Thought Leadership

Pensions Newsletter - Autumn 2014

The Budget last March has radically  changed the landscape for defined  contribution (DC) pensions.


The Budget challenge: offering DC members choice with security

It is forcing trustees and sponsors to radically rethink what they offer their members in the years before retirement. To ensure members are well placed to take advantage of the new opportunities, we believe schemes will need an equally bold investment approach that offers growth, while aiming to provide a really robust safety net for capital.

The Budget changes have created a much wider spectrum of choice for retiring members. This now includes both the old option of buying an annuity, and new ones, such as cashing in accumulated savings or moving into drawdown, where the savings remain invested but also generate an income. More cautious members who still seek the security of an annuity may be best advised to use a traditional gilt-laden, annuity-matching fund in the run-up to retirement. We think, however, that a much larger group will want the flexibility to follow one of the other options. For them, a traditional pre-retirement fund may be positively dangerous, as it could expose them to irretrievable losses if rates rise as expected (see overleaf for more on this).

Instead, we think this group will need a fund with an element of growth to combat the ravages of inflation, but
whose overriding priority is to protect them against debilitating market falls. We believe that generating the growth should be relatively straightforward. A low-risk, multi-asset portfolio should be able to capture the growth wherever it is available, while providing enough diversification to minimise volatility.

The bigger question is how to provide the sort of protection against loss that will give members the comfort to stay invested in growth assets so late in their savings journey. One way would be to use some sort of insurance or guarantee, but this looks expensive. A far better approach, we think, would be to build in a ‘floor’ using a systematic process which aims to limit any loss to a set figure over any investment period, effectively allowing gains to ratchet up (see chart).

Such a process could start with the more modest aim of limiting the volatility of the portfolio. Big upward spikes typically herald big falls in value. So, we would monitor the portfolio’s volatility and when it hit a predetermined level (or ‘cap’), our exposure to risk assets could be reduced until volatility returned to more normal levels. 

If, however, losses continued to mount, an even higher level of protection would kick in. The volatility cap itself would start to be tightened, accelerating the move out of risk assets until the portfolio stabilised. Once the market started to recover, the cap could be gradually lifted back to its original level, allowing the portfolio to participate in the recovery. This would make it possible to set an objective like ‘no loss of more than 8% over any period’.

Embedding such protection in a relatively conservative multi-asset portfolio could, we believe, provide the sort of flexibility we expect most DC pension members will want to retain right up to retirement. We reckon that such a fund could limit losses to a single-digit percentage over any period, while generating a solid margin over inflation and stay well within the government’s new 0.75% charge cap.

This would be a compelling proposition for many members, we believe. And for those who aren’t convinced, a traditional annuity-matching fund will still beckon.

How far might interest rates go as QE goes into reverse? 

This is a time for bond investors to be fearful rather than greedy. Central banks’ bond-buying activities – quantitative easing (QE) – will soon go into reverse. We estimate that fully unwinding QE, along with reserves built up by developing country central banks’ parallel foreign exchange activities, could push up US 10-year yields by as much as 1.3%, with knock-on effects on UK rates. The result could be big losses for any bond investor who has failed to put defensive measures in place.

Theory tells us that a key component of US Treasury yields is the compensation investors expect for taking on duration risk (or increased sensitivity to interest rates). But the US Treasury market is now dominated by two classes of investor with very unconventional risk preferences. From the start of the QE programme in 2008, the balance sheet of the Federal Reserve (Fed) has ballooned by approximately $4.1 trillion as the bank has purchased bonds1.

Unlike most investors, the Fed’s objective has not been to maximise returns but to push yields lower and induce investors to direct their money to more productive lending. The result is that the largest domestic Treasury bond investor in the US has changed from being risk-averse to being risk-seeking. So, where the expected return for duration risk would normally be positive, it is now negative.

This trend has been exacerbated by central banks in developing economies absorbing the ‘excess’ US dollars from QE that come their way through current and capital account surpluses. Their aim has been to prevent rising exchange rates hindering domestic economic development and to insure against crises of confidence. The beneficiary of these flows has again mostly been the large and liquid US Treasury bond market.

There is a clear relationship between the activities of these official investors and yields (see chart). This relationship allows us to estimate the effects of the future unwinding of quantitative easing. Thus, completely reversing QE would involve the sale of 8½% of the total US Treasury market, or $1.5 trillion-worth of bonds. Given the relationship we’ve illustrated, this would imply a rise of 65 basis points in the 10-year duration risk
premium, taking it to a positive level of about 35 basis points (the orange line on the chart).

Unwinding the foreign exchange reserves of central banks could push yields even higher. We estimate that their ‘excess’ reserves now stand a little more than $1 trillion above the trend set before QE started in 2008. We calculate that unwinding these holdings, along with those resulting from QE, could see premia (and hence yields) rise by 133 basis points to just above 1% (grey line on the chart). At the time of writing, that would imply 10-year Treasury yields increasing from about 2.3% to 3.6%. Given the influence of the US market, we would expect this to push up gilt yields too.

There are a few caveats. First, these simulations are based on rises in risk premia alone. A sustained increase in the expected path of inflation or real rates would be in addition to the above projections. Second, we would underline that these are not specific forecasts, but meant to illustrate the impact unwinding QE could have on the US Treasury market.

Nonetheless, it is clear that a reversal of current yield trends could result in substantial losses for investors. Many may need to think about how to position their bond portfolios to protect themselves in circumstances very different from those to which they have become accustomed over the last 10 years or more.

1Source: Federal Reserve

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