UK plc shares suppressed by too much risk in pension funds
High risk in UK pension schemes is an important factor in suppressing the price/earnings ratios of their sponsoring companies, research by global professional services company Towers Watson suggests.
It shows high pension risk companies typically having lower price/earnings ratios and warns that in aggregate pension risk is twice as high as it should be which could precipitate more company defaults as the economy recovers.
Alasdair MacDonald, head of investment strategy at Towers Watson, says: “During the past decade it has only been at the extremes where pension funds were responsible for the collapse of a few companies. However, now we are seeing more clearly the extent to which excessive risk in the pension fund has dampened share performance in the past and how it could potentially imperil many more companies in the future, when the economy recovers and financing rates increase.”
According to the Towers Watson, corporate default rates have been lower than expected despite historically high economic contraction and very low financing costs have preserved some companies that might otherwise gone out of business. It expects that when short rates normalise corporate default rates could rise, particularly in sectors where companies rely heavily on financing and where there is high pension fund risk.
MacDonald says: “For trustees this may mean the worst is still to come when the UK economy recovers. However, they can avoid or mitigate the worst outcomes by developing financial management plans that take into account the corporate covenant; and it is encouraging to see the Pensions Regulators recent support for this approach. These strategic frameworks are useful to help position pension funds to choose the optimal risk level and de-risking strategy, as long as they include the financial circumstances of the sponsor and a macro-economic view to inform an implementation timeline.”
Towers Watson acknowledges that the timing of any de-risking strategy is more complex than in the past because of a more volatile global macro-economic environment which has also become increasingly competitive due to expected lower returns in the foreseeable future. It also points out than many UK pension funds are running excessive poorly rewarded risks through inflation, interest rate and longevity exposure which could be reduced immediately regardless of the macro-economic environment.
MacDonald says: “The de-risking process has become like very complex game of musical chairs. For some funds an improving economic environment means imperative and quick risk reduction, particularly if their sponsor is heavily dependent on financing; otherwise the sponsor gets ‘pulled away’ and contributions dry up. For others, extending the music time to reach a funding target could lead to a lower level of investment risk without additional contributions for the employer; so de-risking doesn’t have to cost you money if you use time as a variable.”
According to the consultancy there are numerous de-risking ideas, including alternative LDI, risk transfer and DIY buy-ins, some of which have limited capacity.
Macdonald says: “Apart from complexity, the main catch is the limited capacity that most of the de-risking strategies have. There was a first mover advantage for the early adopters of previous de-risking ideas, before either market pricing or regulations moved against the ideas. For example, the pricing of interest rate swaps and bonds looked more attractive before the crisis. To profit from current and future innovations, trustees and employers should move quickly, and a good start is a well-designed monitoring framework covering both asset and liability de-risking opportunities.”
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