How DB and DC funds can outsmart prolonged low yields

The growth outlook remains solid, despite a weak first quarter reading for 2015 of 0.3 per cent GDP growth, according to the Office for National Statistics.

Meanwhile, the timelier – and less revised – purchasing managers’ indices show growth is likely to remain nearer 0.7–0.8 per cent a quarter.

Further, the Bank of England’s Monetary Policy Committee has indicated it is in little hurry to tighten monetary policy, given the weak headline consumer price index and benign inflationary pressure, which is certainly an aid to economic recovery.

To assess the medium-term prospect of inflation, at Pimco we strip out the volatile food and energy components to look at core CPI, now running at just 1 per cent.

Resilient UK growth, continued employment expansion and rising nominal wages will begin to put some upward pressure on core inflation over the course of 2015.

However, sterling has appreciated on a trade-weighted basis, helping to counter domestically generated inflation pressure.

These factors will broadly balance out: CPI will remain below the BoE’s 2 per cent target through 2016, allowing the MPC to remain patient before increasing interest rates.

Indeed, the UK is unlikely to see an interest rate hike until mid-2016, and market expectations are such that the ensuing monetary cycle will be benign, with rates peaking at around 1.5 per cent by the end of 2018.

A material rise in yields in the foreseeable future is unlikely with the secular outlook of ‘lower for longer’ for central bank policy rates still intact.

Impact on schemes

Nonetheless, the expected muted rate cycle has implications for UK-based defined benefit and defined contribution pension schemes.

The nature of DB liabilities means schemes focus on long-dated bond yields, which remain near their historical lows.

Such low yields can mean significant funding deficits, estimated to be £242.3bn in aggregate by the Pension Protection Fund at the end of April 2015.

Yet since pension schemes need increased yields, they are likely to be willing buyers of the UK Debt Management Office’s bond issuance – planned to be £37.4bn of nominal gilts and £31.4bn of index-linked gilts over 2015 – in the event of any material rise in yields.

Rather perversely, this means they would cap any rise in the process to their own detriment.

As a result, DB schemes ought to seek less constrained, high-quality bond portfolios that are flexible in their duration exposure and invest more broadly than traditional approaches, enhancing income yields materially above UK government bonds while applying liability-driven investment overlays to match the duration exposures of their liabilities.

For DC schemes, the introduction of new pension flexibility means they now face a dichotomy.

The true ‘liability’ for DC scheme members remains a sustainable income from the point they cease work to their death, implying the need for an intermediate duration bond portfolio as the core of their asset allocation.

Yet regulatory changes allowing members greater flexibility over withdrawing money from their pension scheme will naturally focus attention on their account value rather than on the long-term sustainability of income.

Many DC schemes still invest members into a long-duration bond index prior to retirement. For example, the FTSE Actuaries Government Securities UK Gilts Over 15 Years Index.

To put this simply, with more than 17 years of duration in that index, just a 1 per cent rise in yields would mean members suffer at least a 15 per cent loss to their account value at the point they plan to retire, causing significant discomfort to the member and their employer.

Conversely, investing in stable, low-duration bonds risks ‘reckless conservatism’ due to unacceptably low real yields, while including equities to increase expected returns comes at the price of heightened volatility.

DC schemes must pursue a balancing act, seeking fixed income portfolios that are able to generate the necessary yields to sustain members’ income in retirement, while protecting them against the downside volatility associated with a rising interest rate cycle.

Mike Amey is managing director and head of sterling portfolios at Pimco