Investor: An insider's guide to the market.
Investors throughout the world are today probably breathing a huge sigh of relief due to the uplift in portfolio valuations that has been brought about by the equity bull market of 2003. After an unprecedented three-year bear market, investors faced into 2003 in a nervous and agitated state. The geopolitical environment was grim due to the all-pervasive uncertainty surrounding the Iraq war. At the end of a very weak first quarter, a fourth year of negative equity returns looked like a racing certainty.
In the UK the decline in the FTSE 100 to below the 3,500 level during the first quarter created questions about the solvency of some UK life companies and increasing anxiety about the health of UK pension funds. Several UK life companies sold equities in order to protect their solvency adding further fuel to bearish pressures.
Pension funds, on the other hand, seemed to resist the temptation to sell equities in order to reduce the risk to their portfolios of further market declines. Fortunately, the early end to the war in Iraq acted as a catalyst for an initial sharp bounce in share prices. Subsequently, successive economic data releases made it increasingly clear that a global economic recovery was emerging led by the US. From the start of the second quarter, equity markets continued to respond positively to the more upbeat economic news.
The end result is that 2003 is the first year of the new millennium when equities have outperformed other assets, and by a wide margin.
Along with their overseas counterparts, Irish pension funds suffered badly from the prolonged bear market in equities. Figures produced by Mercer showed that the average annual return from Group Pension Managed funds for the three years to end-2002 was minus 7.8 per cent. The problems facing pension funds were compounded by the fact that the estimated value of their liabilities was rising just as the value of their assets was declining.
The liabilities of pension funds stretch far into the future and actuaries estimate the present or capital value of these future outflows by discounting them, usually using the yield on long-term government bonds as the discount rate. Imagine a pension fund that has only one future payment of €1 million to make in a year's time. If the appropriate discount rate is 10 per cent, actuaries will estimate today's capital value of that liability as €0.909 million. If interest rates decline to 5 per cent, the value today of that same liability rises to €0.952 million.
Government bond yields have been declining steadily for several years leading to a sharp rise in the estimated capital values of the liabilities of pension funds.
This combined with falling asset values has resulted in many pension funds being in deficit i.e. the estimated value of liabilities are higher than the current market value of their assets. Such deficits can be resolved through a number of routes including:
1. Sponsoring companies and their employees increase their annual contributions.
2. Companies may seek to reduce the cost of future liabilities by offering their employees less-attractive pensions.
3. Companies and trustees may just decide to rely on a recovery in stock markets.
The recovery in equity markets in 2003 has taken some pressure off those funds in a weak financial position. In the nine months to end-September 2003, the average pension managed fund had risen by approximately 6.3 per cent and since then markets have risen further. Returns over three and five years are still quite weak but longer term returns are reasonable. In the 10 years to end-September 2003, the average fund produced an annual return of 8.6 per cent compared with an average inflation rate of 3.0 per cent. Therefore, the pension fund industry does have breathing space to decide upon the best way forward.
Having experienced the recent equity bear market, a key aspect of the pension fund debate concerns the appropriate strategic or long-term asset mix. Up to the recent prolonged bear market, the majority of pension trustees and their advisers believed that pension portfolios should have a high equity content. Historically, equities have produced the highest returns, and whilst volatility was also high it was felt that pension funds could withstand such volatility given their long-time horizons. In the current world of low inflation and interest rates combined with high equity market volatility, the wisdom of this approach is being seriously questioned. Among individuals, companies and trustees there is a fundamental reassessment of the risk that a pension portfolio should take and a trend towards lower equity weightings seems to be emerging.
The main alternative asset category to equities is bonds, which include bonds issued by both governments and corporations. Bonds are far less risky than equities and they have the key advantage of paying a fixed rate of interest over their lifetime. In a period of low inflation, bonds produce predictable and moderately attractive returns. Their key drawback is that they provide no protection to any unexpected upsurge in inflation.
Pension trustees and their advisers are not noted for making radical shifts in policy and it is unlikely that there will be a dramatic change to the asset mix of pension funds in 2004.
Nevertheless, an ongoing reassessment of the risk versus return equation from the alternative asset categories is likely to result in a somewhat lower average equity weighting and a higher average bond weighting across the industry.
