Light at the end of the tunnel?

2009 has been a traumatic year for pension funds. Paul Farrow examines how advisers plan to negotiate the problems waiting down the line in 2010

The stock market recovery has taken many by surprise and few would have predicted the strong surge in share prices since their March lows.

Twelve months ago investors were piling into fixed interest assets amid the continued economic uncertainty convinced that it was the asset class to be in and convinced that equities would continue to wobble. They have been proved wrong.

The FTSE has recently hit a 14-month high and the many leading fund managers believe that the run can continue. Fidelity fund guru Anthony Bolton recently said global stocks were still in a bull market and it was not too late to invest now, with technology and consumer sectors expected to lead the next phase of the bull run.

“The bargain phase is over. But despite the fact the market is well off lows, we expect the bull market to go on. It’s a multi-year bull market.” Bolton said.

But it is not difficult to see why many people continue to be unconvinced that the recovery is around the first corner. The legacy of recession looms large even though headlines over recent months have been of economic green shoots and stock market bull runs.

Despite the surge in share prices the UK’s defined contribution market has dipped in terms of assets under management. According to Aon Consulting the UK’s combined DC pension pot stood at F489 billion at the end of October, down by F18bn from September. This is the biggest fall since February, although Aon says the general upward trajectory makes the fall less of a concern.

Britain, for instance, is knee deep in debt, while an era of inflation and higher interest rates is staring to concern some experts. Indeed, for every Anthony Bolton, there is a Neil Woodford. Woodford is one of the UK’s most popular fund managers and he remains pessimistic – and has done for sometime. He believes the huge amount of debt, corporate, government and consumer, will haunt us for sometime to come.

“On the UK economy, I see little reason for confidence and I do not anticipate meaningful recovery in the next three to four years. Markets have seized on stabilisation, which has only been achieved through fiscal intervention by UK authorities, and have concluded that a swift return to sustainable levels of trend-like growth is likely,” said Woodford. “We may well finally emerge from recession in the final quarter of this year but in this kind of environment I think it is possible that the UK could experience further contraction during the years ahead.”

The whys and wherefores of the broader economy are unlikely to worry DC members. They do not tend to alter their investments once the initial investment decision has been made yet given the uncertainty their choice could prove telling – asset allocation is going to be key to successful investing in the years ahead, perhaps more than it has ever been.

Yet for many pension analysts, the recent stock market bull-run has only re-iterated the case for equities as being the number one asset choice for a retirement fund.

Aon Consulting admits that there is an on-going debate about whether the recession will be a double dip but says it hasn’t, and will not alter its view on equities.

“Our view remains that pension investment is long-term and short-term volatility should not influence decisions for DC members with many years to retirement. There has been nothing that has occurred that is sufficiently different to change our view and, as equities have out-performed other asset classes historically, we expect this to remain so in the future,” says Helen Dowsey, principal at Aon.

Crispin Lace, investment adviser at Mercer, echoes this sentiment. He says: “On a three to five year view, our confidence in economic recovery gaining hold is high, which should generally be supportive for equities, but on a twelve month view the outlook for UK equities is much more uncertain.

“The recent strong rise in markets along with current valuations suggest that market sentiment has swung from pessimism about a depression to optimism that the recession is now over and ‘normal’ growth will resume in 2010. Thus, in the short term, UK equity performance is likely to depend on the shape of the economic recovery. Any signs of a double-dip in the economy and equities would be likely to fall back from current market levels.”

The bargain phase is over. But despite the fact the market is well off lows, we expect the bull market to go on. It’s a multi-year bull market

That said, there has been a long and gradual trend in the pension sector of schemes reducing their UK equity bias within the global equity funds. But this trend, consultants say, is unrelated to recent market events. It is because of the increasing globalisation of UK companies, the high stock and sector concentration of the FTSE All-Share and an increasing appreciation of the benefits of diversifying, they add.

“Within the balanced and multi-asset fund space, there has been a gradual shift from more UK equity biased funds to a more global equity biased asset allocation. Historically the typical default fund has been a 70/30 split between UK/Global equities,” said Julian Webb, head of DC pensions, at Fidelity. “A 60/40 split is now typical and in some cases schemes favour a higher weighting to global equities compared with UK.

he events of 2008 have not affected the pace of this move from UK equities to global equities, rather they have stressed the importance of having a mix of asset classes and variety of market exposure to reduce volatility.”

Nick Smith, senior investment consultant at Watson Wyatt, says that it has seen an increase in the demand for money market, and in particular, Treasury Bill-based investments over the past year or so.

He adds: “A number of fiduciaries have also expressed a lot of interest in the type of cash fund offered, particularly given the events of late 2008 when the investment profiles of some cash funds with respect to mortgage-backed and asset-backed securities brought performance issues to the fore.”

Killik & Co, meanwhile, has seen a renewed interest in commercial property from GPP members. “I am starting to see a small increase in the interest in commercial property now that it looks as though valuations may have started to bottom out in the sector. Property shares and Reits have generally performed strongly in the year to date,” says Lee Smythe.

Yet some reckon that more than ever, employees are opting for the lifestyle default option, assuming that this is the safer route because it reduces its exposure to equities as retirement begins to loom.

On the UK economy I see little reason for confidence and I do not anticipate meaningful recovery in the next three to four years.

Dick Strachan, senior consultant at Aon Consulting says: “In turbulent economic times, it’s understandable that members are seeing the default fund as a safe haven. However, the security of the default fund is down to those managing the scheme. To ensure that members are getting the cautious investment option they think they are getting, scheme investment, and the performance of default funds in particular, should be a priority for those running DC pensions.”

“The key point is that employers and trustees must clearly communicate the options available if members are to make informed decisions that are right for their circumstances.”

However, lifestyle funds have their limitations. There is no flexibility within lifestyle structure for the fund to be moved out of equities regardless of their valuation, unless the scheme sponsor decides to change the approach.

Steve Rumbles, head of DC at BlackRock, says: “Members do have the option to opt out of lifestyle and switch to their own self-select fund choices, but consultants say, that in reality, this rarely happens.

“DC members in lifestyle funds will have seen the value of their pension pot plunge during the financial crisis. Alarming for those early in their career but disastrous for those closer to retirement whose fund was still in equities and who do not now have time to recover the value of their fund.”

There are concerns that the inflexibility of lifestyle funds and their perceived safety could catch employees out in the aftermath of the financial crisis.

Another big debate in financial circles is the inflation (which has risen for the first time in eight months) versus deflation argument. Inflation has the advantage for the government in eroding its huge debt and the transition of rising inflation is particularly painful both for bonds and equities.

Mark Dampier, head of research at Hargreaves Lansdown, says that fund managers are convinced that the huge mountain of debt will be overwhelming and will lead to deflation. Falling wages and high unemployment coupled with the fact that the stimuli that we have seen around the world will have to be withdrawn some time lead him to believe that bonds will do well. However, Dampier says that most bond fund managers he has spoken to, feel the huge government stimulus is storing up some real problems for later on.

“For the pension industry these factors have huge implications. If we get a bout of inflation and interest rates rise, and let’s be honest they are at a 311-year low so it’s not too hard to forecast the next move is likely to be up, lifestyling could be a huge disaster. There will be many people who have little idea about their pension even if they have heard of lifestyling but if the money is placed in bonds and the bond market falls sharply then they won’t be de-risking their portfolio at all.”

Dampier points out that when the Federal Reserve raised rates in February 1994 equities fell but so did bonds. Gilts had their worst year in 36 years, falling around 20 per cent.

“The problem with lifestyling is that it is seen as a compliant answer, a tick box which of course is a problem with the culture that we have in this country at the moment. We are storing up a huge problem once again in the industry, this time on lifestyling. You can be sure that the FSA will be writing new rules once the horse is over the horizon so I am putting a warning out now, before that horse has come out of the stable.”

The lifestyling debate is not a new one and the move to multi-asset strategies could help alleviate the inflexibility of many default funds. Those members that have ignored the credit crunch ramifications and continued to be mostly exposed to equities will have seen their pension pots back to where they were, or close to – the FTSE100 has returned more than 40 per cent since its March lows.

If we get a bout of inflation and interest rates rise, and let’s be honest they are at a 311-year low so it’s not too hard to forecast the next move is up, lifestyling could be a huge disaster

It is a point reiterated by Webb at Fidelity. “Thankfully the majority of DC members stayed put and didn’t move out of equities. They can now see the benefits of taking a long-term view of markets.”

The average pension member has remained unmoved by the most severe financial crisis and recession in living memory. This has proved to be a blessing because the surprise market recovery will be likely to have caught even the most experienced investor out. Those that tried to time their way back in probably missed the boat.

The intricacies of asset allocation will become more prevalent as diversified growth strategies become more popular – it will be events like the recent crisis that will sort the wheat from the chaff.

Yet despite member inertia, the crisis has changed the attitude of trustees and sponsors, many of whom have been busily reviewing fund choices and default strategies. Communication strategies appeared to have calmed many members who would have opened annual statements showing grim results.

Smith says: “If anything Watson Wyatt believes this year has been quieter than previous ones because trustees have been more proactive than previously about client communications, warning members of the impact of the financial crisis in late 2008 and thus effectively preparing the ground better. We believe this is a very positive development for the future.”