Calum Brunton Smith has kindly agreed to contribute the following blog for the Dalriada Trustees’ website. Calum is an Investment Consultant with KPMG and has over 7 years investment consulting experience. Calum graduated from Heriot Watt University with a BSc in Actuarial Mathematics & Statistics and is a fellow of the Faculty and Institute of Actuaries.
Over the past three years equity markets have performed very strongly, with global equities returning over 18% p.a. This has provided a significant tailwind for asset strategies, which generally have significant equity exposure and in many cases rely on equities as the primary, and in some cases ‘sole’, source of investment growth.
Whilst all ‘core’ asset classes (equities, property and corporate bonds) have performed strongly over recent years, I don’t believe that funding improvements have materialised, certainly not at the pace expected from this level of investment growth. The primary reason for this is the significant growth in the valuation placed on pension scheme liabilities, which has been driven by falling long-term interest rates over recent periods.
This position has resulted in companies and trustees asking the question “..with all this asset growth, why has our funding level not improved?”. The answer (noted above) has raised the focus on risk management for UK pension schemes.
When looking at the risk profile of an average UK pension scheme, there are typically two stand out risks:
1) Equity risk – resulting from the significant (and often undiversified) equity exposure within pension scheme investment strategies; and
2) Interest rate and inflation risk – increases in liability values resulting from yield movements which are not offset, or indeed reflected, in the bond portfolio.
These two risks are now much better understood by companies and trustees. I believe it’s also fair to say that the broad direction of travel for the UK pensions industry has been to start managing these risk (i.e. increased diversification within growth portfolios and consideration of the effectiveness of bond portfolios in matching liability movements).
The investment industry has responded to the increased appetite to manage these risks – by creating easily accessed pooled investment vehicles (e.g. Diversified Growth Funds (‘DGF’) and Liability Driven Investment (‘LDI’) funds).
Alongside this, the insurance industry has developed a range of innovative risk management solutions. There has been significant innovation on insurance solutions for small to medium sized schemes (e.g. the introduction of medically underwritten buy-in policies and also the use of more targeted insurance policies).
When considering risk management, I believe trustees should first consider what is driving risk within their scheme, prioritise which risks to focus on and then consider the full range of options available to manage these risks.
The current economic backdrop should also be factored into de-risking decisions – in terms of my views:
- I believe trustees should continue to have liability hedging high on their agenda, irrespective of where yields are currently positioned. Ultimately trustees will aim to remove this risk, hence taking a view on interest rates and inflation and reflecting this within the hedging position and/or implementation plan is a sensible direction of travel.
- Following the financial crisis, global equity markets have risen significantly, despite the sluggish GDP growth observed in most global economies. I believe equity markets are starting to look ‘fully valued’ following a period of prolonged growth and low volatility. Going forward, I expect equity markets to be more dependent on real growth for further increases, and that could be hard to come by given the current lack of wage growth and high indebtedness of consumers. I also expect to see equity volatility creep back up to more ‘normal’ levels – which may result in equity valuations suffering over some periods. On this basis, I believe there is value in trustees considering trimming equity exposure and/or introducing downside protection (e.g. equity options, volatility management, etc.).
Overall, I believe risk is now better understood within the UK pensions industry. Much of the innovation within the UK pensions investment management industry has been focused on enabling the Trustees of small to medium sized schemes better manage the risks inherent within their investment strategies.
(Please note, the views expressed above are my own and do not constitute formal advice.)
Calum Brunton Smith