(July 16, 2012) — Pension plans may be facing their greatest challenge ever with the stubbornly low interest rate environment but schemes are still finding ways to cope.
UBS’s annual “Pension Fund Indicators 2012,” detailing the pension situation in the United Kingdom, and consultancy Mercer looked at how low interest rates have hit pension funds and suggested methods to secure real returns despite them. While the latest round of quantitative easing may push the risk-free rate further below the prevailing rate of inflation, it seems that plans are not completely out of options to earn money.
Mercer pointed to two possibilities: corporate bonds, which offer more attractive yields than gilts, or annuity “buy-ins,” which involve annuitizing pension obligations but retaining the assets within the plan.
“The pricing of corporate bonds presently looks attractive relative to gilts, even after allowing for default risk,” said Stuart Benson, partner in Mercer’s Financial Strategy Group. “In an insurance transaction, pricing can also be attractive relative to gilts, and the risk of increased costs from rising pensioner longevity is insured as part of the buy-in package. There are clearly some attractions to both routes. However, these decisions are more complex than they might look.”
With corporate bonds, the consultancy cautioned that they mature much earlier than gilts, which could increase the risk of having inadequate assets down the road. Furthermore, corporate bonds do not provide inflation risk protection, so switching from gilts to corporate bonds could increase overall risk. Likewise, pension buy-ins bring risk as well, and a plan must be careful to pick the right insurer if such a transaction is pursued.
Many pensions are also looking to alternatives to overcome negative real rates. The UBS report noted that UK pensions on average allocate 9% to alternatives, up from 1% 10 years ago.
But the authors of the UBS report sounded a bearish note, asserting that more innovation is needed if pensions are to surmount rock-bottom rates. “What is required is a more fundamental investment program engineered to generate income in a more appropriate way,” said Ian Barnes, head of UK and Ireland at UBS Global Asset Management. “The market has few such products at the moment and we encourage the industry to concentrate on developing solutions for this problem, [or] else a bad situation will be made worse.”
To read the UBS report, click here.