A case of the jitters

WITH CONTINUING uncertainty over the European sovereign debt crisis causing developed stock market indices to gyrate wildly, losing and gaining hundreds of points on a daily basis, pension funds face some real dilemmas.

As the director of consulting at one professional services firm points out, pension fund trustees, scheme sponsors and investment managers all have some key decisions to make.

“First and foremost, for all three groups there is the fact that the scheme already has assets in play. Some will have new contributions coming in that have to be allocated, and there you can take fresh decisions, but for the most part the choice is between sticking with the strategy you already have, or changing course in the light of the increased volatility and the increased threat of a global double-dip recession,” he says.

For the most part, businesses are opting to stay with existing strategies, with some rebalancing and tweaking. Most, for example, would already be either very underweight or would have moved out of financial assets as an equity class some time ago, given the weakness in banking stocks.

Typically in the UK, schemes will be invested in government and corporate bonds, and in equities. Through the summer, equity allocations moved to below scheme target allocations, given the volatility that there has been in equities.

“Some of them might be thinking that with equity markets looking cheap, now might be a good time to take some profit out of bonds, where performance has been good, and they will be looking for opportunistic buys in equities,” he says.

Other schemes will be going in the opposite direction, having serious worries about the possibility of equities falling still further and therefore coming out of equities, increasing their cash allocation and awaiting developments.

Chris Falconer, a senior manager within Grant Thornton’s employee benefits team, says individual employees in money purchase schemes are facing the same problems as fund managers, since they have the option to switch between funds and asset classes. They could leave things to the money purchase scheme default setup, but that raises all sorts of questions. The problem is that if they intervene and actively manage the allocation of their pension pot, the knee-jerk reaction is to be guided by media headlines and the feeling of gloom and doom.

“I have spoken with more than 1,000 employees in schemes, and what emerges is a real disconnect between what they see in media headlines and the realities of long-term investment, which is what a pension plan is,” Falconer says.

With hindsight it generally becomes clear that the most profitable investments are those made at, or near, the bottom of a down cycle, which is probably where we are right now. From that standpoint, funds and individual employees in money purchase schemes who exit equities now are simply depriving themselves of the chance of buying assets at cheaper prices.

Crunch point

“If you are making regular payments into a scheme over a lifetime, then pound cost averaging (investing the same amount at regular intervals in a security regardless of its price) smooths out the peaks and troughs in the market, and downturns are more favourable to the ultimate size of the pension pot than upturns,” Falconer says.

The crunch point is how far you are from retirement, or – in the case of a final salary pension plan – how far along in its lifecycle it is. For an employee just a year or two from retirement and still with a substantial portion of the fund in equities, the current market volatility is a real cause for concern.

“Employees close to retirement, and who are in money purchase schemes, are facing a double-whammy right now. The extremely low base rate and low yields for long-term bonds means that annuities are at very low levels. At the same time, markets have shed billions in value, so equities are depressed. The best option for someone in this predicament may well be to put off retirement for a year or two in the hope that the markets will recover,” Falconer says. Against this, we have the instance of Japan, where almost two decades on the market is still a long way off the peak it hit in the early 1990s.

There is no doubt that pension fund assets have taken a battering and that they will be in for more of the same if Europe’s sovereign debt crisis rumbles on.

Keith Guthrie, chief investment officer at Cardano, says scheme funding levels could fall by 20% or more if fears of a full-blown eurozone crisis continue to grow. “Most UK pension funds remain heavily invested in equities, and only a small proportion of their liability risks are hedged,” he says.

In particular, Cardano specialises in foreign currency (FX) and in helping pension funds to both hedge out FX risk and to treat FX as a source of growth inside the fund as an asset class in its own right. On the first point, Guthrie points out that UK funds with US equity assets have done very well not hedging their risks over the past few years, where the pound has been falling against the dollar. This has increased the value of any US equity assets that funds might be realising, and has increased the general value of the US holdings once they are translated back to US pounds for fund valuation purposes.

However, t’was not ever thus. Guthrie notes that Australian and New Zealand pension funds that were not hedged against US assets through the 2008 crash got hit with a double-whammy. The value of their assets kept plummeting, and since the Aussie and Kiwi dollars appreciated strongly against the US dollar through the crash, they also saw valuations drop sharply. Funds need to take advice and consider FX risk very carefully through the huge volatility in global currency markets. ?