MERCER’S EUROPEAN ASSET ALLOCATION SURVEY: PENSION FUNDS FOCUS ON BOND EXPOSURES AND ALTERNATIVES AS NEGATIVE YIELDS BITE

• Institutional investors keep the faith with emerging markets
• Increasing focus on cashflow-driven financing as 42% of schemes are cashflow-negative
• Report shows that smaller UK pension schemes most exposed to Brexit related volatility

New data from Mercer shows that institutional investors across Europe are reviewing their bond portfolios as negative yields reduce income and have an impact on their ability to meet and hedge their liabilities.  According to Mercer’s 2016 Asset Allocation Survey pension schemes are also seeking to manage volatility (especially in the more mature markets): average equity allocations across the region have reduced since the 2015 survey, with a corresponding increase in allocations to alternative assets.

Mercer’s European Asset Allocation Survey gathers investment information from nearly 1,100 institutional investors across 14 European countries, reflecting total assets of around €930 billion. The report also highlights that institutional investors have, in the main, retained allocations to emerging markets, despite a sustained period of disappointing performance since 2013.

“It is encouraging to see institutional investors taking a long-term view in relation to emerging markets, in marked contrast to the behavior of retail investors since the taper tantrum in 2013. We continue to advocate exposure to emerging markets as part of a well-diversified growth portfolio,” said Phil Edwards, European Director of Strategic Research in Mercer’s Investments business.

In the UK, an increasing number of plans are adopting or considering a cashflow-driven approach to their funding and investment strategy. This trend corresponds with a rise in the proportion of plans that are now cashflow-negative and increasingly focused on what their ‘end-game’ looks like. In addition the report notes that, on average, smaller UK pension plans are more exposed to any market volatility associated with the EU referendum.

According to Nathan Baker, Principal in Mercer’s Investments business, “Although it’s not possible to know now with any certainty how the referendum will impact portfolios, a typical small UK plan is more UK-centric, more exposed to movements in sterling versus other currencies, and is managed in a less dynamic fashion. On balance, they would appear more exposed to any associated volatility, and less well positioned to take advantage of it.”

The report highlights four main trends, two of which are specific to the UK:

Negative Bond Yields
Although bond allocations across Europe in aggregate remained broadly flat over the year, schemes in regions experiencing some of the lowest yields, such as Sweden and Germany, saw bond exposures fall.

In general, within bond portfolios there has been a shift away from low- or negative-yielding domestic government bonds towards higher-yielding non-domestic and/or corporate bonds. The varied responses of plans across Europe to the challenge of negative yields reflect the complex interplay of regulatory constraints, the availability of acceptable alternatives, and investor risk tolerance.

Emerging Markets
Although retail investor flows into/out of emerging markets remain volatile, institutional allocations have, on the whole, held steady. In spite of disappointing performance over a number of years, emerging markets continued to account for around 6% of overall assets (unchanged from last year) and both emerging market equity and debt remain common components of institutional portfolios across Europe.

The rise of cashflow-driven financing
The proportion of plans that are now cash flow negative (that is, when monthly outgoings to meet pension payments are higher than monthly contributions into the plan, leading to a cash demand on the asset portfolio) has risen from 37% to 42% since last year’s survey. This has fuelled interest in income-generative assets and cash-flow-driven financing strategies. Such approaches involve the asset portfolio being tailored to more closely meet the projected liability cash flows while ensuring funding-level stability. Of those UK plans that are cash-flow positive, 44% thought that they would become cash-flow negative in under five years, 34% between 5-10 years, 12% between 10-15 years and 11% in over 15 years’ time.

UK Plans and the EU Referendum
Specific to UK schemes, smaller pension plans tend to have a higher exposure to UK assets (domestic markets occupy 30% of smaller plan equity portfolios versus 16% for larger plans), lower levels of currency hedging (the average hedge ratio is 39% for smaller plans versus 45% for larger plans), and a less dynamic investment strategy (trigger-based hedging strategies are less commonly used). Although the impact of the referendum on capital markets remains unclear, the combination of these factors suggests that the “average” smaller plan may be more exposed to volatility associated with the referendum.

“Many markets are suffering from reduced liquidity which creates volatility; investors should be alert to and set up to capitalise on opportunities that market volatility may create,” said Nathan Baker. “It’s also worth noting that some of the most recent developments in credit markets – increased leverage, weaker credit standards and an increase in M&A activity – broadly mirror those that tend to be seen in the later phase of the credit cycle. These conditions argue for robust risk management (including consideration of tail risk protection where appropriate) as well as being alive to the opportunities that may arise in distressed debt.”

Mercer also believes there is a scarcity of “easy beta” (returns to be harvested from traditional market exposures), given the current level of valuations across most major markets. The consultancy says that one way to address the challenge posed by a lower return world is to seek a greater contribution to portfolio returns from manager skill, also known as alpha.

“We continue to encourage investors with long-term liabilities to think long-term on the asset side too,” concluded Mr. Baker. “Many institutional investors retain a long time horizon but fail to exploit all the benefits that may be available to them. In particular, long-term investors should be able to capture relatively attractive returns in private markets, partly from illiquidity premia, and should be able to behave in a contrarian manner when market dislocations arise”.