With the approval of several Covid-19 vaccines and the implementation of vaccination programmes around the world, economies began to fire up again after a year in the doldrums. This has meant capital markets have turned to preparing for life after the coronavirus.
Although the economic outlook has improved, however, not all challenges have gone away.
While the UK’s vaccine rollout was lauded, the path to ‘Freedom Day’ in July was not smooth, and further spikes have hampered the return to pre-Covid-19 normality. The coronavirus continued to impact supply chains, leading to panic buying at petrol station forecourts and gaps on the supermarket shelves in the autumn. Several countries in Europe are experiencing fresh surges, most recently Austria.
Meanwhile, the UK and EU struggled to find a way forward on the Northern Ireland Protocol negotiations for much of the year – and has still not been resolved – highlighting that Brexit will remain an ongoing issue for years to come. And, since the second quarter, inflation has taken off around the developed world, putting pressure on both consumers and some corporate earnings.
Nevertheless, a more optimistic mood has set in. Global institutional investors were already anticipating better returns halfway through 2021, according to UK asset manager Schroders’ Institutional Investor Survey published in July. This found asset allocators
were expecting average returns of 6.4 per cent, up from 5.6 per cent in 2020.
Schroders chief economist Keith Wade noted that confidence had been boosted by the vaccine rollout, increasing consumer demand and expectations of a strong economic recovery.
“It could be that even professional investors are being swayed by the strong real returns achieved by both equity and bonds in the past decade,” he said. “ They’re feeling more optimistic. The reality is that to achieve decent returns, investors will need to navigate a number of challenges.”
Turning deficits into surpluses
With all this in mind, how did UK pension schemes fair in 2021? The most up to date figures from the Corporate Adviser Pension Average show a 21.02 per cent return for the average DC default fund’s portfolio for younger savers, in the 12 months to 30 June 2021, giving a 10.03 per cent a year five-year annualised return. Figures are before charges were deducted.
They have done pretty well on the DB side too, according to the Pension Protection Fund’s PPF 7800 Index. The index – which tracks the performance of all 5,318 DB schemes eligible for inclusion in the pension rescue fund – showed that schemes made considerable progress in meeting their liabilities in 2021.
At the end of 2020, the funding ratio for DB schemes – driven by equity markets and gilt yields – had stood at 95.5 per cent, reflecting aggregate scheme liabilities exceeding assets. By October 2021, the funding position had reversed to a positive 105.9 per cent, following assets surpassing liabilities in February.
Since the sharp sell-off in March 2020, equity markets have recovered their losses and continued rising. The strong performance of equity markets in 2021, which came off the back of the strengthening economic outlook, has been positive for
DB schemes.
“The combination of rising equities and yields – albeit driven by inflation as much as growth expectations – proved a powerful positive,” explains Altaf Kassam, EMEA head of investment strategy and research at asset manager State Street Global Advisors (SSGA).
The value of scheme assets is affected by the change in prices of all asset classes, but the amount invested by schemes in equities and bonds – and the volatility of these assets – means they are the biggest drivers of change. Liabilities, meanwhile, are more sensitive to gilt yields, depending on the discount rate used; as gilt yields have risen over 2021, says Kassam, scheme liabilities have declined.
“Credit spreads on sterling investment-grade corporate bonds have tightened, which has contributed to improved funding levels year-to-date,” notes Crevan Begley, investment consulting director at employee benefits & actuarial consultancy Broadstone. “[However] pension schemes that hedged all of their interest rate and inflation rate risk would not have seen their funding levels impacted from changes in nominal interest rates or inflation expectations over the year.”
Rising inflation
If inflation continues to rise, the ultra-low interest rate environment in place since the Global Financial Crisis is likely to end. Central banks come under even greater pressure to hike rates. Although many believe that higher inflation could be transitory, the Federal Reserve and other central banks have signalled their intention to raise rates to bring inflation down to more manageable levels.
Higher rates could see companies and consumers that are used to low borrowing costs start to struggle. As such, Broadstone’s Begley says many schemes had already started de-risking portfolios to lock in funding level gains made throughout the year and limit the impact of a changing policy outlook.
“A key consideration for 2022 will be the financial conditions in developed market economies
and the extent monetary policy may tighten to combat rising inflation expectations,” says
Begley. “A higher interest rate environment may have a negative impact on risk asset returns over the course of 2022.”
This has already impacted asset allocation decisions. Kassam explains that SSGA is remaining underweight developed market government bonds in anticipation of “imminent” rate hikes.
“Historically, commodities have had a larger beta and stronger positive correlation to inflation relative to traditional equities and bonds as well as many other real asset classes,” he says. He is bullish on risk assets, which he expects to remain positive heading into 2022. He favours equities, in particular, as earnings expectations remain positive and real interest rates are in negative territory, at least for now.
“In equities, strong earnings prospects and less-stretched valuations will continue to add to European equities’ appeal,” says Kassam. “But higher background volatility means investors should look to low volatility and defensive strategies as ballast, as well as commodity sectors and cyclical factors for inflation hedging.”
Careful manager selection
The threat of inflation has led trustees to become more interested in alternative asset classes as a way of protecting portfolios, says Brendan McLean, head of manager research at pensions consultancy Spence & Partners.
“There’s more interest in alternative asset classes as they are less correlated to the broader market and aren’t priced regularly,” says McLean, “whether that be private credit or infrastructure, which are less volatile.
“In addition, for infrastructure or even long-lease property strategies, a lot of the assets are inflation-linked, which minimises the impact of rising inflation.”
As such, schemes will have to ensure they are flexible enough to meet the challenges of the post-pandemic market environment, McLean continues, adding that careful manager selection will be necessary during this period.
“Everything’s bounced back, everything’s looking quite highly valued,” says McLean. “The way we navigate this scenario is by picking managers that can change their asset allocations and invest dynamically. Generally, we would leave tactical decisions to investment managers because it’s quite hard for trustees to trade tactically.”
One way that trustees can play a more active role in protecting schemes, according to McLean, is by hedging interest rates or inflation. This may be extremely important in the year ahead.
“Many clients have more systematic de-risking processes, so they don’t have to make a specific bet on the levels of interest rates,” he explains. “But, as the funding level goes up, they will naturally add more hedging.”
While there will be several challenges facing schemes in 2022, some are ‘known’ and have already been signposted, such as a more inflationary environment and interest rate hikes. Nevertheless, trustees will need to act early to ensure they are ready.