Market shocks prompt allocation overhauls

Corporate pension fund portfolios in the U.K. and U.S. that have been distorted by recent market events are set for an asset allocation overhaul.

A combination of rising interest rates leading to falling liabilities, plus increased needs for liquidity in portfolios means asset allocations are, in some cases, no longer serving their intended purpose on either side of the pond. Sources said pension fund sponsors now have an opportunity to further derisk portfolios, with a view to completing a risk transfer or achieving self-sufficiency.

At the same time, and as a result of falling public markets, private markets exposures are now overweight their targets in many cases — making the need to reconsider asset allocations even more acute for these corporate funds.

"For many pension funds, when they make it through this very volatile period, they're likely to see very significant increases in funding positions and won't need as much risk — albeit with a smaller asset pool and much smaller liability pool. Definite asset allocation changes are going to be needed, and the rebuilding of their portfolios," said Calum Mackenzie, Edinburgh-based investment partner at Aon PLC.

For U.K. pension funds in particular, surging gilt yields — and therefore plummeting gilt prices — left pension funds scrambling, yet again, for cash to post as collateral for derivatives positions used to hedge liabilities against moves in interest rates. The total notional value of U.K. hedged liabilities was £1.6 trillion ($1.8 trillion) in 2021, according to the Investment Association's latest Investment Management Survey 2021/22.

"We have been in absolute urgent mode" since the government announced its mini-budget — which included tax cuts — on Sept. 23, Mr. Mackenzie said.

On Sept. 27, the 10-year gilt yield was 4.15%, while the 30-year yield was 4.99%. On Sept. 23, the day the mini-budget was announced, 10-year gilts were at 3.83% and 30-year gilts were at 4.04%. By comparison, on July 29 — just before a bout of gilt volatility as the race to become the new prime minister began heating up — 10-year gilts were at 1.86% and 30-year gilt yields were 2.4%.

"No pension fund that was using an LDI strategy with any level of leverage — which most pension funds were using — has escaped this. No matter how good your collateral waterfall was, how well organized (you were,) it has hit because the swings have been so huge," Mr. Mackenzie said.

A base case for meeting those calls was "probably a combination of run-off of illiquids, giving them natural cash flow, plus selling some publicly traded assets. But in practice, the speed of the collateral calls (has meant) they have had to take more from liquid assets than they otherwise would have chosen to do. In that sense, schemes are looking at asset allocations and tweaking them accordingly," said Elaine Torry, Glasgow, Scotland-based partner and co-head of investment, DB, at consultant Hymans Robertson LLP.

However, U.K. pension funds have been granted some breathing space with the Bank of England's emergency intervention in gilt markets last week. In response to the violent moves in bond markets, the bank on Sept. 28 announced a temporary and "targeted" purchase program of long-dated index-linked gilts in efforts to protect the U.K.'s financial stability. It said it would buy up to £5 billion ($5.7 billion) in gilts in daily auctions starting Sept. 28 until Oct. 14 — equating to a total £65 billion.

Recent weeks have also tested pension fund governance. "It's quite a lively environment to navigate (with) collateral requirements, making sure there is sufficient liquidity across the balance sheet to support the strategies that pension schemes have put in place," said David Rae, London-based managing director and head of strategic client solutions at Russell Investments. "I think the controls that have been put in place since the global financial crisis have made that an easier thing to navigate ... but there are parallels in terms of the volume of activity," he said.

Sources said now the real work begins, as pension funds, along with their corporate sponsors and consultants, begin revisiting investment strategies to figure out whether their asset allocations are still relevant. Improved funding levels on both sides of the Atlantic means pension fund executives and their consultants can think about derisking portfolios.

"For those plans where the funded status has improved, yes, we are looking at asset allocation shifts now. Very broadly, we're trying to derisk their portfolios to move away from growth-oriented assets more towards hedging assets — (which) usually means long-duration fixed income of some sort," said Sona Menon, Boston-based head of North American pension practice at Cambridge Associates LLC.

It's a consideration for U.K. pension funds, too. "A lot of schemes have seen a significant improvement in funding level, and as a result can see a shorter time horizon either to an insurance transfer or just closing out the risk," Russell's Mr. Rae said. "That calls into question the need for some of the less-liquid assets, like private equity in particular."

But it's a conundrum. While equities are down, so are bonds. "So, on average, (funds are) selling depressed assets to buy even more depressed assets, and all in an effort to increase the interest rate hedge ratio of the plan," Ms. Menon said.

There are also conversations among U.S. plans on what constitutes an appropriate interest rate hedge, since it "now takes less dollars to achieve the same interest rate hedge," said Aaron Chastain, Atlanta-based senior consultant at NEPC LLC.

However, before making asset allocation decisions based on the current markets, Cambridge executives are reminding clients that the denominator effect "can be temporary — public equities and public bonds may … rebound, and in many cases in the past we've seen this," Ms. Menon said. The denominator effect occurs when the value of one part of the investment fund, in this case public markets, decreases and with it pulls down the overall value of the portfolio, leaving exposures that did not decrease as a bigger portion of the total portfolio.

Part of the derisking decision relates to private markets allocations, which many pension funds will now find accounting for a bigger portion of their overall portfolios than before.

For some, the only option is to sell out of positions and take unenviable haircuts on their assets — for example, if they are in urgent need of more liquidity or need to quickly sell out of assets that insurers will not take as part of a risk transfer deal.

Sources said some pension funds — albeit a very small number — are taking haircuts of up to 20% by selling their private assets on the secondary market, just to reduce those weightings.

For others, though, new tactics are being employed as part of overhauled asset allocations.

One option is to continue to invest in private assets but reduce the commitment size, which will help to manage exposures.

"We're not … stopping investing in private markets, not just because of the temporary effect but also because this is a time of market dislocation, and (it usually means) great opportunities for investment," Ms. Menon said.

NEPC's Mr. Chastain is also seeing some clients reducing commitment sizes but not stopping investments altogether. They "definitely don't want to eliminate those relationships (with fund managers) for a shorter-term market event in terms of an asset allocation perspective," he said.

Some clients are also looking to broaden the allowable range for investment in private markets. While any such decision needs to go through the proper governance process, there is a "recognition in the broader investment community that … (it may be better) to broaden your flexibility," Ms. Menon said.

Finally, there's a "very small subset" of plans that have terminated their private markets allocations because the funded status has improved and "they want out," she added.

Whatever path is taken, conversations are now taking place between pension fund executives, sponsoring employers and their consultants.

"We're seeing more evidence of trustees and companies working together to make sure they use their pension assets and pension plan to their full potential — whether that be some sort of shared surplus, funding DC or benefit augmentations — we're seeing more discussions there," Aon's Mr. Mackenzie said.

The future relationship between a pension fund and its sponsoring employer is "a big strategic decision — there are going to be instances where what was a 10-year recovery plan is now looking like it can be done in two years. Is there a meeting in the middle between trustees and corporates where trustees take less risk, corporates pay contributions for less time, and there's a middle ground? That will be where we see a lot of action," Mr. Mackenzie added.