The role of bonds in pension systems is set to change. The significant allocation to bonds by pension funds has been a function of the large proportion of defined benefit (DB) funds and, until recently, quiescent inflation. We do not think either of these forces still holds. The combination of increased longevity, higher equilibrium inflation and lower growth rates implies that the strategic asset allocation of pension systems is likely to change.
To be clear, there is still a role for bonds, but via active fixed income or as part of longevity insurance, which is very different from large passive holdings of long-duration government bonds. Pension systems will have to adapt their strategic asset allocations in the face of a new investment regime, which could see a significant allocation shift out of bonds and into other assets over the next decade.
There’s a stark conclusion in applying our forecasts for asset-class real returns to someone earning a median salary and paying 8 per cent of it each year into a simple target-date structure that de-risked in the mid portion of their career before retiring at 65.
That person, if they are early in their career, would face a “hardship outcome” below the minimum level deemed necessary for retirement. We have used a spin of Graham Greene’s novel for the title of this research. It seems appropriate to reflect the view expressed in his novel ’The End of The Affair’ that a sense of unhappiness is much easier to convey than one of happiness. The intent of the structuring of retirement systems should, we argue, be minimizing the risk of unhappiness for many at the prospect of their life in retirement.
Putting aside for the moment the minutiae of optimal asset allocation, our overarching point is that the ability to offer — and indeed any expectation of receiving — guaranteed incomes is going away. This is the consequence of 100 years of improved life expectancy, as well as of the unwinding of a specific set of macro conditions in the second half of the 20th century, mainly subdued inflation and strong real growth.
In addition, the fall in birthrates to below the replacement rate both lowers expected economic growth rates and makes it infeasible, as well as morally questionable, to attempt to transfer the cost of retirement to future generations. The consequence of this shift is that nominal liability managers are in terminal decline. A combination of increased longevity, higher inflation and lower growth implies that a change in asset allocation is needed, including the option of buying longevity insurance.
Lower returns on equities, positive correlations with bonds, higher inflation and greater longevity force DC plans to make uncomfortable compromises. The options are: later retirement, higher contributions, lower retirement income or higher investment risk.
There is another potential path for the system overall, albeit not for individual funds: to dump the risk onto later generations. Countries that don’t even attempt to fund retirement, such as Italy, do this already. However, this approach raises profound questions of intergenerational fairness and is doubly hard given shrinking working-age populations and the fact that younger cohorts are less well off than older cohorts were at the same age.
We want to be clear at the outset: we are not suggesting that pension funds should not hold any bonds; simply that their role in pension allocation is changing. There is a role for bonds within longevity insurance/pooling, but this may become a limited role that requires a new type of bond. There is also an important role for liquidity — although overall liquidity needs are small. But in all of this, the overall pension exposure to passive longer-duration government bonds is going to be significantly attenuated.
If pension funds are set to have fewer government bonds, what asset classes are set to benefit? We think the main shift will be an increase in the strategic asset allocation toward real assets, which would include equities. Private assets overall will likely see an increased allocation too, in part reflecting both investor needs and the change in the source of marginal capital raising in the economy. There will likely also be increased allocations to strategies that seek to address longevity risk.
