Did Pension Equity Divestment Go Too Far?

(October 19, 2012) — The head of the United Kingdom’s professional actuarial body suspects defined benefit pension funds have moved too far out of equities in a bid to diversify.

Philip Scott, who has been president of the organisation since June this year, thinks the financial situation has changed and pension funds wanting to make up deficits and earn well balanced risk/return trades offs need to look back to stocks.

“We used to think equities yielded less than gilts – that reversed some time ago. At what point will these low government bond yields come back? We don’t know, but has equity divestment gone too far? Yes, I think so. And it might be time to go back into to stocks,” Scott told aiCIO.

“The safest position is to match cash flows with government bonds, so we are debating asset allocation and how far investors should go from this safe position,” said Scott, who has held the most senior positions at Aviva, one of the UK’s largest insurers and chairs the risk committee as a non-executive director at the Royal Bank of Scotland.

Over the past decade, pension funds in the United Kingdom and across Europe have been progressively moving out of equities in a bid for better portfolio diversification. Mercer Investment Consulting showed in its annual asset allocation survey this year that the average holding of equities by European pension funds had fallen from 68% in 2003 to 43% last year.

These funds’ allocations to bonds picked up some of this spare capital, but there has also been a major push into alternative assets over the last 10 years, the survey showed.

“In the 1950s actuaries encouraged pension investors to move into equities and a good chunk of the assets they now hold have come from that push,” said Scott. “We have to start asking about reinvesting in equities. We have no crystal balls on asset allocation, but we can stimulate things.”

Scott, a former equities and bond fund manager, said pension funds should be considering the returns they are getting on assets and look forward to where they might be in the near future.

He said although actuaries’ focus had long been on risk management and strategic asset allocation, risk had been overlooked by many.

“In the five years leading up to the financial crisis we seemed to be living in a risk-free wold – credit spreads seemed to suggest that was the case. A lot of the crisis occurred due to people mis-reading risk so it is no surprise that investors want to understand more about it now – and regulators want to do more to manage it.”

Scott said the magnitude and fall-out of the most recent crisis was of a magnitude not seen before in finance and it was hard to see investors, and other market participants, bouncing back to indulging in risk in the same way as they had done in the mid-2000s.

“Regulators have tried to learn from the crisis, but monetary easing can only do so much – they have used quantitative easing and lowered interest rates, they can’t do any more. Now the central banks have to work out how to wind down their balance sheets,” Scott said.

All the same, he said that investors were realising that fixed income returns were not going up while equity markets still had some way to climb to regain territory anywhere near their pre-crisis highs.

“There are lots of uncertainties, but we can already see that due to the unwinding of the crisis the growth rate is going to be lower in this decade than we have seen previously – but for pension funds, mortality improvements are likely to be slower than previously too.”

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