Optimism in global markets remained elusive among speakers and panelists at this year's NAPF investment conference, despite 2012 having delivered relatively buoyant returns for the average U.K. pension fund.
“Return distributions have broadened and flattened, and have fatter tails” relative to the past 30 years, Arno Kitts, managing director and head of the U.K. institutional business at BlackRock Inc., said at the National Association of Pension Funds' annual meeting March 6-8 in Edinburgh. Also, “we've got volatility of volatility.”
To date, despite the strongest economic stimulus in the history of the world, the resulting economic recovery is one of the weakest in comparison to previous financial crises, Mr. Kitts added.
“Static, strategic asset allocation makes sense in a stable paradigm environment; it makes less sense when the future is as uncertain as it is now. Flexible asset allocation is key,” Mr. Kitts said. “Secondly, prospective returns are not attractive. They're not attractive for bonds, and they're not attractive for equities. We're going to have to work our assets much harder.”
In a keynote address on March 6, Tony Blair — former U.K. prime minister — also noted that pension funds are struggling to navigate through an era of “uniquely low predictability.” As a result, it is much more difficult for investors to make long-term financial decisions.
“The best short-term politics is often in conflict with the best long-term policy,” said Mr. Blair, British Labour Party leader who served as prime minister from 1997 to 2007. Referring to the eurozone crisis, Mr. Blair said there were essentially three problems: liquidity, solvency and growth.
“The recovery is fragile,” Mr. Blair added. “Pumping money in has given liquidity. But solvency and growth remain issues. … This will make it harder for politicians to make the right decisions” for long-term economic recovery as they face short-term political pressure.
Paul Marsh, emeritus professor of finance at London Business School, said expected annualized real returns from equities is about 3% to 3.5% “for the next generation.” Estimates cited by Mr. Marsh are based on historical equity risk premiums between 1900 and 2012, after having taken into account survivorship bias, or the tendency for widely accepted ERP estimates to focus on the most successful markets such as the U.S. If including performances of economies such as Russia, China and Austria over the same period, the historical ERP falls to 3.5% from 4.1% for global equities, according to “Credit Suisse Global Investment Returns Yearbook 2013” published in February and presented at the conference.
“A lot of people are still making projections that are unrealistic, given what we know about historical asset returns,” Mr. Marsh said at the conference. For example, the average S&P 500 company is forecasting expected returns at 7.6%, even as the proportion of equities held has steadily fallen. Given low expected returns for fixed income, plan executives need about a 10% real return in equities to meet such targets.
“In the United States, they are plain crazy,” Mr. Marsh said. But even in other pension markets with lower return expectations — such as the U.K. and the Netherlands — these targets are generally “a stretch.”
Low expected returns will not only affect pension plans and charities/endowments, but also money management fees. “As an industry, you shouldn't be in denial, but nor should you bank on equities to bail you out,” Mr. Marsh said. He also addressed recent calls for regulators to ease rules used to calculate pension liabilities, allowing for some volatility smoothing among U.K. pension funds.
Arguing for a different way to calculate liabilities so as to improve the funded status volatility is “a bit like seeing Hurricane Sandy approaching you and, (in) deciding what action you're going to take, rather than boarding up your house you decide to smash the barometer.”
Quantitative easing measures by governments globally have driven discount rates used to value pension liabilities to historically low rates. The NAPF estimates £375 billion ($560 billion) of asset purchasing by the Bank of England has had the effect of increasing pension fund deficits “by at least £90 billion,” according to data provided by the NAPF.
Nevertheless, “smoothing is not the right answer,” according to Darren Philp, director of policy at the NAPF. “If it goes ahead, not only will it be too little, too late, but it might do more harm than good. It risks making matters worse for pension funds once interest rates start picking up.”
Andrew Kirton, London-based global chief investment officer at Mercer, warned investors to “be alert to inflation risk.”
Furthermore, Mr. Kirton called for pension funds to broaden their portfolios, balance risk premiums within equity strategies and take advantage of pension funds' “competitive advantage” in illiquid assets in order to increase robustness and resilience amid difficult market conditions.
“Keep an eye on fees and trading costs,” Mr. Kirton added. Particularly in a low-returning environment, “benefits can flow from containing costs.”
