Comment: One of the hot topics in financial markets in recent years has been the crisis which is enveloping the pension fund system, with particular focus on the size of the deficits facing many defined benefit schemes and the impact that these deficits are likely to have on the companies that sponsor them, writes Pearse MacManus
The causes of the crisis are well known - increased longevity, low bond yields (discount rates) which increase the present value of the pension liability, and the low level of past contributions. Equity market volatility in recent years has brought the problem to the fore, a problem that was there for some time but hidden by the extraordinarily high equity market returns seen in the 1990s. To compound the problem, companies are now required under a recent accounting standards to show pension scheme deficits in their annual accounts.
It may be well-intentioned, but this accounting standard is actually exacerbating the sense of crisis, rather than generating a solution. In the late 1990s, on the back of extraordinarily strong equity market returns, many defined benefit pension plans appeared to be in surplus. Many plan sponsors used this actuarial surplus (created in large part by the under-estimation of the future pension liability) as an opportunity to inflate corporate profits by taking pension contribution holidays. The bursting of the equity market bubble and the fall in long-bond yields resulted in a massive swing from surplus to deficit for many defined benefit schemes and this in turn resulted in a raft of legislation intended to safeguard defined benefit pension plans. Unfortunately, it had the opposite effect and skewed asset allocation towards long dated bonds at a time when long-term yields have been extraordinarily low by historical standards.
In other words, pension fund assets have once again been driven towards the most expensive asset class - equities during the bubble, and bonds when yields are low.
A rational response to the pension deficit crisis is to make the pension fund assets work to reduce the deficit (as opposed to making the pension fund deficit work to reduce the pension fund assets). The most costly, but quickest, way to reduce the deficit is to plug the hole by investing the fund's assets in the low yielding bonds that provide the discount rate for the plan's liabilities.
However, this will ensure that future returns on those assets are lower than they would otherwise be, with long-dated European real yields currently just 2 per cent, having risen from a low of 1.3 per cent in early January. An alternative way to reduce the deficit in a pension fund is to invest in assets with higher risk premiums.
While this will in all probability lead to increased volatility when looking at shorter time horizons, the excess return provided by these assets over the long-term will provide a more efficient means of ensuring pension funds are fully funded - and when it comes to pensions, time is something that is very much on the side of plan sponsors, provided the focus remains on the long-term, not the short-term.
To put this into perspective with some data, the Dow Jones EuroStoxx Equity Index trades on a forward price earnings ratio (p/e) of 12.5 times, which translates into an earnings yield of 8 per cent. This is almost 6 per cent above the 30-year real yield available in European bonds, and 5.5 per cent more than European inflation.
Of course, in order to achieve the highest long-term return possible from the pension fund's assets, the choice of manager is of profound importance. An active manager with a proven, long-term track record is of critical importance to the long-term health of a pension scheme - focusing on more short-term returns can lead to a value/growth style bias, when in reality these styles often follow economic cycles, while an indexation approach can miss the global themes that are prevalent at any point in time in financial markets. This type of active approach can also add value via asset allocation towards equities when equities are cheap, and towards bonds and cash when equities are expensive.
For more mature pension plans where liability-matching is a higher short/medium term priority, a quasi-indexed approach to the investment of this portion of the pension fund assets makes sense - an active manager with tight constraints relative to the relevant index can add value via yield curve strategies and very small duration moves, but will not at any time have a large mismatch between the duration of the assets and that of the liabilities.
When choosing a manager for this portion of the pension fund's assets, the key consideration is cost. There is no point matching the return of a benchmark index if much of that return is eaten up by fees.
Ultimately, the so-called pensions crisis may be a mess that many parties had a hand in making, but there is a solution. The answer is not simply to match the liabilities and then close the fund. This may address the accounting issue but over the longer term it will be at a very high cost and, in the shorter term, will have an adverse effect on employee relations.
The solution is to adopt an investment strategy that will address the deficit by investing an appropriate proportion in equities that have the potential to reduce it rather than contain it and to ensure that the bond component is invested in a vehicle that is competitively priced. Over the long term, this approach will be more cost-effective and far more popular with the employees.
• Pearse MacManus is head of fixed income at Oppenheim Investment Managers
