Is recent history a threat to pension scheme models?
Brexit deal ructions have this week prompted a sharp rally in gilts, with yields correspondingly plunging back to levels around 1.4% for the 10-year benchmark bonds.
However, there remains a distinct possibility that they resume their upwards trajectory, if the latest episode in the long saga is resolved in a manner that is seen as positive by the markets.
It was already happening prior to this latest uncertainty, with the 10-year gilt yield above 1.7% in October.
Nonetheless, it is a scenario that schemes have not had to deal with for more than a decade, as gilt yields having fallen consistently for the last 20 years.
There is a real danger now that – Brexit uncertainty aside – scheme models are not configured suitably for a world which sees yields climb on fixed income assets and equities fall.
After all, it would be hard to deny that we are at a turning point for markets, with inflation and interest rate expectations creeping higher (albeit more slowly than expected).
The implications for schemes in such a scenario could be very negative, with schemes that are fully hedged potentially seeing both losses on equities but also failing to lower liability values by capturing rising yields.
There is also the concern that, with so many schemes having significant exposure to equities or other assets such as property, the downside risk is more significant than expected.
So what should schemes be doing to mitigate this potential risk? It is quite an ask to overhaul a way of thinking which has been prevalent for such a long time, but that is exactly what schemes must do now if they are to adapt to a new environment.
As to what they should be considering, there are a number of options available.
Firstly, the issue of hedging needs to be addressed. Do they, for example, need to be fully hedged, or is there an option to adjust this? By reducing hedging levels (but not significantly) whilst having large equity allocations, you could create a more diversified risk stance for what could be to come.
On top of that, schemes should reassess other investments, for example, do they have assets that have done well because of falling rates but could be negatively impacted when rates rise.
These could include certain areas of property, sectors in equity that are more highly leveraged and some debt instruments.
Ultimately when it comes down to it, good risk analysis is about planning for the future not the past, whilst at turning points in an economic cycle using the past as an indicator can actually add risk not reduce it.
By Dan Banks, Director at River and Mercantile Solutions