Pension Funds Letter 11 - Unexpected opportunities for pension funds

Summary

EDITORIAL

Unexpected opportunities for pension funds

In the wake of the Covid-19 pandemic, a lot of discussion has focused on the worsening of the retirement prospects of savers around the world. Indeed, exceptional policies, such as the possibility of raiding retirement pots in advance and the low interest rate environment supported by dovish monetary policies, could potentially have dramatic impacts on the availability of pensions in the long run.

However, the first quarter of 2021 brought about some welcome and, to some extent, surprising news. The funding ratios of pension funds around the world have generally improved, in contrast to what had been happening in previous years, mostly thanks to the exceptional performance of growth assets. In turn, this improved funding status will eventually lead to a much-desired reduction in the pressure on pension funds’ financial leverage, cash flows and P&L.

The next big question then, is how to lock in the gains in the funded status. This context is ideal for de-risking, i.e., buying long-dated bonds and selling equities. Pension funds might also decide to step up their liability-driven investments (LDI), with different hedging strategies depending on their market structure and specific needs. Regulatory changes pushing for an acceleration in the shift towards defined contribution schemes will also have a major impact on the selection of liability hedging strategies.

Another risk on the horizon that must be taken into account is inflation, which affects defined benefit and defined contribution pension funds differently. Indeed, the inflation-hedging power of the single asset classes strongly depends on the present macroeconomic regime: there is no one-size-fits-all for the optimal strategic allocation to hedge against inflation risk.

Overall, the improvement in the funded status is expected to remain stable in the medium term, according to our analysis. However, this central scenario does not take into account market narratives, drivers of long-term expectations that push existing trends in one direction or another: for example, the “road back to the 70s” narrative, focused on higher growth and higher inflation, could drive a real regime shift with unexpected consequences.

Pension funds should be aware of these narratives and be prepared if a return of inflation does materialise.

EXECUTIVE SUMMARY