As the majority of defined benefit pension schemes in Ireland today continue to work towards closing their respective funding deficits in the face of stringent regulations set out by the Pensions Authority's, we ask whether trustees are in danger of excessive prudence and being forced into making difficult investment decisions that could result in poor outcomes for members, not by choice but by compulsion.
Before we outline our case, we would first like to take you on a trip down memory lane, back to the good old days of the 1970's, '80's and '90's, when the life of a DB pension scheme trustee was much more pleasant. Back then, Irish investors earned double digit returns on their pension portfolios, irrespective of whether they invested in high risk equities or lower risk bonds. It was a time when the typical equity portfolio comprised 40% Irish and 60% global equities. During the 1970's, equity portfolios returned 12.1% p.a. on average at a time of double digit inflation. In the 1980's when stocks were great value, the typical equity portfolio returned 17.9% p.a. on average. Again in the 1990's, equities delivered strong returns for Irish DB scheme investors. Pension schemes that favoured a lower risk approach and invested in Irish government bonds were rewarded with similar returns over the period: 11% p.a. in the 1970's, 14% p.a. in the 1980's and 11% p.a. in the 1990's.
The last decade has proven more challenging for investors with equities returning 'only' +6.5% p.a. and bonds +5.1% p.a. Today, stocks are expensive. The S&P 500, an index of the largest 500 public companies in the United States, trades at a price-earnings multiple of 25 times the average of the last 10 years of corporate earnings. US corporate earnings are also booming and have reached 10% of US GDP versus an historical average of 6%. If earnings and P/E multiples mean-revert over time, there is plenty of room for stocks to fall. In addition to equities being expensive, investor sentiment is also approaching a bullish extreme. The Investors Intelligence Survey recently reported the lowest percentage of investors with a bearish view on stocks in over 20 years. We also are currently witnessing a massive surge in leveraged loan issuance.
Banks are once again lending to high risk companies and repackaging those loans into ETF's for investors. Peaks in leveraged loan issuance have always corresponded with peaks in the stock market. When the current surge in leveraged loans turns lower, equity markets could be in for trouble.
Bonds aren't looking particularly cheap either. German government bond yields have fallen from 9% in 1990 to 1.5% today. The Eurozone is at risk of a deflationary crisis similar to that which has blighted Japan for over two decades. So, given the challenging investment climate we currently face, are trustees in danger of excessive prudence and being forced into making difficult decisions that will result in poor outcomes for members?
Trustees are right to adopt a prudent approach to managing risk and in fact, over 87% of defined benefit schemes today now follow a tailored approach to scheme design. However, as the majority now focus on matching liabilities with long duration government bonds, excessive prudence becomes a reasonable question to raise. In aggregate, Irish defined benefit pension assets total €50 billion. 40% or €20 billion are invested in 12 year duration government bonds. A 1% change interest rates impacts the capital value of those bonds by 12% or €2.4 billion. If yields mean revert over time from 1.8% today for a basket of 12 year duration AAA government bonds, back to the 10-year average of 4.8%, a 3% rise in yields would result in a -36% or €7.2 billion capital loss on those safe liability matching bonds. While it's true that a rise in yields of this magnitude could result in a liability reduction in excess of 40% so the net position could be a €14 billion improvement in funding, the improvement would be significantly greater if matching bonds were not held as yields rose.
What happens if a Japanese style deflationary crisis occurs in Europe? How bad could things get? Japanese 10 year yields bottomed at 0.50% in 2003 and again in 2013 following their deflationary collapse. If the EU experienced a similar crisis, the yield on a mix of 12 year duration AAA government bonds could fall another 1.3% to 0.5%. This implies that the maximum gain in capital value on these AAA bonds is +15% or €3 billion. The maximum capital loss is -€7.2 billion (-36%) at a 4.8% yield, -€12 billion (-60%) at a 6.8% yield and -€16.8 billion (-84%) at an 8.8% yield. Pensioner liabilities of course will fall as interest rates rise, but with only 15% upside and enormous potential downside, why take the risk?
In reality, while we expect bond yields to rise over the long term, the timing of any rise in uncertain. Trustees need to acknowledge the potential capital loss of investing in long dated bonds at current yields. They should also recognise the risk reduction they bring and certainty to funding positions. At some point bond valuation may become secondary to the price of certainty in funding. At that point, while this excessive prudence may hamper the potential for total return, it may be for the benefit of prudent risk management. In the current investment climate, funding proposals that target returns of 4-5% p.a. while forcing schemes to hold 70-100% bonds by their funding proposal deadline, simply cannot and will not work. A dangerous precedent has been set. There is still time to change before it's too late.