Pressures to shift holdings away from UK equities to primarily corporate bonds will continue to drive strategic holding decisions amongst pension fund trustees and life assurance companies, according to Legal&General research.
The Minimum Funding Requirement, FRS 17 accounting rules, and changing views on mortality rates are just three factors persuading pension funds they must switch to bonds to better match assets with liabilities.
The bear market exacerbated by events of 11 September, 2001, coupled with an increasing drive to close existing schemes to new members – primarily DB schemes – have coupled lower equity returns with schemes that are maturing faster than they otherwise would do if new members were still coming in, warns Andrew Clare, L&G financial economist.
”This is a risk-reduction exercise,” he says of the shift.
”Because the liabilities are ‘bond-like’, there is movement towards fixed income from equities.”
Interestingly, however, pension funds have actually increased their holdings of foreign equities, partly reflecting the increasing globalisation of stock markets and the abilities of companies to tap financing in non-domestic markets.
Gilts are also in the firing line because of the Bank of England’s brief to keep inflation in check, albeit gilt holdings by pension funds are up on 10 years ago.
Relative to gilt yields, ‘AA’-rated corporate bonds are preferable for much of the liability matching requirements of the schemes, the data suggests.
Index-linked gilts are also yielding at lower rates because of the leash on inflation.
A lot of asset reallocation between gilts and corporate bonds took place between 1999-2003, when bond spreads were higher than currently, Clare says.
Sadly, pension funds seem to have missed the boat on commercial property returns, which over the past decade have been above 10% annually in 8 out of the pasts 10 years.
Instead the funds have actually been net sellers. New vehicles such as real estate investment trusts proposed by chancellor Gordon Brown may increase interest in the asset class, but it is hard to see another decade when returns would be so strong so consistently, Clare adds.
Clare believes the data and the reasons for the shifts in holdings point to continued movement out of equities by pension funds into corporate bonds.
Effects of this change have been felt, for example, by the pattern of movement in the FTSE 100 index this year: whenever the index has approached the 4,600 level pre-planned selling of equities by the funds has taken place, he suggests.
Life assurance companies already hold a far greater proportion of corporate bonds relative to equities, which suggests pension funds will move the same way, Clare says.
”Arguably, pension funds have more reason to hold bonds than life assurers,” he says.
The switch may be checked by, for example, rising inflation, which makes equities a more attractive asset class, but overall investors should expect the stock market to keep feeling the effects of the changes going on, Clare concludes.IFAonline
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