1 September 2011 | By Bernard Abrahamsen
Traditional ways of meeting their pension fund liabilities are no longer enough for the public sector. It’s time to look for alternatives
2011 has been an absorbing year for markets and investors alike. Market turbulence remains as sure a thing as rain during a British summer. There is no end in sight to the financial crisis, and European sovereign debt woes are continuing to stifle recovery.
With the UK's total liability for funding public sector pensions topping £1 trillion (according to figures from Treasury accounts last month), it is only natural for us to look at how such events have affected the nature of fixed income investing, particularly for pension funds.
Pension fund trustees, especially in the public sector, should of course be speaking regularly with their advisors and fund managers to ensure they are fully aware of how protected their portfolios are at all times and particularly at this stage of the economic crisis. What is particularly of concern for public sector pension funds is a potential inability to meet the demands that will be put upon them.
Not only is an ageing population putting significant cost pressures on pensions, but also the funds’ liabilities have risen much more sharply than the value of their assets due to rising inflation and low interest rates, leaving a large funding gap. Can fixed income help reduce this gap? We believe so.
Traditionally, local authorities invested in public debt simply as a way of providing regular contractual cash flows to enable their pension funds to earn enough income to pay pensions. This is clearly no longer the case. With UK inflation in danger of spiralling out of control and market conditions extremely challenging, local authorities need to reassess the position of fixed income within their portfolios and seek out alternative opportunities – principally those that are safe, senior and secured.
But exactly why is this such an issue right now? Well, for starters pension funds face the huge task of meeting their long-term liabilities against a backdrop of inflation which is currently more than two times above the Bank of England’s target rate, and edging towards 5%. Traditionally, local authorities have used index-linked gilts as a means of hedging their pension funds’ inflation liabilities. Most UK pension funds, with sterling liabilities, will have a large proportion, if not all of their sovereign bond allocation in the UK. In fact the UK 30-year gilt has been the hero of this crisis – in the last five years its yield has barely strayed outside a 4% to 4.5% range, even when the financial system seemed on the verge of collapse.
However, with the UK government’s outstanding index-linked gilt issuance worth only £270 billion and public sector pension liabilities now over £1 trillion, there is a massive funding gap. Inflation-linked corporate bonds can help fill some of this gap and are an asset class that pensions funds have previously welcomed. But corporate bonds do not tend to trade on the secondary market and are therefore relatively illiquid; neither do they offer any security.
However there are alternative opportunities within the fixed income arena that allow long-term institutional investors to better match their long-term liabilities and reduce their exposure to short-term volatility.
Long-lease property is one such asset class that provides investors with a long-term, safe, secure and inflation-linked investment. Characteristically, this asset class targets tenants whose business models are protected against inflation, such as supermarkets, but instead of purchasing the supermarket operator’s bond, the investor purchases its property outright and rents it back to the supermarket over a long-term lease (typically 25-30 years). The investor then receives regular income through the tenant’s rental payments, which can be contractually obliged to increase with inflation. Furthermore, the investment is secured against the underlying property, which also offers the potential for capital gains.
Another potential source of inflation-linked cash flows lies in lending to not-for-profit Housing Associations who provide the UK’s social housing. Properties are offered at below-market rents, which rise, in general, by a little more than inflation, allowing investors to meet their inflation-linked liabilities. The HAs will typically pay back the capital of the loan through its term, unlike a bond investment, thereby reducing the risk that the lender will not see their capital returned to them. Moreover, as banks are unwilling to lend for the 30-40 year periods that suit the social housing sector, pension funds are being looked at more and more as a source of funding.
Finally, leveraged loans are worth mentioning, particularly with their ability to mitigate interest rate risk. Leveraged loans are similar to high-yield bonds in that borrowers are of comparable credit quality, the difference being that loans are secured and are senior to high-yield bonds in the issuer’s capital structure. This effectively means that, should the borrower default on its loan, as a levered investor, you are first in line to the company’s assets. Moreover, while high-yield bonds tend to be fixed rate in nature, cash flows from loans are paid on a floating-rate basis, which in a rising interest-rate environment will provide some added security. This is an asset class that is particularly suited to a pension fund’s needs in the current environment.
While we believe it is vital that local authorities take notice of the economic environment, it is almost as important not to get distracted by all this short-term noise. De-risking by moving from equities to bonds in order to remove a lot of market volatility is a natural course of action to take, but local authorities must also ensure their pension funds remain focused on their long-terms risks from interest rates and inflation and acknowledge that there is a wide range of alternative opportunities available to use.
Bernard Abrahamsen is head of institutional sales and distribution at M&G Investments
This article reflects the authors present opinions reflecting current market conditions; are subject to change without notice; and involve a number of assumptions which may not prove valid. This is not an offer of any particular security, strategy or investment product. It has been written for informational/ educational purposes only and should not be considered as investment advice or as a recommendation of any particular security, strategy or investment product.
Traditional ways of meeting their pension fund liabilities are no longer enough for the public sector. It’s time to look for alternatives
Credit: iStock
With the UK's total liability for funding public sector pensions topping £1 trillion (according to figures from Treasury accounts last month), it is only natural for us to look at how such events have affected the nature of fixed income investing, particularly for pension funds.
Pension fund trustees, especially in the public sector, should of course be speaking regularly with their advisors and fund managers to ensure they are fully aware of how protected their portfolios are at all times and particularly at this stage of the economic crisis. What is particularly of concern for public sector pension funds is a potential inability to meet the demands that will be put upon them.
Not only is an ageing population putting significant cost pressures on pensions, but also the funds’ liabilities have risen much more sharply than the value of their assets due to rising inflation and low interest rates, leaving a large funding gap. Can fixed income help reduce this gap? We believe so.
Traditionally, local authorities invested in public debt simply as a way of providing regular contractual cash flows to enable their pension funds to earn enough income to pay pensions. This is clearly no longer the case. With UK inflation in danger of spiralling out of control and market conditions extremely challenging, local authorities need to reassess the position of fixed income within their portfolios and seek out alternative opportunities – principally those that are safe, senior and secured.
But exactly why is this such an issue right now? Well, for starters pension funds face the huge task of meeting their long-term liabilities against a backdrop of inflation which is currently more than two times above the Bank of England’s target rate, and edging towards 5%. Traditionally, local authorities have used index-linked gilts as a means of hedging their pension funds’ inflation liabilities. Most UK pension funds, with sterling liabilities, will have a large proportion, if not all of their sovereign bond allocation in the UK. In fact the UK 30-year gilt has been the hero of this crisis – in the last five years its yield has barely strayed outside a 4% to 4.5% range, even when the financial system seemed on the verge of collapse.
However, with the UK government’s outstanding index-linked gilt issuance worth only £270 billion and public sector pension liabilities now over £1 trillion, there is a massive funding gap. Inflation-linked corporate bonds can help fill some of this gap and are an asset class that pensions funds have previously welcomed. But corporate bonds do not tend to trade on the secondary market and are therefore relatively illiquid; neither do they offer any security.
However there are alternative opportunities within the fixed income arena that allow long-term institutional investors to better match their long-term liabilities and reduce their exposure to short-term volatility.
Long-lease property is one such asset class that provides investors with a long-term, safe, secure and inflation-linked investment. Characteristically, this asset class targets tenants whose business models are protected against inflation, such as supermarkets, but instead of purchasing the supermarket operator’s bond, the investor purchases its property outright and rents it back to the supermarket over a long-term lease (typically 25-30 years). The investor then receives regular income through the tenant’s rental payments, which can be contractually obliged to increase with inflation. Furthermore, the investment is secured against the underlying property, which also offers the potential for capital gains.
Another potential source of inflation-linked cash flows lies in lending to not-for-profit Housing Associations who provide the UK’s social housing. Properties are offered at below-market rents, which rise, in general, by a little more than inflation, allowing investors to meet their inflation-linked liabilities. The HAs will typically pay back the capital of the loan through its term, unlike a bond investment, thereby reducing the risk that the lender will not see their capital returned to them. Moreover, as banks are unwilling to lend for the 30-40 year periods that suit the social housing sector, pension funds are being looked at more and more as a source of funding.
Finally, leveraged loans are worth mentioning, particularly with their ability to mitigate interest rate risk. Leveraged loans are similar to high-yield bonds in that borrowers are of comparable credit quality, the difference being that loans are secured and are senior to high-yield bonds in the issuer’s capital structure. This effectively means that, should the borrower default on its loan, as a levered investor, you are first in line to the company’s assets. Moreover, while high-yield bonds tend to be fixed rate in nature, cash flows from loans are paid on a floating-rate basis, which in a rising interest-rate environment will provide some added security. This is an asset class that is particularly suited to a pension fund’s needs in the current environment.
While we believe it is vital that local authorities take notice of the economic environment, it is almost as important not to get distracted by all this short-term noise. De-risking by moving from equities to bonds in order to remove a lot of market volatility is a natural course of action to take, but local authorities must also ensure their pension funds remain focused on their long-terms risks from interest rates and inflation and acknowledge that there is a wide range of alternative opportunities available to use.
Bernard Abrahamsen is head of institutional sales and distribution at M&G Investments
This article reflects the authors present opinions reflecting current market conditions; are subject to change without notice; and involve a number of assumptions which may not prove valid. This is not an offer of any particular security, strategy or investment product. It has been written for informational/ educational purposes only and should not be considered as investment advice or as a recommendation of any particular security, strategy or investment product.
