Equity cult in the dock

A decade of negative real returns for equities has triggered
debate on whether shares should remain the core component of pensions. Paul Farrow investigates

It is official. Equities were the worst performing asset class over the past decade, delivering negative real returns since 1998.

According to the 2009 Barclays Equity Gilt Study, UK equities suffered average annual returns of -1.5 per cent in the decade to the end of 2008. The study, a benchmark analysis of asset class returns, shows that since 1899, this is the 17th year that has been followed by a decade of negative equity returns.

It all means that pension statements that will soon be landing on people’s doormats will make for grim reading. The future doesn’t look rosy either, with markets falling in recent weeks and gloom from many high profile stockwatchers.

According to Aon Consulting, Britain’s defined contribution pension assets lost 10 per cent of their value during the month of February alone, plunging £42bn as a result of falls in equity markets.

The Aon DC Pension Tracker, which measures the asset value of 3.7m UK workers’ pension accounts, has shown a fall from £410bn at the end of January 2009 to £368bn at the end of February. This continues the mainly downward trend witnessed since the start of the credit crunch in September 2007, when the value of DC pension assets stood at £550bn. As of the end of February, accumulative losses amount to £182bn – a 33 per cent slump.

Falls in equities as well as worsening annuity rates have also had an adverse effect on the value of worker’s projected pensions. A 60 year old paying total contributions of 10 per cent of their £25,000 salary and expecting to retire in five years time has seen their total projected pension fall by 40 per cent over the last seventeen months. They can now expect to receive just £10,270 annually for the rest of their life, compared to the £17,100 forecast in September 2007.

Providers are expecting a backlash from employees. “We are just about to send out statements to the majority of our 175,000 DC members,” says Steve Rumbles, head of DC at BlackRock. The company has penned a leaflet to explain to employees what has gone wrong. “They will discover that even though they have been putting in 10 per cent of their salary each month their pension will be worth less. That is when the fun and games will begin,” he adds.

Given the prolonged under performance of equities it has triggered the debate on whether shares should remain the core component of pensions.

Helen Dowsey, principal at Aon Consulting says the role of equities has been discussed increasingly more with clients and members, in light of the financial crisis, but reckons that it is dangerous – and too early, to draw conclusions.

“We have had one board of trustees suggest recently they should leave existing pension pots in equities but put new money into corporate bonds. That is an extremely dangerous strategy – what happens if equities rebound and members miss the boat?”

She adds: “We have been to many presentations by economists – they show us that when equities recover from a slump they do so sharply – so you get a V-shaped graph. They all agree it will happen, they just can’t agree when. It means that trustees and members face some very difficult decisions but if you make a call it could look ridiculous in 18 months time.”

Talk to fund managers, providers, financial advisers and consultants and none appear to believe that we are witnessing the end of the equity cult – they still believe that equities are best-placed to win over the longer-term.

Alasdair Buchanan at Scottish Life, does not believe that the cult of the equity is dead and while they will underperform over some time scales, more often than not they will deliver more than other assets. He says: “There is a danger of a one size fits all approach. Shares are the best asset class although that may not always be the case. But they should be the best on average.”

Tom McPhail, head of pension research at Hargreaves is also convinced that equities should still rule the roost for the majority of pension savers. He reckons that logic of investing in the growth of the economy as a better long term investment view than other asset classes still holds good in spite of cyclical fluctuations in valuations.

“Broadly anyone with ten or more years to go to retirement should absolutely still look to the stock market for their pension investments,” he says. “Anyone whose pension matured ten years ago would have been delighted; anyone who had the foresight to derisk their pension fund over the last few years would also be quite happy. For someone a few years from retirement now, selling out of equities and into fixed interest and cash would probably be an expensive decision.”

Although calling the death of equities is premature, many fund managers argue that it’s no longer as simple as equities versus bonds. Other asset classes have come into play, which in turn has led to the emergence of diversified growth funds and multi-asset offerings. The offerings come from groups such as M&G, Fidelity, JPM, Schroders and Cazenove.

“These types of funds are increasingly present on the platform of stakeholder and GPP schemes and may provide an interesting alternative for members to the more traditional equity investments going forward,” says Mark Jaffray, senior investment consultant at Hymans Robertson LLPBlackRock is one DC provider that is pinning hope on the success of diversified growth and believes that it is the type of plan that members want – as they smooth returns. “Employees want to generate money but not in a way that shoots the lights out. They want smoother returns,” says Rumbles.

Today BlackRock’s diversified growth fund is split 32 per cent in core and so-called tilt equities, 3 per cent dividends, 21 per cent alternative assets and 43 per cent bonds. A year ago the fund had just 26 per cent in bonds and more than half in equities.

Rumbles adds: “Over the past year 10 clients have adapted diversified growth in a lifestyle option. We invest in many assets, including gold, property and infrastructure.”

Prudential also reckons that diversified growth could be a useful default option in the DC and GPP marketplace. Martin Bogira, DC solutions director at Prudential says: “Managers have more flexibility to change the asset mix to market conditions – members are beginning to consider the funds, although the take-up is still slow.”

Not everyone is sold on the diversified growth theory. Dowsey is concerned that with many strategies less than five years old, the jury is still out on whether they are the answer. Certainly the performance of some has been found wanting and although they aim to deliver a return in excess of inflation, few have to date.

Aon remains committed to the tried and tested assets of equities, bonds and cash – and lifestyling. The consultant has just finished some extensive research on the lifestyle options and how it should be split. It says that whichever way the calculation was cut, it kept coming up with the same answer: a 50:50 global tracker with the lifestyle option kicking in seven years from retirement.

Again, ask people whether lifestyling strategies should change and the answer from the industry tends to be no – although in some cases for those nearing retirement there could be a question of whether they should stop lifestyling and pile back into equities in a last ditch attempt to boost their dwindling pension pot.

“The traditional lifestyling option of moving out of equities 10 or so years from retirement will have protected many members, but some may feel they have to delay retirement or alter their original retirement date – and if so may have to stop the lifestyling option,” adds Bogira.

Dowsey says that trustees and employees need to take an active role in reviewing their pensions to deal with the current situation.

“For those facing retirement in the near future, particularly those who have not started switching out of equities as part of a lifestyle strategy, the situation looks bleak and they need to consider all the options open to them. For example, by shopping around for the best annuity provider.

“We encourage people to be creative in the way they face their retirement. It might be appropriate to convert only a portion of your pension fund to an annuity now and convert the remainder at a later date. Or, it may be possible to continue in paid work post retirement, although the recent European Court of Justice decision to allow mandatory retirement ages in UK will impact the number of older employees who can remain in their jobs after the age of 65.”

It is easy to be sceptical about shares right now given their woeful performance, but the analysts who have just finished writing the 2009 Barclays Equity Gilt Study give reason for hope. It could give the majority of providers who are sticking by equities a reason to smile in a decade’s time and justify their decision not to bail out of the stock market just yet.

Barclays Capital says that the underperformance of shares has nothing to do with the asset class per se. Secondly, it says the macroeconomic environment has little influence on shares, which is a cheery thought given the deepening global recession. Even corporate profitability isn’t the deciding factor on whether a share outperforms or not.

The study concludes that the “brutal” lesson we can learn from the past 10 years is that valuations are the core determinant of equity market returns.

Its research suggests that the reason shares have had such an abysmal ride over the past decade is that they were overvalued. Through the good times we were paying too much to get access to bumper profits.

“When the surge in growth ended abruptly in 2008, equity prices fell in line with the actual and expected decline in profits. Expensive valuations therefore caused equity returns to underperform profits following the 2001 slowdown and then did the same during the ensuing boom, while finally failing to provide a cushion when the business cycle turned down,” the study concludes.

The authors of the study believe that equity valuations will fall a little further and remain low for a while, before recovering late in the decade. Meanwhile, bonds’ rising yields will “self-evidently” damage returns. The end result, they say, is that equities will outperform bonds over the next 10 years. n

Are projections based on 5, 7 and 9 % returns realistic?

Even though there are many consultants and providers still backing equities, they do reckon that the regulator’s forecast based on 5, 7 and 9 per cent growth are beginning to look tired.

“I do wonder whether the illustrations are applicable any more and that modelling is a better way for employees to understand future projections,” says Julian Webb, head of DC solutions at Fidelity.

Like many providers, Webb feels that employees Webb: “Modelling is a better way for the future projections”need to take a more holistic approach and understand fully the ramifications of the pension choices they make. A number of companies have developed new tools in this regard. For example, Fidelity has just launched on online tool based on stochastic modelling, which is the aggregation of past and expected investment returns and longevity data to create a potential outcome.

The plan allows employees to analyses a DC member’s attitude to risk and provides a suggested mix of assets leading up to retirement. It also aggregates current and future pension and non-pension savings, for the member and their spouse, to provide a projected income in retirement.

“When members obtain their results they can model a wide range of scenarios by altering their levels of contribution, investment allocation and retirement dates,” says Webb. “It is a more effective way of engaging with their employees. The majority of tools available on the market provide a simplistic view of retirement targets and projected income with little opportunity to model different combinations of variables.”

Stochastic modelling has been used by Scottish Life too, while Aon has developed a model that shows employees the ramifications of their decisions – so if they want an equity-based fund they will understand what will happen to their pot if equities fall sharply, or increase.