Thought Leadership

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.

15/12/2014

Mark Humphreys

Mark Humphreys

Head of UK Strategic Solutions

Rosalind Mann

Rosalind Mann

UK Strategic Solutions

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
(source: Bloomberg).

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.

This document is not suitable for retail clients. This document is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is
not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Schroder Investment Management Limited (Schroders) does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This does not exclude or restrict any duty or liability that Schroders has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Schroders has expressed its own views and opinions in this document and these may change. Reliance should not be placed on the views and information in the document when taking individual investment and/ or strategic decisions. Past performance is not a guide to future returns. The value of investments can fall as well as rise as a result of market movements. Forecast Risk Warning. The forecasts stated in the presentation are the result of statistical modelling, based on a number of assumptions and should be seen as objectives only. There is no assurance or guarantee that these results will be achieved and they should not be considered as predictions of actual results which may be realised in the future. Forecasts are subject to a high level of uncertainty regarding future economic and market factors that may affect actual future performance. The forecasts are provided to you for information purposes as at today’s date. Our assumptions may change materially with changes in underlying assumptions that may occur, among other things, as economic and market conditions change. We assume no obligation to provide you with updates or changes to this data as assumptions, economic and market conditions, models or other matters change. Hypothetical Modelling Results. The hypothetical results shown in this presentation must be considered as no more than an approximate representation of a portfolios’ performance, not as indicative of how it would have performed in the past. It is the result of statistical modelling, based on a number of assumptions and there are a number of material limitations of the retroactive reconstruction of any performance results from performance records. For example, it does not take into account any dealing costs or liquidity issues which would have affected a real investment’s
performance. Issued in December 2014 by Schroder Investment Management Limited, 31, Gresham Street, EC2V 7QA, who is authorised and regulated by the Financial Conduct Authority INS03508 w46358

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