Is it time for schemes to run to safety? Professional Pensions Opinion Piece

As concerned pension funds are flocking to 'safe' assets or buying equity protection, John Gray points out there is no such thing as a 'free lunch' in life

There is an ancient saying attributed to Saint Teresa of Avila that "More tears are shed over answered prayers than unanswered ones." 

I think that most pension trustees have been grappling with what to do about the ongoing highs in the equity markets and whether (or when) there will be the inevitable market correction. Returns have been exceptional for some time and many funds have made a lot of money. Is it time to run to safety or is it truly ‘different this time'?

Many active fund managers have been sitting on their hands for a long while, refusing to invest in what they consider to be an overvalued market that is bound to crash and destroy value. However, this has impacted on their performance, which has suffered accordingly.

Some funds are moving out of equities, realising gains and locking into what they believe to be ‘safer' and less volatile asset classes.

Other funds are buying complex ‘insurance' products that for a fee will protect against market losses or can even offer protection for no apparent cost (instead of an upfront fee you give up on gains from possible future market rises). 

There is, of course, no such thing as a ‘free lunch' in life. Most open public and private defined benefit (DB) schemes (yes there are still open private schemes) are dependent on taking long-term equity risk to meet their obligations. If they reduce their exposure to equities then they may have to increase contributions. 

There is also the argument that pension funds are in for the long run - so why worry about short-term temporary movements? Equity markets always recover eventually and then go on to more record highs… don't they?

I remember a few years ago funds being strongly lobbied to take out similar insurance products. Since then markets have risen even further and if they had bought then this would have meant unnecessary costs and/or lost equity return opportunities.

To complicate matters further for us poor trustees, there are also voices out there arguing the risk is overstated and that equities are not necessarily overpriced in all markets. Twice now in recent months I have attended pension conferences and heard positive views on the near future. This included a respected economist of a major international bank and a senior investment manager of a large mainstream equity fund. There were ‘ifs and buts' expressed about the impact of Brexit and Trump etc. But it was not at all doom and gloom.

Meanwhile, elsewhere I have heard very robust arguments that we are about to go over a cliff edge.

The elephant in the room is fund valuations. If the market does crash at the eve of a valuation and it results in massive deficits then that will cause all sort of problems for these funds. So you could understand the temptation for funds to be defensive and ‘safety first' even though there will be costs.

Let's leave aside for the moment about whether it is really a good idea to drive pension investment decision-making on the basis of what is essentially an artificial ‘snap shot' of inherently volatile valuations. I think it does make sense to crystallise some of your gains and take defensive measures. If your fund is currently nearly fully funded (like most local government pension funds) then why take the risk?

The current positive funding level of so many DB funds does make you wonder why so many people wrote off DB schemes and closed them at huge cost in the private sector. But let's leave that aside for another day as well. 

John Gray is chair of the Newham Council Pension investment and accounts committee, writing in a personal capacity

Only worry about your pension if there is another Russian Revolution...

I recently went to an "off the record" Chatham House rules debate on whether closed defined benefit pension schemes should invest in equities (shares) or not?

Now, I doubt very much that all that many people will share my keen interest in such matters, but if you currently contribute to a funded defined benefit pension scheme or if you have a frozen one from a previous employer then you should. 

This is your money, your "deferred pay" and unless you at least try and take an interest in it then who will you blame if it all goes horribly wrong? 

The argument goes something like this. Pension funds which are "closed" (for some reason it wasn't made clear in the debate but I assume it was funds that were closed to new members and future accrual of pension benefits by existing members) are concerned about the long term not the short term and that the strength of the employer "promise" to the scheme to fund it until it pays out all its obligations is more important than anything else. Such schemes can afford to hold illiquid assets which have attractive tax efficient returns with a low probability of risk. So why invest in risky, liquid and unstable equities? 

The alternative argument was that equities should be part of a mix of investments. Admittedly returns in equities in recent years have been appalling but "No means Never" and you should not throw the baby out with the bath water. UK Pensions PLC have massive pension shortfalls in funding liabilities and the only way to close this gap is the long term historic out performance from equity investments. Past performance is not guarantee of the future but the long term equity premium over bonds is an accepted market compensation for risk. 

Why this is important is that if the trustees of your pension scheme gets this equities and/or bonds decision wrong, then your scheme may end up in the tender mercies of the Government Pension Protecting Fund (PPF).  The PPF is a very good thing but most people would lose out financially if their pension had to be rescued by it. 

So the lesson is if you are in such a scheme then take an active interest in it and in the trustees that run it on your behalf. Read the stuff they send out to you, ask questions, take part in elections of member nominated trustees, turn up to any meetings and even consider standing yourself to be a trustee. Make sure that your scheme is run in the interests of the beneficiaries and not by any vested interests (and there are many). 

Apparently there is an argument that the only real danger to equities not out performing bonds is if the economy suffered from something completely dramatic as the Russian revolution of 1917. 

I hesitate to point out that next week is in fact the 95th anniversary of the Bolshevik Revolution and the Storming of the Winter Places. I hope they will keep "Pleb Gate" locked up for this anniversary.

Update: I have just been reminded that the number one issue with closed schemes is that they cost far, far more to run when closed than if they were kept open. Pension funds need new blood, new contributors to stop them becoming mature and cash deficit. Millions of workers are simply being cheated and conned out of a decent retirement while employers are often being mislead and badly advised. While many DB schemes and Government regulations need to be updated they do not have to be closed. If they are closed then it is in the real long term interests of the workers and employers that they should be reopened.