In environment of high inflation of rising interest rates has forced defined contribution (DC) schemes to re-evaluate traditional asset allocations. These schemes are including inflationary pressures in their long-term decision-making processes, with many not confident of a return to ‘normality’ anytime soon. Julien Dauchez, head of portfolio consulting at Natixis Investment Managers, does not expect inflation to resemble pre-pandemic conditions for years to come.
As to how this might impact the DC sphere, Dauchez says: “Within equity buckets, you would assume that there would be more interest in companies with a possibility of strong pricing power, and therefore an ability to pass on inflation to their own customers.”
Con Keating, head of research at Brighton Rock Group, an insurance company for pension schemes, is sceptical of the Bank of England bringing inflation back under its 2 per cent target any time soon. Of the impact to DC schemes, Keating echoes the Aon findings: “The effects are clear. You want to avoid conventional bonds. Conventional bonds are simply going to be eroded in value. Good night Henry, as it were.”
Demographic impact
In this turbulent atmosphere, DC schemes are fundamentally reassessing their allocations. A survey conducted by Aon into DC pension schemes underlined two key points of concern: if members’ savings are held in a cash fund, they will have no protection against inflation, and with the inflation currently being witnessed, fixed income is no longer providing meaningful yields.
“Asset allocation [of DC schemes] is leading to a reassessment based on an asset’s attractiveness in a high inflation environment. The assets to consider or to favour are those that can hedge against inflation compared to something such as fixed rate government bonds, which would offer no protection”, says Dauchez.
Schemes may be reassessing their fixed income holdings, but equities are by no stretch immune to higher inflation. Previously reliable stocks and sectors have taken a hit this year, and overall, both the FTSE 100 is down 2.35 per cent year-to-date, and the S&P 500 is down 16.18 per cent for the same period.
Of the current state of equities in DC schemes, Rona Train, partner at Hymans Robertson, says: “Equities are likely to provide amongst the best long-term returns for savers, but we believe improvements can be made on traditional approaches for accessing global equity markets by addressing climate and wider sustainable considerations, as well as extending the opportunity set to include less liquid assets.”
As an example, Train claims that by incorporating allocations of 20 per cent to less liquid assets such as infrastructure and private equity, retirement outcomes could be improved for DC savers by up to 20 per cent. This view is supported by the Pension Policy Institute which has shown an earner contributing to a pension with 10 to 15 per cent of funds in illiquids could have a pension pot at retirement 2 to 3 per cent higher than if their pension was not invested in any illiquids.
However, younger investors who can grasp these benefits, overall, are only one sector affected by an inflationary atmosphere.
On the wider demographics at play, Mabrouk Chetouane, head of global market strategy at Natixis Investment Managers, says: “If you are a young worker at the very beginning of a DC scheme, the current inflation and its impact on the market will not necessarily be an acute problem.
“Clearly, the problems are more for those DC plan investors and beneficiaries who are much closer to retirement. The burden we see there is twofold. The first one obviously is the direct impact of inflation, as it erodes returns and income for those about to retire. Inflation has also led to an increase in long-term rates which in turn sends risk assets in a spin.”
According to Hymans Robertson analysis, those within 10 years of retirement could be up to 10 per cent worse off relative to where they may have expected to be at the start of 2022, which could lead to some employees being forced to delay their planned retirement dates.
Moving to alternatives
As identified by Train and evidenced by the activity of DC schemes in the US and the UK, providers are looking past traditional allocation mixes in the current marketplace, including a focus on alternatives.
Policymakers have already been focusing on this area. In September 2021 the UK’s Productive Finance Working Group published a series of recommendations looking to facilitate greater DC investment in longer-term, less liquid assets. The aim of this was to encourage trustees to consider how increasing investment in these assets could generate greater long-term value for their members.
However, Henry Tapper, chief executive at pensions analyst AgeWage, still believes tradition will hold: “Strategically, the composition of DC defaults has remained consistent over 50 years, typically investing heavily in equities with low allocations to bonds. The history of DC funds is littered with tactical allocations to trendy asset classes, but none has altered the general direction of travel.”
For Tapper, in the UK tactical adjustments in DC have risen out of changes in government policy such as exchange controls, on the issuance of debt instruments by the Treasury, and deliberate interventions such as the ‘Build Back Better’ Covid-19 initiative, nudging DC defaults towards private markets and greater investment in infrastructure and other illiquids.
“DC is seeing a trend towards real value and a trend towards real assets. This exposure to real things, whether it’s infrastructure, whether it’s property, leads in total to moving from liquid to less liquid investments,” says Cedric Bucher, CEO at Hearthstone Investments.
This shift may be with good reason. In H1 2022, the IA UK direct property sector showed 5.3 per cent growth, while the IA Sterling Corporate Bond dropped 12.5 per cent.
Keating on the other hand, adamantly does not see an area such as real estate as a valuable part of a DC pension portfolio: “For one thing, it’s really expensive. In my eyes, the only parts of real estate which are increasing margins come from large landlords following rental increase strategies that I find disgusting.”
The relationship between ESG and inflationary pressures
The pressure of high inflation is forcing DC schemes to act for the sake of their members’ benefits, but this has the potential to clash with the growing theme of ESG. An obvious case in point is the explosion in profits in oil and gas firms as energy prices boom, yet pension firms are wary of investing in such assets.
Natixis’s Dauchez explains combatting inflationary pressures, while meeting recently-embedded ESG criteria, will be a challenging consideration for some schemes.
“On the bond side, in DC you would expect more inflation-linked bonds such as TIPS, obviously, but down the road, these portfolios need to consider at least commodities for instance, even though this would raise really some moral issues for a number of investors at a time when ESG has become absolutely prominent,” says Dauchez.
According to Hyman Robertson’s Train, ESG opportunities exist in this environment, but risks remain for DC schemes to navigate: “Greenwashing potential is a real threat and could impact negatively on trust from members. Addressing these areas in a robust manner will contribute to improved retirement outcomes for DC savers.”