Investing in a time of negative real yields: when 're-risking' can be 'de-risking'
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Investing in a time of negative real yields: when ‘re-risking’ can be ‘de-risking’
About Fathom Consulting
We are an independent, London-based consultancy providing bespoke
Investing in a time of negative real
project work, as well as economic analysis and forecasts for the
global economy and key asset prices. Our Global Economic Strategic yields: when ‘re-risking’ can be
Allocation Model (GESAM) places the interaction between the real
economy and financial markets at its core. Key international linkages
include capital flows across countries, which are intermediated by the
‘de-risking’
banking sector. It covers more than 170 countries – accounting for
more than 98% of global GDP.
“The UK defined-benefit pension industry’s long-standing love affair with
We specialise in pensions. Working with individual pension funds, index-linked government securities, or gilts, is well documented. At a little under
and with industry bodies, we use our proprietary model of a defined-
20%, their share in the typical scheme portfolio has almost doubled during the past
benefit scheme to consider the outlook for scheme funding under a
variety of macro-economic scenarios. Our model is stochastic, and
six years, even as the return on those assets has fallen to such an extent that anyone
provides information on the range of possible outcomes, rather than holding them to maturity is guaranteed to suffer a real terms loss. Traditionally,
simple point estimates. these investments have been seen as safe-havens. But in an environment of
negative yields and record deficits they are anything but. In this paper, we call for a
Further information and contact details:
radical rethink. Whether index-linked yields return to normal, or whether they stay
Web: www.fathom-consulting.com/services/expertise/pensions
low, we find that a reallocation out of fixed income and into equities would increase
E-mail: enquiries@fathom-consulting.com
Telephone: +44(0)20 7796 9561
the likelihood that any given scheme was able to reach a position of full funding.
Moreover, this return-seeking approach would see fewer schemes transfer to the
Pension Protection Fund, which means that fewer members would suffer a cut in
About Pension Insurance Corporation plc their benefits. Re-risking really can be de-risking.”
Pension Insurance Corporation (“PIC”) provides tailored pension
insurance buyouts and buy-ins to the trustees and sponsors of UK
defined benefit pension funds. PIC brings safety and security to
scheme members’ benefits through innovative, bespoke insurance
solutions, which include deferred premiums and the use of company
assets as part payment.
PIC has more than £16bn in assets and has insured almost 130,000
pension fund members. Clients include FTSE 100 companies,
multinationals and the public sector.
PIC is authorised by the Prudential Regulation Authority and regulated
by the Financial Conduct Authority and Prudential Regulation
Authority (FRN 454345).
For further information please visit www.pensioncorporation.com
This paper was funded by Pension Insurance Corporation as part of the company’s ongoing Thought Leadership programme
Executive Summary Table of Contents
•• Today’s environment of negative yields on index-linked gilts is doubly harmful to the funding Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
position of defined-benefit pension schemes. Not only is the real value of scheme assets eroded,
but accounting rules mean that scheme liabilities are higher than they would be in a more normal
yield environment.
1. A global phenomenon, affecting some countries more than others . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
•• It is perhaps no surprise, therefore, that despite substantial injections of additional cash from
scheme sponsors, in the form of deficit reduction contributions, scheme deficits are close to a 2. Why are UK index-linked yields negative? And when might they go up again?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
record high.
Measuring inflation risk. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
•• Declining real yields on sovereign debt are neither a recent phenomenon, nor one that is confined
to the UK. The trend is common to most major economies, where it has been in place for the best 3. Alternative investment strategies for UK DB schemes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
part of 20 years.
4. Conclusions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
•• After examining the causes of the decline, we find that the barriers to a full normalisation of UK
index-linked yields are substantial. It would require that policy makers in a number of countries,
including China, take appropriate action. And that is not going to happen overnight. Indeed,
we see a sizeable risk that it does not happen at all within a timeframe that is relevant to the
maturing UK defined-benefit sector. Appendix 1: Fathom’s DB pension model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
•• Scheme trustees have responded to the decline in index-linked yields by almost doubling the Appendix 2: Understanding the ‘normalisation’ and ‘yields stay low’ scenarios. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
share of index-linked gilts in their portfolio. At first glance, this is a curious response, and one that
merits further investigation.
•• In this paper, we use our defined-benefit pension scheme model to consider the merits of an Authors: Andrew Brigden and Danny Gabay
alternative, return-seeking strategy under two different macro-economic and financial market
scenarios.
•• We find that, whether index-linked gilt yields return to their long-run average of around
2.0%, or whether they stay low, a reallocation out of fixed income into equities would confer a
number of benefits. Understandably, the probability that any given scheme became fully funded
would increase, but surprisingly, funding uncertainty would reduce beyond the very near term.
Consequently, fewer schemes would transfer to the PPF, which means that fewer members would
see their benefits reduced.
•• Increasing the share of risk-seeking assets in the portfolio is particularly advantageous both to
poorly funded schemes, and to those that have a weak corporate sponsor.
•• Intuitively, when the trustees of an underfunded scheme increase their allocation to index-
linked gilts, they are merely swapping one form of risk for another. They are protecting members’
interests from unexpected movements in inflation. But they are simultaneously prolonging the
time it takes to return to a fully-funded position, raising the prospect that the scheme sponsor
fails before they are able to do so.
•• We find that the asset allocation of UK DB schemes has become too defensive. Schemes appear
to be positioned either for further declines in index-linked gilt yields, or for a sizeable increase in
inflation uncertainty. While we would not rule out either of these entirely, we regard them as low
probability events.
Introduction
The global economic and financial market landscape remains exceptionally challenging for the UK In our earlier work, scheme trustees were largely passive takers of whatever the global economy and
defined-benefit (DB) pensions industry. It is now more than four years since the yield on a basket of its financial markets threw at them. Although we developed simple asset allocation rules, which saw
index-linked gilts turned negative for the first time. Index-linked gilt yields have remained negative investment in fixed income assets rise with scheme funding, and with scheme maturity, these rules
and, by October 2015, were close to historic lows. Accounting regulations mean that low, and indeed were data-determined. They were calibrated using actual patterns of investment reported in the Pension
negative real rates of return on government debt are doubly harmful to scheme funding. In the present Protection Fund’s Purple Book. Here we take a different tack. We take a step back and ask instead
environment, any organisation holding index-linked gilts to maturity is guaranteed to lose money on whether the observed approach of asset allocators is a sensible one.
that investment, after adjusting for inflation. Moreover, with actuaries required to discount expected
The remainder of this report comes in four sections. In the first section, we briefly review the
future cash payments at a rate closely tied to the yield on government debt, scheme liabilities will
behaviour of index-linked yields around the world. We find that, although these have fallen globally,
increase in proportion to the decline in index-linked yields. Using data from the Pension Protection Fund
the reductions in some countries have been more marked than elsewhere. In the second section we
we estimate that, by October 2015, the aggregate funding ratio across all DB schemes was close to an
consider what light, if any, economic theory is able to shed on this phenomenon. If we are able to
all-time low – see Figure 1. With record levels of deficit reduction contributions made in recent years,
understand the causes of the steady decline in index-linked yields, then we will be better placed to
underfunded schemes have been running hard, and yet they have been unable even to keep still.
make judgments about the set of circumstances that might cause them to normalise, or indeed to stay
where they are. It is striking that, as yields have fallen, the share of UK DB scheme portfolios allocated
Figure 1: Aggregate funding ratio of UK DB schemes, s179 basis
to fixed income assets has tended to rise. In the third section, we use Fathom’s DB pension scheme
Per cent model to consider under what circumstance this might be the best strategy. We address the issue first
180 in a world where yields normalise, and second in a world where they do not. A final section concludes.
160
140
120
100
80
60
2003 2004 2005 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Source: Pension Protection Fund / Fathom
In our previous report with Pension Insurance Corporation, “Who carries the risk? Asset-allocation
challenges for defined-benefit pension schemes and their corporate sponsors on the road to buyout”,
published in December 2014, we considered the consequences for the industry of the Office for Budget
Responsibility’s latest set of long-term forecasts for the UK economy. As we noted at the time, those
forecasts were music to the ears of trustees battling large scheme deficits. Growth was expected
to average 2¼% while inflation remained close to target. Against this backdrop, there was a steady
normalisation of both index-linked and conventional yields. But we also considered a darker alternative,
where yields stayed low.
6 7
1. A global phenomenon, affecting some
countries more than others
This section examines the evolution of index-linked gilt yields over the past 30 years or so. Comparisons are Today, the largest index-linked sovereign bond markets are found in the US, the UK and France. In Figure
drawn with the experience of other sovereigns that also issue debt, the repayment of which is tied to an index 3 we show how, in each of those three countries, the weighted average yield on the entire outstanding
of consumer prices. stock of index-linked government debt has fallen dramatically, and at a fairly steady pace, since the
late 1990s. That suggests there is a global aspect to the decline in index-linked yields. And whatever
The UK was one of the first major economies to issue index-linked government debt, which it did for
explanation we put forward for the behaviour of the UK gilt market, it must take this into account.
the first time back in 1981. The market remained small until the mid-1980s, and it is from this point
that the Bank of England makes available estimates of the yield on synthetic, zero-coupon, index-
Figure 3: Index-linked sovereign yields
linked gilts. According to these data, ten-year index-linked yields were remarkably stable for a period
of some 15 years, generally trading in a range between 3% and 4% (see Figure 2). But from the late Weighted average, per cent
1990s, ten-year index-linked yields began to fall. They passed through 2% before the end of the 5 UK
decade, through 1% in the late 2000s, before finally dropping below zero in the early 2010s. What of US
4
other countries? FR
3
Figure 2: Ten-year index-linked gilt yields
2
Per cent 1
6
0
5
-1
4
-2
3
1998 2000 2002 2004 2006 2008 2010 2012 2014 2016
2
Source: Thomson Reuters Datastream / Fathom
1
0
-1
-2
1985 1990 1995 2000 2005 2010 2015
Source: Thomson Reuters Datastream / Fathom
8 9
1. A global phenomenon, affecting some countries more than others 1. A global phenomenon, affecting some countries more than others
While index-linked yields have fallen in many developed economies, UK index-linked yields are By comparing forward interest rate curves, rather than weighted-average yields, we can side step the
particularly low. By the end of October 2015, the yield across the entire outstanding stock of index- difficulties posed by marked differences in weighted-average duration across countries. In a speech given
linked gilts was around -0.8%. The equivalent figure for US Treasury Inflation-Protected Securities (TIPS) in 2014, Bank of England Chief Economist Andrew Haldane described a forward real interest rate curve
was +0.5%. It is likely that differences in the measurement of inflation in each country will account for the UK economy based on a comparison between conventional gilt yields and inflation swaps of
for some of this spread, but not all of it. The performance of UK index-linked yields is all the more varying maturities1. He drew attention to the fact that, at the time, investors were pricing in a negative
remarkable when you consider their duration. Figure 4 shows that the average duration of index-linked real rate of interest in the UK for the next 50 years. As we show in Figure 5, more than one year later,
government bonds in the UK is now in excess of 20 years, while in the US and France it is less than 10 UK real forward rates of interest are still negative at every horizon. Here, the contrast with the US is
years. On a duration-adjusted basis, it is likely that the contrast between UK index-linked yields, and more evident. As of October 2015, US real forward rates of interest turned positive within a couple of
those in other advanced economies, is greater still. years, from which point they continued to rise, peaking close to 2% in just over twenty years or so.
Figure 4: Duration of index-linked market Figure 5: Real forward rates in October 2015
Weighted average, years Per cent
25 UK 3 UK
US US
FR 2
20
1
15
0
10
-1
5
-2
0 -3
1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 0 5 10 15 20 25 30 35 40 45 50
Maturity, years
Source: Thomson Reuters Datastream / Fathom
Source: Thomson Reuters Datastream / Fathom
1
‘Twin Peaks’, speech given by Andrew Haldane at the Kenilworth Chamber of Trade on 17 October 2014.
10 11
1. A global phenomenon, affecting some countries more than others 1. A global phenomenon, affecting some countries more than others
How have asset allocators responded to the twin challenges of negative real returns on government
debt, and widening scheme deficits? In a word, defensively. Over the past six years, as UK index-linked
yields have fallen from 1.5% to as little as -1.0%, DB schemes have almost doubled their holdings of
index-linked gilts from just over 10% of all assets, to just under 20% - see Figure 62. If held to maturity,
close to one fifth of their portfolio is now guaranteed to lose money, after adjusting for inflation.
Figure 6: Asset allocation of DB schemes
Share, per cent Index-linked yield, per cent
70 2.0 Equities
All fixed income
60 1.5
Index-linked gilts
50 1.0 Index-linked yield,
(right-hand scale)
40 0.5
30 0.0
20 -0.5
10 -1.0
0 -1.5
-10 -2.0
2006 2007 2008 2009 2010 2011 2012 2013 2014
Source: Pension Protection Fund / Thomson Reuters / Fathom
Index-linked gilts are attractive to DB schemes because they offer protection against both inflation
risk and interest rate risk. By holding only index-linked gilts of an appropriate maturity, trustees can
in principle protect with certainty their current funding position. Without doubt, for a fully funded
scheme, this is a very sensible approach. But for an underfunded scheme, when determining the
allocation to index-linked gilts, there is an important trade-off to be made. On the one hand, by
allocating more to index-linked gilts, the degree of protection against a further deterioration in scheme
funding is increased. On the other hand, by allocating more to index-linked gilts, the chance that the
scheme is able to return to a position of full funding without considerable additional support from
the sponsor is reduced. By allocating more to index-linked gilts, an underfunded scheme is, in a sense,
locking-in to failure. Or, to put it another way, it is guaranteeing continued dependence on the scheme
sponsor. This trade-off becomes all the more acute in an environment of negative yields.
Have underfunded schemes achieved the correct balance between insurance, and risk-taking? A
principle objective of this paper is to provide a framework in which that question can be addressed.
2
P art of the increased allocation to index-linked gilts, and to fixed income assets in general, may be a consequence of rising maturity. With the
vast majority of schemes now closed to new members, pensions in payment account for an increasing share of scheme liabilities. Offsetting this,
scheme funding has deteriorated since 2008, which by itself should encourage a greater allocation to equities.
12 13
2. Why are UK index-linked yields negative? And when might they go up again?
2. Why are UK index-linked yields negative?
And when might they go up again?
In this section we ask what economic theory has to say about the decline in UK index-linked yields. We divide Figure 7 compares the average real return to UK government debt since 1831, with the average real rate
the explanations into those that are global, and those that are specific to the UK. of growth of the UK economy over the same period. They differ by just 0.1 percentage point. A similar
relationship holds in most other developed economies5.
Economic models that seek to explain how individuals should, over time, make best use of their finite
resources tend to invoke the concept of a global real risk-free rate of interest. In a world without risk, this is If a country’s real rate of interest tends to match its rate of economic growth so closely, why might
simultaneously the real reward to a household that saves a sum of money for a period of time, and the real real rates of interest today be so low, both in the UK and in many other developed economies?
cost to a firm that borrows a sum of money for a period of time in order to invest. Savings and investment It is important at the outset to make clear that Ramsey’s model does nothing more than explain how both
can differ within a country – when a country invests more than it saves it is running a current account a representative household and a representative firm ought to behave, if each is trying simultaneously to
deficit and borrowing from abroad. But globally, savings and investment must match, and it is variations in maximise its own welfare over time. The period when global index-linked yields began to fall coincided
the global real risk-free rate of interest that ensure this is achieved period by period3. with the emergence onto the world stage of a new economic superpower – China. China is a socialist
state, which means that many economic decisions are in effect taken not by self-interested private
Figure 7: UK growth and real yields since 1831 individuals, or by profit-maximising firms, but by a committee of central planners. Central planners,
whether deliberately or otherwise, will often allocate resources in a way that is very different from the
Averages, per cent
predictions of benchmark economic models, which tend to assume that markets are both efficient, and
3.0
perfectly competitive.
2.5
Figure 8: Domestic savings
2.0
1.5 Share of GDP, per cent
60 China
1.0
All emerging economies
50 World
0.5
0.0 40
Growth Real Yield
30
Source: Thomson Reuters Datastream / Fathom
20
How much should an individual choose to spend today, and how much should be put away for a rainy 10
day? That is one of the fundamental questions of economics. Writing in 1928, the mathematician 0
Frank Ramsey developed a framework for answering this question that is still popular today4. 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
He demonstrated that, under certain conditions, an individual should keep saving until the additional
Source: Thomson Reuters Datastream / Fathom
return to further investment – known as the marginal product of capital – falls to a level that is closely
linked to a country’s rate of economic expansion. In other words, his theory predicts a strong relationship
between the rewards to saving, measured by the real risk-free rate, and growth. And here, for once, is a
theory that appears to work.
3
If, for example, there were a sudden increase in desired savings around the world, but no change in desired investment, then the global real risk- 5
T he yields on index-linked government debt in any particular country will differ from the global real risk-free rate for a number of reasons
free rate would fall in order to bring the two into line. including: default risk; the use of unconventional monetary policy such as quantitative easing (QE); and the operation of conventional monetary
4
Ramsey, F (1928). policy, which largely determines the short-end of the index-linked curve.
14 152. Why are UK index-linked yields negative? And when might they go up again? 2. Why are UK index-linked yields negative? And when might they go up again?
Figure 9: Investment Figure 10: World real risk-free rate
Share of GDP, per cent Per cent
50 Japan 4.0
South Korea
3.5
China
40
Thailand 3.0
Malaysia
2.5
30 US
2.0
20 1.5
1.0
10
0.5
0 0
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 1990 1992 1994 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015
Source: Thomson Reuters Datastream / Fathom Source: Thomson Reuters Datastream / Fathom
Since its accession to the World Trade Organisation in 2001, China has adopted a policy of growth There is now a growing acceptance that China’s economic model of the past ten to fifteen years has been
through investment and net trade. It has run a series of large current account surpluses. Its investment, fundamentally flawed. China has invested too much, and consumed too little, driving down the global
in other words, has been more than financed through its own domestic savings. China is by some margin marginal product of capital, and by extension the global real risk free rate. And it is now starting to face
the world’s biggest saver. At almost 50%, its domestic savings as a proportion of its GDP is double the consequences – which in our view are likely to include a full-blown banking crisis in China. Figure
the global average – see Figure 8. And it is substantially higher than the average even for emerging 10 shows a measure of the global marginal product of capital derived from GESAM, Fathom’s global
economies. By the late 1990s, China was already investing heavily, though its investment-to-GDP ratio economic and financial market model. It has tracked index-linked yields around the world remarkably
fell some way short of the peaks reached by the so-called ‘Asian Tigers’, including Malaysia and Thailand closely.
– see Figure 9. During the early 2000s, China stepped up its investment, using around 40% of its annual
There are alternative explanations for the downward trend in index-linked yields. A number of
output to raise its productive capacity. When the global financial crisis hit, and demand for China’s
prominent economists blame secular stagnation. Born out of the experience of the Great Depression,
exports fell, the central planners in Beijing chose to support economic growth by investing even more.
and now associated with the views of former US Treasury Secretary Larry Summers among others,
By 2014 China’s investment-to-GDP ratio was among the largest ever recorded, anywhere in the world.
secular stagnation is used to describe a prolonged period of slow growth. Opinions differ as to the
underlying cause, even among its proponents. Some pin the blame on deteriorating demographic trends
and deficient demand, while others point to a slowdown in the rate of technological innovation.
16 172. Why are UK index-linked yields negative? And when might they go up again? 2. Why are UK index-linked yields negative? And when might they go up again?
Figure 11: UK labour productivity Figure 12: UK bank lending to non-financial corporates
Index of output per hour, 2000 = 100 £ bilions per quarter
140 25
120 20
100 15
80 10
60 5
40 0
20 -5
0 -10
1850 1875 1900 1925 1950 1975 2000 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Source: Thomson Reuters Datastream / Fathom Source: Thomson Reuters Datastream / Fathom
We doubt that a period of secular stagnation is able to account for much, if any of the downward trend In our view, there are two main elements to the downward trend in UK index-linked yields – a trend
in index-linked yields around the world. Despite its ageing population, US growth remains strong. In its that has been in place for the best part of 20 years. The first is global, and relates to a prolonged period
October 2015 World Economic Outlook, the IMF forecast that it would expand by 2.6% in 2015, not far of over-investment by China – on some measures the world’s largest economy. This has driven down
from its long-term average. Growth next year was expected to rise to 2.8%. And growth in US productivity the marginal product of capital, and with it the global real risk-free rate of interest6. The second is UK
has held up relatively well too, particularly in comparison to other major economies. The same cannot specific. To quote from an article in the Bank of England Quarterly Bulletin, since the crisis hit in 2008
be said of the UK, however. In the seven years since the crisis hit, UK productivity has barely grown at there has been ‘reduced investment in physical and intangible capital, … impaired resource allocation,
all. According to latest estimates, in the seven years through to 2014, output per hour worked in the UK and unusually high firm survival rates’7. In short, the UK economy is not operating as efficiently as it
economy grew at an average annual rate of less than 0.1%, well below its long-term average rate of used to do, in large part because its banking system remains impaired. In turn, that has lowered the
growth of close to 2.0%. As we show in Figure 11, for UK labour productivity to drift sideways for a period UK’s sustainable rate of economic growth, and with it UK index-linked yields.
of seven years is unprecedented. Fathom’s long-held view is that the dire performance of UK productivity
If we are right, then UK index-linked yields will remain low unless and until China does the right thing,
since 2008 is a direct consequence of the financial crisis, and of the response of policy makers to that
and rebalances its economy away from investment towards consumption. But that is only part of the
crisis. A long period of near-zero interest rates has allowed unproductive firms to remain in business.
solution. We would also need to see a radically different approach from UK policy makers. In order to
At the same time banks, fearing a significant downturn in the quality of their assets once interest rates
address the nation’s productivity crisis, UK banks are likely to require further recapitalisation, so that
begin to rise, have been unwilling to lend to companies, and to small- and medium-sized enterprises
they are confident enough to lend to innovative new start-ups. Meanwhile older, less productive firms
(SMEs) in particular. As we show in Figure 12, and in contrast to the situation in the US, UK bank lending
should be allowed to fail. In short, the barriers to a full normalisation of UK index-linked yields are
to non-financial corporations has fallen in almost every quarter since the crisis began.
considerable. Full normalisation is not going to take place overnight. Indeed, we see a genuine risk that
it does not take place at all – at least not on a timescale that is relevant to the maturing UK DB sector.
6
More recently, the QE policies adopted by a number of major central banks will have added further downward impetus.
7
Barnett et al. (2014).
18 19Measuring inflation risk
On reaching retirement, members of a defined-benefit pension scheme will typically be entitled to receive, Figure A: UK RPI Inflation
each year, a sum of money the size of which is linked to the Retail Prices Index (RPI). From the perspective
Per cent
of scheme trustees, this means that uncertainty about the future level of the RPI creates uncertainty about
25
scheme liabilities. It is, in short, a source of funding risk.
20
Conceptually, there are two elements to inflation risk. The first is the size of unexpected movements in
inflation – or inflation ‘shocks’ – from one year to the next. The second is their persistence. When inflation 15
rises unexpectedly, does it return quickly to its usual level, or does it remain elevated for a number of
years? Imagine there is an unexpected increase in inflation of one percentage point. How will that affect 10
scheme liabilities? In an economy where inflation returns quickly to its usual level, so that inflation at
5
time t+1 does not depend at all on inflation at time t, then an unexpected increase in inflation of one
percentage point will raise the expected level of prices at all points in the future by precisely 1%. It will 0
therefore raise index-linked liabilities by 1%. At the other extreme, in an economy where there is no mean
-5
reversion in inflation, so that an investor’s best guess about inflation next year is that it will be the same
1950 1960 1970 1980 1990 2000 2010
as it was this year, the effects are much more pernicious. An unexpected increase in inflation of one
percentage point will raise the expected level of prices by 1% in the first year, 2% in the second year, 3% in Source: Thomson Reuters Datastream / Fathom
the third year and so on. The impact on the price level rises without bound the further out one looks. To a
large extent, the persistence of shocks to inflation is a consequence of the objectives, and the effectiveness
of monetary policy. Figure B: UK Inflation Persistence10
It is possible to test, statistically, for both the size and the persistence of inflation shocks. In doing so, Long-run impact on the price level of a percentage point shock to inflation11
and using more than two centuries of data, we find evidence that recent inflation shocks have tended 5
to be small in comparison to the average of the past8. Interestingly, we also find that they have been less
persistent. Figure A shows actual RPI inflation since 1950. Casual observation suggests that, since the early 4
1990s, RPI inflation has had a well-defined mean. The same is true of the period running up to the first oil
shock in the early 1970s. Figure B shows the estimated long-run impact of a one percentage point shock 3
to inflation on the price level9. There are periods through the 1970s where that impact was unbounded –
and inflation displayed no mean reversion. More recently, that long-run impact has been at or below one, 2
suggesting that inflation shocks have no persistence at all.
1
Since UK policy makers began targeting inflation in the early 1990s, it appears that inflation shocks have
not only been smaller, they have been less persistent. The first of these observations may be coincidence, 0
but the second is an intended consequence of the current monetary policy framework. For now at least, 1950 1960 1970 1980 1990 2000 2010
the benefits of hedging against inflation risk may be smaller than they once were.
Source: Thomson Reuters Datastream / Fathom
8
We estimated a simple AR(1) model of inflation over the period from 1752 to 2014. The standard deviation of the residual from that model is 10
Shaded areas indicate periods where the long-run impact is statistically significantly greater than one.
1.6% over the past ten years, but 6.5% over the full sample. 11
F or brief periods in the 1970s inflation displayed no mean reversion at all. This meant that, in theory at least, the long-run impact on the price
9
It is derived from the same simple AR(1) model described above, but estimated as a rolling regression with a window length of ten years. level of a percentage point shock to inflation was unbounded. No data are shown for these periods.
20 213. Alternative investment strategies for UK DB schemes
3. Alternative investment strategies for UK
DB schemes
In this section we evaluate the likely performance of schemes in aggregate, and of specific classes of scheme, Figure 13 records the distribution of possible future funding ratios of the more than 6,000 schemes
under both a benchmark asset allocation, and a return-seeking alternative. We do this both in a world where currently monitored by the Pension Protection Fund (PPF) under the ‘normalisation’ scenario. Figure 14
UK index-linked yields normalise, and in a world where they do not. repeats the exercise for the ‘yields stay low’ scenario. In each case, we assume that schemes follow simple
asset allocation rules calibrated according to data presented in section 7 of the 2014 Purple Book. Put
The results in this section are derived from Fathom’s DB pension scheme model, described in more
simply, these imply that around 80% of the portfolio is invested in equities and fixed income, with the
detail in Appendix 1. The model is stochastic, which means that, instead of presenting point estimates
remainder distributed between cash, property and other investments, including hedge funds. For any
for scheme funding under a variety of macro-economic and financial market scenarios, we are instead
individual scheme, the split between equities and fixed income is a function of scheme funding and
able to assess the whole distribution of possible outcomes, taking into account uncertainty about asset
scheme maturity, with better-funded, more mature schemes holding a greater proportion in fixed income
returns, inflation and other major determinants of scheme funding.
and vice versa.
Figure 13: Normalisation scenario, funding distribution, benchmark AA In the ‘normalisation’ scenario, where index-linked yields climb steadily towards their long-run average of
2% over the next five to six years, the median scheme becomes fully funded by 201712. It reaches a buyout
Assets as a share of liabilities, per cent
level of funding, which we define as a situation where assets are equal to 125% of the technical
130 95th percentile
50th percentile
provisions, some three years later. Even in this relatively optimistic scenario, we find that a little over 5% of
5th percentile schemes fail to reach a position of full funding within the next 20 years. These are likely to include:
110
schemes that were poorly funded to start with; schemes that had a weak corporate sponsor; and schemes
90
that suffered a particularly poor set of returns on their investments. In the ‘yields stay low’ scenario, the
median scheme remains underfunded for longer. And even 20 years from now, more than 10% of schemes
70
remain underfunded in this scenario. The question for us is, by pursuing an alternative investment strategy,
could the universe of schemes do better?
50
Figure 15: Equity allocation as a function of funding
30
2016 2018 2020 2022 2024 2026 2028 2030 2032 2034 Equity allocation, per cent
80
Source: Fathom
70
60
Figure 14: Yields stay low scenario, funding distribution, benchmark AA
50
Assets as a share of liabilities, per cent
130 95th percentile 40
50th percentile
5th percentile 30
110
20
90
30 40 50 60 70 80 90 100
Funding ratio, per cent
70
Source: Pension Protection Fund / Fathom
50
30
2016 2018 2020 2022 2024 2026 2028 2030 2032 2034
Source: Fathom 12
More detail on the assumptions underpinning asset returns in each scenario can be found in Appendix 2.
22 233. Alternative investment strategies for UK DB schemes 3. Alternative investment strategies for UK DB schemes
Figure 16: Equity allocation as a function of maturity Figure 17: Asset allocation strategies
Equity allocation, per cent Share of equity and bond portfolio, per cent
80 60 Bonds
Equities
70 55
60 50
50
45
40
40
30
35
Benchmark Optimal, yields stay low Optimal, normalisation
20
0 10 20 30 40 50 60 70 80 90 100
Source: Fathom
Share of pensioner liabilities in all liabilities, per cent
Source: Pension Protection Fund / Fathom
Figure 17 shows the suggested reallocation for both the ‘normalisation’ and ‘yields stay low’ scenarios.
It focuses purely on the equity and fixed income portfolios – allocations to other asset classes are
Figures 15 and 16 show the calibrated, non-linear decision rules that make the benchmark allocation unchanged. In the benchmark allocation, the median scheme allocates 56% of its combined equity and
to equities a function of both scheme maturity, and scheme funding13. What we are contemplating is a fixed income portfolio to fixed income, and 44% to equities, giving a spread of twelve percentage points in
reallocation out of fixed income and into equities that makes the allocation to equities higher at every favour of fixed income. Even in a world where yields remain low, our optimiser suggests this spread should
level of scheme maturity, and at every level of scheme funding, while still allowing for substitution out narrow to just over six percentage points. In a world where yields normalise, the spread should go through
of equities and into fixed income as maturity rises and funding improves. To keep the problem tractable, zero. In other words, the median scheme should hold more equities than fixed income.
we consider only reallocations that generate a parallel upward shift in each of the curves shown
in Figures 15 and 16. And to simplify things still further, we seek a reallocation that maximises the Figure 18: Probability that a randomly chosen scheme is fully funded
expected return to the portfolio, while keeping the variance of expected returns constant. We do this
Per cent
without regard to funding uncertainty. In other words, we look for a return-seeking reallocation that
100
deliberately ignores liability-driven investment considerations altogether. ‘Normalisation’, alternative AA
‘Normalisation’, benchmark AA
‘Yields stay low’, alternative AA
80
‘Yields stay low’, benchmark AA
60
40
20
0
2014 2016 2018 2020 2022 2024 2026 2028 2030 2032 2034
Source: Fathom
13
here the rules conflict, which they will do more or less all of the time, we make the actual allocation to equities a simple average of the
W
requirement of each rule.
24 253. Alternative investment strategies for UK DB schemes 3. Alternative investment strategies for UK DB schemes
How would the DB universe fare if it adopted these reallocations? Let us consider first the implications Figure 20
for scheme funding. Figure 18 records the probability that a scheme chosen at random is fully funded at
each point in time from 2015 through to 2034. It does this for both the benchmark and the alternative, Performance of the universe of DB schemes in different states of the world
or return-seeking allocations in each of our two states of the world. A key finding is that the return-
'Normalisation' scenario ‘Yields stay low' scenario
seeking reallocation increases the chances that a scheme is fully funded at every horizon, and in each
Benchmark AA Alternative AA Difference Benchmark AA Alternative AA Difference
state of the world. This is hardly rocket science. It should come as no great surprise that a reallocation
in favour of assets with a higher expected return raises the chance that any scheme chosen at random Probability fully funded in
82.1 88.2 6.2 71.6 76.9 5.3
10 years, per cent
reaches a position of full funding. What is perhaps more surprising is that it appears to achieve this at
Standard deviation of funding
very little cost. 18.1 15.1 -3.0 23.1 21.5 -1.6
ratio in 10 years, percentage points
Present value of DRCs over
Figure 19: Funding uncertainty 20 years, £ billions
127.6 97.6 -30.0 416.6 356.3 -60.3
Standard deviation of universe of funding ratios, percentage points
As a share of initial assets, per cent 10.0 7.6 -2.4 32.9 28.1 -4.8
30 ‘Normalisation’, alternative AA Probability sponsor bust in
9.0 8.1 -0.9 11.4 10.7 -0.7
‘Normalisation’, benchmark AA 20 years, per cent
25 ‘Yields stay low’, alternative AA Present value of deficits
‘Yields stay low’, benchmark AA transferred to PPF over 20 years, 8.5 6.1 -2.5 26.0 24.2 -1.8
20 £ billions
As a share of initial liabilities,
15 0.5 0.4 -0.1 1.5 1.4 -0.1
per cent
10
Source: Fathom
5
0 From society’s perspective, it could be said that the ultimate arbiter of the value of a proposed reallocation of
2014 2016 2018 2020 2022 2024 2026 2028 2030 2032 2034
assets lies in a comparison of the magnitude of the deficits that one would expect to be transferred to the PPF in
Source: Fathom each case. We assume that, when a scheme loses its corporate sponsor before it has become fully funded on a
section 179 basis, then its assets and its liabilities are transferred to the PPF. This imposes a cost on scheme
members, who receive less generous benefits. Because the PPF is a public body, it also imposes a cost on society
Figure 19 records the standard deviation of possible future funding ratios across the universe of DB at large. In Figure 20, we provide a number of summary statistics relating to the universe of DB schemes, for each
schemes from 2015 through to 2034, for each allocation and in each state of the world. In the short allocation and in each state of the world. Under the benchmark allocation, the present value of deficits transferred
run, the alternative, return-seeking allocation raises funding uncertainty, in part because each scheme is to the PPF is around three times as large in the ‘yields stay low’ scenario as it is in the ‘normalisation’ scenario14.
more exposed to unexpected movements in inflation. But the increase in uncertainty is both very small, But, more importantly, the present value of deficits transferred to the PPF is lower under the alternative, risk-
and short lived. Within about three years, funding uncertainty is actually lower under the alternative seeking allocation regardless of the state of the world. It is almost 30% lower in the ‘normalisation’ scenario and
allocation, even though it appears to leave the scheme more exposed to inflation risk. The reason is that close to 10% lower in the ‘yields remain low’ scenario. The alternative allocation is also more attractive from the
the alternative, return-seeking allocation propels each scheme more rapidly towards a buyout level of perspective of the corporate sponsor, who makes fewer deficit reduction contributions, and faces a lower
funding. As the funding position improves, it de-risks. And when it reaches a buyout level of funding, it prospect of failure, in each state of the world.
de-risks completely by transferring its assets and its liabilities to an insurer. Moreover, and as we set out
in a box on pages 20-21 of this report, since the current framework for monetary policy was established
in the early- to mid-1990s, inflation has been unusually predictable. Inflation risk – for now at least – is
not what it used to be.
14
The PPF publishes its own forecasts for the magnitude of the deficits it is likely receive. According to Chart 6.3 on page 16 of its July 2015 ‘Long-
Term Funding Strategy Update’, cumulative transfers over the next 15 years are projected to be around £7.5 billion. Results from our own model
suggest that, in the ‘normalisation’ scenario, using the benchmark allocation, they will be a little higher at £10.0 billion.
26 273. Alternative investment strategies for UK DB schemes 3. Alternative investment strategies for UK DB schemes
The discussion so far has concentrated on the universe of DB schemes. But are there certain classes of scheme for Figure 21
which an alternative, return-seeking allocation would be particularly attractive? Equally, are there other classes of
scheme who would be better advised to stay as they are? In an attempt to address these issues, we compare Performance of poorly-funded and well-funded schemes in different states of the world
results for four scheme archetypes, both with each other, and with the general population of schemes.
'Normalisation' scenario ‘Yields stay low' scenario
Figure 21 presents separate summary statistics for schemes that start out well-funded, and for those that start
Benchmark AA Alternative AA Difference Benchmark AA Alternative AA Difference
out poorly-funded. Figure 22 presents separate summary statistics for schemes that start out with a strong
corporate sponsor, and for those that start out with a weak corporate sponsor. Schemes with low initial funding ratio15
Probability fully funded in
51.8 64.0 12.1 44.6 49.6 5.0
The results are largely as one might expect. The alternative, return-seeking allocation benefits poorly- 10 years, per cent
funded schemes more than it benefits well-funded ones, regardless of the state of the world. That is Standard deviation of funding
23.3 22.2 -1.0 26.3 26.2 -0.1
because it raises the probability that a poorly-funded scheme becomes fully-funded by more than it ratio in 10 years, percentage points
does the probability that a well-funded scheme becomes fully funded. And the alternative, return- Present value of DRCs over
80.1 63.9 -16.2 191.1 170.0 -21.0
20 years, £ billions
seeking allocation should be more attractive to trustees of schemes with a weak corporate sponsor than
to trustees of schemes with a strong corporate sponsor. As a share of initial liabilities, the reduction in As a share of initial assets, per cent 38.8 30.6 -8.2 93.8 83.8 -10.0
the present value of section 179 deficits transferred to the PPF resulting from the reallocation is around Probability sponsor bust in
10.7 9.0 -1.7 13.8 13.5 -0.4
twenty times larger for schemes with a weak sponsor than it is for schemes with a strong sponsor. 20 years, per cent
Present value of deficits transferred
6.4 4.8 -1.6 18.5 16.7 -1.8
to PPF over 20 years, £ billions
As a share of initial liabilities,
1.5 1.1 -0.4 4.4 3.9 -0.4
per cent
Schemes with high initial funding ratio16
Probability fully funded in
99.4 99.9 0.5 95.0 97.3 2.3
10 years, per cent
Standard deviation of funding
3.7 1.2 -2.5 10.5 7.8 -2.7
ratio in 10 years, percentage points
Present value of DRCs over
3.8 3.5 -0.2 32.3 27.3 -5.0
20 years, £ billions
As a share of initial assets, per cent 0.9 0.8 -0.1 7.5 6.3 -1.2
Probability sponsor bust in
7.3 7.5 0.2 8.7 8.0 -0.7
20 years, per cent
Present value of deficits transferred
0.2 0.1 -0.1 1.7 2.2 0.5
to PPF over 20 years, £ billions
As a share of initial liabilities,
0.0 0.0 0.0 0.4 0.5 0.1
per cent
Source: Fathom
15
Schemes with an initial funding ratio in the lower quartile of all initial funding ratios
16
Schemes with an initial funding ratio in the upper quartile of all initial funding ratios
28 293. Alternative investment strategies for UK DB schemes
4. Conclusions
Figure 22 Index-linked gilt yields have been negative for more than four years and are close to record lows. Falling
real yields on government debt are neither a recent phenomenon, nor one that is specific to the UK. The
Performance of schemes with a weak and a strong sponsor in different states of the world trend is common to most major economies, and it has been in place for the best part of 20 years. We
have argued that a full normalisation of UK index-linked yields, which are lower than those seen in a
'Normalisation' scenario ‘Yields stay low' scenario
number of other countries, including the US, would require both a rebalancing of China’s economy, and
Benchmark AA Alternative AA Difference Benchmark AA Alternative AA Difference
a radically different approach from UK policy makers towards the UK productivity crisis. These changes
Schemes with weak sponsor17 will not happen overnight, and indeed may not happen at all on a timescale that is relevant to the
maturing UK DB sector.
Probability fully funded in
79.2 86.8 7.6 67.6 74.6 7.0
10 years, per cent
UK DB schemes have responded to the decline in index-linked yields by almost doubling their exposure
Standard deviation of funding ratio to index-linked gilts. Taking into account the fact that the vast majority of UK DB schemes are
21.3 17.3 -4.0 25.8 23.9 -1.9
in 10 years, percentage points
underfunded, this strategy appears defensive. In this paper we have evaluated an alternative, return-
Present value of DRCs over
20 years, £ billions
26.8 21.1 -5.7 90.7 78.1 -12.6 seeking strategy under two different macro-economic and financial market scenarios. In a world where
yields normalise over a number of years, we find that a sizeable reallocation requiring schemes to hold
As a share of initial assets, per cent 8.4 6.5 -1.9 28.8 24.7 -4.1
more equities than fixed-income assets could deliver significant benefits. The probability that any given
Probability sponsor bust in scheme became fully funded would increase, while funding uncertainty would reduce beyond the very
26.0 24.1 -2.0 30.7 29.7 -1.0
20 years, per cent
near term. Fewer schemes would transfer to the PPF, which means that fewer members would see their
Present value of deficits transferred
to PPF over 20 years, £ billions
7.7 4.8 -2.9 23.8 19.3 -4.5 benefits reduced. The present value of deficit reduction contributions would be lower, which might
benefit society if it lead to greater investment in fixed capital. The reallocation would be of particular
As a share of initial liabilities,
1.8 1.1 -0.7 5.6 4.6 -1.1 benefit to poorly-funded schemes, and to those with a weak corporate sponsor. In a world where yields
per cent
stay low, the ideal reallocation out of fixed income and into equities would be smaller. Nevertheless, it
Schemes with strong sponsor18
would confer similar benefits.
Probability fully funded in It goes more or less without saying that a group of trustees who chose to reallocate out of fixed income
83.4 88.2 4.8 73.8 78.2 4.3
10 years, per cent
and into equities on the eve of the global financial crisis would be regretting that decision today.
Standard deviation of funding ratio
in 10 years, percentage points
16.3 14.6 -1.7 21.5 20.0 -1.5 Between December 2007 and October 2015, the average annual return to UK equities has been more
than two percentage points below the average annual return to conventional gilts.
Present value of DRCs over
34.3 27.4 -6.9 113.6 95.7 -17.9
20 years, £ billions
Clearly, re-risking does not pay off in all circumstances. Specifically, re-risking would not pay off if
As a share of initial assets, per cent 10.7 8.7 -2.1 35.7 30.3 -5.4 index-linked yields were to fall materially from here, nor would it pay off if there were a significant
Probability sponsor bust in
0.4 0.1 -0.2 1.1 0.8 -0.4
change in the monetary policy framework, such as a doubling of the inflation target. While we cannot
20 years, per cent
rule out either of these options entirely, we regard them as low probability events. That is why we
Present value of deficits transferred conclude that, in recent years, the asset allocation of UK DB schemes has become too defensive. A
0.2 0.1 -0.1 1.5 1.3 -0.2
to PPF over 20 years, £ billions
reallocation out of fixed income and into equities would prove beneficial, particularly to poorly-funded
As a share of initial liabilities,
per cent
0.0 0.0 0.0 0.4 0.3 -0.1 schemes with a weak corporate sponsor, in what we see as some of the more likely macro-economic
and financial market scenarios.
Source: Fathom
17
Sponsors financial liabilities as a proportion of its financial assets are in the upper quartile
18
Sponsors financial liabilities as a proportion of its financial assets are in the lower quartile
30 31Appendix 1: Fathom’s DB pension model Appendix 2: Understanding the ‘normalisation’
and ‘yields stay low’ scenarios
Fathom’s DB pension model takes a bottom-up approach to the calculation of scheme liabilities. In the ‘normalisation’ scenario, index-linked yields return to their long-run average of around 2% over
We assume that the sponsoring firm employs a mixture of male and female staff of all ages that is a period of seven to eight years. Inflation expectations remain close to target. With an inflation risk
representative of the UK workforce as a whole, as measured by the Office for National Statistics (ONS). premium on conventional gilts of around half a percentage point, this means that conventional yields
Active scheme members receive a level of pay commensurate with their age and their sex as reported peak at just over 5% in this scenario. Equity returns are determined by a dividend discount model, with
in the Annual Survey of Hours and Earnings (ASHE). Each year, an active member of the scheme resigns the equity risk premium (ERP) set at 4%. That is a little below the average observed excess return to UK
from the firm with fixed probability q and becomes a deferred member. The parameter q was chosen equities since the 1930s19. Equities suffer in the short term in this scenario as the discount rate rises.
so that, given a plausible set of mortality assumptions, the predicted mix of active members, deferred Thereafter, they return close to 9% per annum in cash terms.
members and pensioners was representative of the national average as recorded in the Pension
In the ‘yields stay low’ scenario, index-linked yields fail to turn positive, drifting between -1% and
Protection Fund’s Purple Book for 2014. We assume that all benefits accrued since 1997 have been
0%. Conventional yields are correspondingly weaker. Equities suffer less in the short term – there
indexed to RPI under an LPI 0-5 rule. Finally, we assume that the scheme closed to new members in
is no sudden rise in the discount rate. But they perform less well further out than they do in the
2007. We took this decision on the grounds that, at that time, the proportion of DB schemes that were
‘normalisation’ scenario.
closed to new members was close to 50%.
Rather than focus on just a single scheme, we attempt to capture the distribution of possible outcomes
across all DB schemes. To achieve this, we run a large number of stochastic simulations so that, in
addition to modelling the impact of uncertain asset returns, we are able to consider the prospects for a
wide spectrum of schemes, including those that start out with both weak and strong funding positions.
Specifically, we assume that initial funding ratios across all schemes are normally distributed, with
parameters based on data provided in the PPF’s Purple Book for 2014.
We employ two simple asset allocation rules that make the allocation to fixed income an increasing, and
the allocation to equities, a decreasing function of scheme maturity and scheme funding. As with the
initial funding ratio, we calibrate the asset allocation rules using data provided by the PPF. The Purple
Book contains information on the portfolio of assets that are held by schemes with a funding ratio
that falls into one of four ranges, and by schemes with a share of pension-in-payment liabilities in all
liabilities that falls into one of five ranges. We used the method of polynomial regression to estimate
two smooth decision rules. One makes the proportion of all assets that are allocated to equities a non-
linear function of the funding ratio, while another makes the proportion of all assets that are allocated
to equities a non-linear function of scheme maturity. The two rules are illustrated in the main text in
Figures 15 and 16.
19
Some investors argue that the ERP is lower than it used to be. We have investigated the sensitivity of our results to alternative assumptions
about this key parameter. We find that, even if the ERP is a low as 2%, our main finding still holds. A reallocation out of fixed income into
equities both improves the likelihood of achieving a position of full funding while lowering the present value of PPF transfers, even if the ERP is
as low as 2%.
32 33References
Barnett, A, Batten, S, Frankin, J and Sebastia-Barriel, M (2014) ‘The UK productivity puzzle’, Bank of England Quarterly Bulletin, pp. 114-126.
Ramsey, F (1928) ‘A mathematical theory of saving’, Economic Journal, Vol. 38, No. 52, pp. 543-559.
Disclaimer
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by law, Pension Corporation, its members, employees and agents do not accept or assume any liability, responsibility or duty of care for any
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