, consistent with the average contribution rate for UK DB pension schemes.
