Mercer’s latest European Asset Allocation Survey has highlighted that 55% of the UK’s defined benefit (DB) pension schemes are now cashflow negative (up from 42% in 2016) with 85% of the remainder expecting to be cashflow negative by 2027. Cashflow negative schemes lack sufficient income from investments and contributions to pay member pensions, so typically need to sell assets to meet their liabilities. Consequently, they are more vulnerable to market corrections since they may be forced to disinvest during a period of market stress.
Mercer’s report also noted that, in parallel, pension schemes are investing in alternative assets that offer some additional return in exchange for reduced liquidity and greater complexity as well as providing a regular income stream. The average allocation to alternatives increased in 2017 to 22% compared to 21% in 2016 (up from 4% in 2008).
According to Phil Edwards, Mercer’s Global Director of Strategic Research, “While many private markets have seen significant inflows in recent years, opportunities remain for high quality managers to extract returns in less liquid and more complex markets. This is especially true in areas where the supply of capital remains constrained – most notably private debt finance for smaller companies who have limited access to the capital markets. Such income generative assets can help investors meet their cashflow needs whilst also reducing their exposure to equity risk.
He continued, “Being cashflow negative is a natural life stage of a mature DB pension scheme, of course, but recent stock market performance may have lulled some into a false sense of security. Our report highlights that less than 40% of schemes have a formal de-risking journey mapped out. This leaves a large body of schemes with no clear plan in place.”
Trustees of cashflow negative schemes need to be sure that, in the event of a large market correction, liquid assets are available to meet cashflow and collateral needs, without requiring the scheme to crystallise losses. We would encourage all schemes – large and small – to use scenario planning and stress-test analysis to understand how a market correction might impact their financial health.”
This is the 15th edition of Mercer’s annual European Asset Allocation Report. The 2017 report survey gathered information from 1,241 institutional investors across 13 countries, reflecting total assets of around €1.1 trillion. This release deals only with UK scheme information.
The report highlights that de-risking continues to be a dominant trend in the UK pensions industry with 47% of respondents stating that their long-term funding objective was self-sufficiency, 36% focused on their technical provisions liabilities and 17% targeting buy-out.
In terms of asset allocation (See Chart 1) since 2008, UK plan equity allocations have halved from 58% to 29%. Report participants see this continuing, expressing their intention to further cut equity allocations in the years ahead. Indeed, in 2016, equity allocations fell as some schemes took opportunities to de-risk in the latter part of the year as equity markets and bond yields rose. Equity allocations averaged 29% in 2017 - compared to 31% in 2016 - while allocation to bonds rose from 48% to 49%.
Mercer’s report showed an increase in exposure to hedge funds (from 33% to 37% of investors covered by the survey) as investors respond to the challenging environment for traditional market exposures (such as equities and bonds).
“There is a growing consensus that portfolios dominated by equities, credit and government bonds will offer a relatively unattractive risk/return trade-off in the future,” said Phil Edwards. “Whilst hedge funds have faced a challenging post-crisis environment, with falling volatility reducing the potential for generating alpha, institutional investors have, in the main, retained their allocations in recognition of the valuable role they can play in portfolios.”