DB funds should increase equity exposure: Redington

UK defined benefit pension schemes are unlikely to be fully funded until at least 2030, and probably later than that, unless they increase their allocation to equities, according to Redington, the London-based pension industry investment consultancy.

This means that the current outlook for defined benefit (DB) pension funds is bleaker than it was 10 years ago.

Lacklustre returns across most asset classes over the last decade, combined with a massive rebalancing away from equities, appears to be behind this worsening position, Redington said.

Dan Mikulskis, managing director, ALM and investment strategy at Redington, said: “While the headline funding ratio may be deteriorating, we found funding-level risk has indeed reduced over the last decade.

“This can almost all be explained by reductions in equity holding, as opposed to liability hedging. This leaves schemes expecting much less return in the future but still with substantial risk to interest rates.”

In 2006, equities represented 61% of the relevant pension funds’ holdings. By 2015 this had almost halved to 35%. Mikulskis said this low allocation to equities exposes funds to too much interest rate risk.

“A significant rise in long-dated interest rates might bail schemes out, but the potential volatility to schemes funding positions associated with holding this position is considerable,” he said.

“We believe this risk could be far better deployed by seeking returns on the asset side.”

If pension funds are to be fully-funded by 2030, they will need to generate returns of  2.5% above interest rates on cash deposits. If contribution rates fall, this could increase to a required return  of 3% above the cash rate.

Redington, however, puts current returns at just 1.7% per anum over cash.

“Our analysis indicates that if schemes took the same amount of overall risk, but focused on the asset side risks, where we believe the risks are better rewarded, then this objective would be achievable,” said Mikulskis.

Redington is an independent investment consultant to more than 60 pension funds and other long-term savings institutions, which it says are responsible for more than £350bn worth of assets. It was founded in May 2006 by Robert Gardner and Dawid Konotey-Ahulu, who remain co-chief executives of the firm.

 

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