UK Pension funds facing enormous challenges after the Brexit.
10-year gilt prices registered their largest five-day rally since 2010 after the referendum, rising by more than 4% in price from Thursday, June 23, the day of the vote, to the following Thursday. The announcement by the Bank of England of new easy quantitative measures, the risk of potential interest rates cut are not going to change this trend.
For Pension funds such event as a huge impact on their balance sheet. The high increase in gilt prices means a substantial decrease in long-term interest rate which implied a fall out of the Discount rate. The discount rate is applied to calculate the value of the fund liabilities. It means that future cash flows are discounted to account for the effect of inflation. So, when the discount rate decreases, liabilities increase. In average, one percent reduction in the discount rate is equivalent to an increase of twenty percent liabilities. The necessary exposure to fixed incomes is going to deliver a poor performance in the coming years.
According to the IMF, leaving the EU would hit British living standards and wipe up to 5.5% off GDP by 2019. Regarding the high exposure to the UK market, British pension funds would not perform at their counterparts in the rest of Europe on their domestic market position.
The local real estate market would also bring a negative performance in pension fund performance. In a recent report, the Bank of England underlined its concerns over U.K. commercial real in its Financial. It said flows from foreign investors into commercial real estate fell by almost 50% in the first quarter this year. This week, some of the nation’s largest insurers and asset managers moved to stop spooked investors pulling money out of their funds. The U.K. commercial real-estate market holds in aggregate about $1.04 trillion billion worth of assets.
At the end of the year 2015, the deficit of the pension fund was estimated around 85%, versus 81% in the US and 91% in Canada. Considering the evolution of the PPF 7800 — an index of thousands of defined benefit pension schemes —, we can guess the deficit widened by 7% more since the beginning of this year. This figure does not take into consideration the future negative impact of the discount rate’s decrease.
For different reasons, – monetary policy environment, equity market volatility, macroeconomic uncertainties or regulation -, the Pension trend before the Brexit was not on the positive way for recovery. But today, the Brexit is pushing the industry to implement drastic changes in their governance and the reshape of their investment process.
Consequences are not neutral. Likely, the trend for the DB schemes will continue. Most of them will be closed to new entrances at the favour of the DC plans. The investment will be diverted away from their primary purpose, into filling pension fund deficit. Pension could need to increase the price of annuities for DB and DC schemes. In the short term, most of these measures look inevitable.
But more importantly, the Pension industry needs to implement new governance rules. Diversify its fixed income portfolios or apply some Liability Driven Investment (LDI) strategies are not going to be good enough to do the job. A pension fund following an LDI strategy focuses on the pension-fund assets in the context of the promises made to employees and pensioners. It takes as a benchmark its liabilities. LDI investment strategies have come to prominence in the UK as a result of changes in the regulatory and accounting framework. Indeed, the IAS 19 Gaap requires that UK companies post the funding position of a pension fund on the corporate sponsor’s balance sheet.
The first task for the pension fund is to find a balance between the return needed to fulfil the liabilities and the risk. It is not an easy challenge. We can have an approach to the risk and build a portfolio according to some risk factors: volatility, correlation, VAR… However, in the case of a pension fund, we have some liabilities to cover and also in the major cases some deficit to fill. Because these elements, I believe an approach by the return is more appropriate. What is the definition of performance in the multi-asset management world? Theoretically, it is a simple question. The return is the sum of the cash, the Beta – the value created from your exposure to the market-, and the Alpha, – the value created from your fund or stock picking -. The cash performance is a function of the level of interest rate decided by the Central Bank.
Regarding the current monetary policy, it is unlikely that the situation changes in the short-term or medium-term so that interest rates will remain at very low level. In consequences, no return can be expected from your cash exposure.
Talking about the Beta means talking about the asset allocation. In the case of the pension fund, we are approaching a disputable issue. What should be the asset class of the pension fund? In the US, the Yale model is still predominant in organising the asset allocation. The portfolio is split between six different types of investment: domestic equities, foreign equities, private equity, real assets (usually property), absolute return funds and bonds. In Europe, pension manager splits their investment into four different asset classes: Bond, Equity, alternatives and a fourth category which differs according to the different houses and where various investments like corporate, debt, private equity or real estate could be found. Such definition raises a lot of questions about the definition of an asset class. Is Alternative an asset class? Can we find decorrelated performance between domestic and international equities? Likely, the first work is to build an asset class division matching the return expected, the regulation in place and coming, and creating an uncorrelated asset class mix. The subject is vast and could be by itself a book’s topic. But it is clear that a higher level of economic uncertainties, greater geopolitical risks and a massive increase of threats (for instance terrorism, cyber attacks), means it is going to be harder to be reliable only on Asset allocation for long-term investors.
For the last few years, Pension Funds have diversified their source of performances, looking for Alpha, and including in their universe some alternative strategies. At the end of 2015, Pension fund had a position valued to $1.4 trillion in the alternative world including hedge fund and CTA. The experience has been mixed, and different factors can explain this. Firstly, you have a multitude of alternative strategies with various characteristics in term of products used, correlation to the risk premium, liquidity, risk variable, markets or complexity. Secondly, the analysis of a hedge fund is a bit different than a long-only strategy. The Corporate risk is more significant than a mutual fund. The life expectancy of a hedge fund is five years. The rate failure is quite stable around 20 percent. An alternative investment is more expensive than active long-only or passive strategies. The norm for the right one is still 2 percent management fees and 20 percent performance fees. Historically, in term of performance, the small and medium hedge funds in term of size overperform the large hedge fund. But the percentage of failure is much higher in the hedge fund with smaller AUM.
Such factors imply a profound and severe due diligence, not only about the quality of the investment strategy and risk management but also about the organisation, the people, the company finance, the operational side of the business and a close monitoring of the strategy’s evolution. Big pension fund recruiting professional dedicated to this task. The other decided to externalise such responsibility to companies specialised about the alternative world. Any pension fund that did that heard about this two wonderful words: “risk adjusted”. It has been the major explanation to justify an alternative portfolio not performing.
Increasing the spectrum of the investment by including new asset classes is a necessity for Pension fund. Some are fitting the target of long-term investors like infrastructures or private debt. But pension funds also need to find a balance between the ability to capture value on short term movement and their long-term objectives. This can include different options: using alternative as short term hedging, design a long-term strategy with a scenario or develop a Tactical Asset Allocation (TAA) and not only use a Strategic Asset Allocation (SAA).
You do not have a perfect combination, and the final solution depends on of the liabilities duration, the situation of the pension deficit, the resources available and the evolution of the regulation. In all case, such changes mean a revolution in term of company governance. First, most of these changes imply an increase of operational and market risk. Second, an efficient decision-making structure is a fundamental element of the success. Finally, the cost efficiency is also a key factor.
The implementation of a new governance is a challenge. Culturally, it is not going to be easy for most of the people working in the pension area. It also implies to recruit new people coming from different environments. The quality of the integration of such people is crucial to the success of these changes. Finding such people is going to be also challenging regarding the uncertainties brought by the Brexit. With the depreciation of the currency and a non-guarantee of circulation for European citizens, British Pension fund could have some difficulties to attract the best talents.