Risks & opportunities for pension funds
06 November 2008
Risks & Opportunities For Pension Funds
Despite a deep bear market, many pension funds are currently better placed than commonly realised, albeit that this could change dramatically in coming months, according to analysis published today by leading investment house, Standard Life Investments.
In the latest edition of Global Insight, its monthly investment view, Standard Life Investments analyses the key drivers of pension assets and liabilities and argues that the bear market of 2007-08 has a number of important implications for pension schemes. In particular, Global Insight considers how recent developments in financial markets will encourage schemes to consider new investment techniques, increasingly required in order to meet the expectations of a good retirement income.
Andrew Milligan, Head of Global Strategy at Standard Life Investments, said:
"In recent weeks, there has been much media discussion about whether the drastic fall in share prices has materially hurt defined benefit schemes. The asset side of the balance sheet is important, but just as important are changes in how liabilities are measured, reflecting changes in inflation and longevity assumptions as well as the discount rate. Are pension schemes in deficit or in surplus? In reality, the answer depends on which assumptions are used for which group of companies. On some measures, schemes in aggregate remain in small surplus, in others there is a deficit. It is important to emphasise that the current situation reflects the sharp rise in corporate bond yields which is partially offsetting the impact of lower equity prices. It is vital to look ahead: situations where such bond yields fell back, with or without further falls in equity markets, would then lead to a sizeable deterioration in pension balances.
"The shock waves from a financial crisis last some time. Into 2010, pension schemes will need to cope with a profits recession, as well as a much more volatile inflation cycle - with potential deflation next year before a return to higher inflation thereafter. Pension schemes also have an important role as major shareholders, for example reacting to the after effects of government rescue packages such as the dilution of shareholdings in major banks and a tighter regulatory framework.
"The aftermath of the bear market has other implications for defined benefit pension schemes, for example in terms of corporate sponsors, counterparty risk and new investment techniques. Difficult discussions can be expected in some firms, about injecting cash into a pension scheme, when finance directors are focused on protecting current cash flows and bank convenants. The financial crisis has brought home to many schemes the importance of counterparty risk, for example when entering into long term inflation swaps. In addition, after two equity bear markets in only a decade, should pension schemes adopt a more dynamic approach to strategic asset allocation?
"Lastly, the bear market also has implications for defined contribution (DC) schemes. Politicians are already discussing one aspect, whether to alter rules which force investors to take an annuity at a set age even if share prices are abnormally low. A second issue to consider is how the economic recession will impact on inflows into DC schemes. Household incomes are under pressure, so it is no surprise that there are already reports of households cutting back on pension contributions to meet other bills, damaging though this is for their longer term wealth. More positively, the bear market in residential property may be an opportunity for pension schemes to re-establish themselves in the public’s consciousness. After the 2000-03 bear market, and the collapse of such firms as Equitable Life, many savers decided to look after their own pension pot. One route, for example, was buy to let residential property. This market has become much less attractive as a long term savings vehicle. Is this an opportunity for traditional pensions to fill the frame?"
