Thought Leadership (Professional Only)
Is certainty worth paying for?
Pension schemes still need to hold equities to close their funding gaps. However, equity markets are characterised by large and sudden losses, which could throw a scheme’s derisking plans off course.
15 December 2014
Pension schemes still need to hold equities to close their funding gaps. However, equity markets are characterised by funding gaps. However, equity markets are characterised by risking plans off course. With equity valuations close to all-time highs on many measures, the risk of experiencing losses over short holding periods may be higher than starting from more modest levels. Are there ways for pension schemes to manage the risk of equity losses without sacrificing too much of the upside?
Can you afford a large loss in equity markets? It depends on your time horizon
Pension scheme trustees will be painfully aware of the large and sudden losses that can be experienced in equity markets. Chart 1 shows the total losses experienced from the highest to the lowest points for the US equity market since the 1950s. For example, from the point when US equities began to fall in October 2007 until they bottomed out in March 2009, prices had dropped by over 55%.
In spite of these losses, equity markets do generate a positive real return over long time periods. Short-term losses are less of a problem for truly long-term investors who can afford to wait for markets to recover. Historically, for holding periods of 10 years or more, the risk of an overall loss has been quite low (see Table 1).
The problem for defined benefit pension scheme trustees is that they may not have the luxury of waiting for markets to recover. With more schemes closing every year, pension schemes’ time horizons are shrinking. Even those schemes with recovery plans stretching longer than 10 years may have a lower ability to tolerate losses from their equities if they plan to gradually de-risk their investment strategies. Consider an example scheme with a plan to de-risk by reducing its equity allocation in the next three years (Figure 1). There is a much shorter time horizon for the portion of the equities that will be sold when the scheme de-risks. If equities were to suffer another large loss during that time, the scheme’s de-risking plan could be thrown off course.
From today’s starting point, you may need an even longer time horizon
After several years of very strong returns, equity market valuations are near all-time highs1, and the ratio of equity prices to earnings is now in the top 20% compared to history (see Chart 2). Based on past experience, the chance of losses from equities is higher from this starting point than if we started from more “neutral” levels (see Table 2).
1 Source: On 3 December the US equity market (as measured by the S&P 500) was at its highest ever value of 2074
Important information: The views and opinions contained herein are those of Mark Humphreys, Head of UK Strategic Solutions, and Rosalind Mann, UK Strategic Solutions at Schroders, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. For professional investors and advisers only.
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