Everybody knows that pension funds are derisking, right?

November 6, 2014 Categories: Pension Insights

russell-investments-wire-blog-Everybody-knows
Everybody knows that pension funds are derisking, right? Except, it seems, the data.

The release of the PPF’s Purple Book 2014 last week gives us the latest comprehensive data set. As the chart below shows, having made big derisking asset allocation shifts in the noughties, pension fund asset allocations have been pretty static for a few years now.

russell-uk-pensions-asset-allocation-2006-2013

The question is, why? Given all the rhetoric around derisking, isn’t this surprising?

I’ve argued for a while now that it’s not. As I set out in my blog Flight paths on cruise control – but watch out for turbulence in January, derisking has stalled because plans can’t afford to derisk any further. Bonds are expensive, and pension funds need the returns from growth assets to help fund deficits.

You can see some of this in scheme returns data released by The Pensions Regulator. This shows that for schemes in deficit on a technical provisions basis, the investment return above gilts embedded into discount rates has been increasing. This is consistent with relying more on investment returns to fund benefits.

russell-uk-pensions-asset-graph-2

The scheme returns data also shows that over one in five schemes providing returns during 2013 have at least one contingent asset in place, compared with around one in six three years previously. I think this uptick in the use of contingent assets, together with the new defined benefit funding code which takes a softer line on finding the right balance between trustees and sponsors, presages a fall in contributions from the extraordinary levels seen in recent years.

But there is another puzzle in the PPF’s data. Roughly the asset allocations shown in the chart correspond to end March1. Over 2013, many funds saw big funding level gains, following a stonking bull run in equity markets and a relatively benign year in bond markets. In fact the’ taper tantrum’ of May 2013 worked in favour of pension fund funding levels. So how come we didn’t see a change in asset allocation as pension funds grabbed that opportunity to derisk?

I see two possible reasons. The first is that the market experience in 2013 was enough just to dig pension funds out of the hole that they’d fallen into in 2011, but not enough to allow a further derisking. That was the case for about one-third of our fiduciary management clients. The other possible reason is that funds did not act quickly enough to lock in their gains, and then saw 2014 wreak havoc on the gains made in 2013. By my estimate, the typical pension fund has lost around 8% in funding level terms so far this year. Many may be regretting today that they did not act more quickly at the end of 2013.

We can draw a few of lessons from all of this. The most important is that while we must continue to plan to derisk, we must act now to manage risk. Flight paths, journey plans, glide paths – call them what you will – are plans for risk reduction in the future. Creating diversified, efficient and market responsive portfolios is risk management now. 2014 has served as a stark reminder that risk management right now is critical to success in the future.

However, as always with investments, things are not as simple as they may first appear. My colleague David Rae’s next blog on this subject will reveal this. He will highlight that the de-risking we would have expected is actually taking place, but in the form of increased use of derivative based liability hedging, which isn’t reflected in the asset allocation charts because of it’s synthetic nature.

1The data is taken from scheme returns, which have a number of effective dates – the average effective date is 31 March.

Sorca Kelly-Scholte – Managing Director, Client Strategies & Research, EMEA

Sorca Kelly-Scholte
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