Budget headwinds mean pension funds must be nimble

We have become well accustomed to regular and frequent changes to pension policy and allowances. It is therefore a welcome relief that there was no such tinkering for pension funds to contend with this time.

While the lack of any pensions-specific changes was appreciated, the Budget was not short on issues that represent real challenges for the pensions industry to contend with.

Anaemic GDP growth in the UK

The Budget headlines, of course, focused on the new Office for Budget Responsibility forecasts for weaker productivity, business, and GDP growth over the next five-year forecast period.

The chancellor was forced to present the worst official growth forecasts since November 1983.

As damning as the latest statistics may be, they do little to fundamentally alter the UK’s unattractiveness as an investment opportunity.

The uncertainty surrounding the Brexit negotiations and the UK’s departure from the EU is a major headwind for investment. Pension investors need to continue to look further afield for the best investment opportunities.

In an environment where many asset classes look expensive, pension funds need to maintain a disciplined approach to identifying and appraising investment opportunities, and be nimble to include them within their portfolios.

With US equity valuations looking particularly expensive, some opportunities exist in other regions, including Europe and Japan.

Exposure to emerging markets, both through equity and debt instruments, present some of the best areas for pension funds to generate growth. However, they do involve market-specific idiosyncratic risk, as well as being particularly susceptible to the future path of the dollar.

Fiscal weakness and gilt issuance

Alongside the Budget announcement and the OBR forecasts, the Debt Management Office also presents its gilt remit and issuance projections.

In the near term there is very little change to the projected gilt issuance, as this year’s government revenues have fared better than predicted.

However, the medium term sees a notable increase in the expected gilt issuance. With a forecast reduction of almost £60bn in tax receipts, there is a significant increase in the central government net cash requirement.

The DMO is forecasting an almost £55bn increase in debt issuance between now and April 2022.

Defined benefit pension funds have been on a constant search for gilts, particularly index-linked gilts, to hedge liability valuation risks. The greater forecast issuance in later years should present opportunities for those pension funds still searching for longer-dated interest rate and inflation exposure.

The exact timing and issuance profile remains uncertain, so the requirement to be nimble holds true here too.

Despite the greater issuance, weakening growth is going to keep long-term interest rates at relatively low levels. DB pension funds need to budget for a slow grind back to full funding, rather than expecting a marked reduction in their liability values.

Patient capital

The sole mention of pensions came in relation to Damon Buffini’s Patient Capital Review. The government continues to look for ways to encourage pension fund assets into early stage investments, technology and infrastructure.

However, with most corporate DB pension funds closed to new members and future accruals, these are not the most natural of investments.

Most maturing schemes are looking for more stable return patterns and would prefer to explore more esoteric segments of the fixed income and credit markets rather than private equity.

‘Box office Phil’ did not disappoint with a fairly unspectacular Budget. The reality of course is that his hands remain tied by Brexit uncertainty.

All in all, the Budget reinforced the critical need for pension funds to diversify, remain fleet of foot and adopt strong risk management processes.

David Rae is head of client strategy and research at Russell Investments