LONDON, September 14, 2020 – Underfunded defined benefit pension schemes in the UK are over-dependent on historically improbable equity returns, if they are to avoid carrying over funding gaps into the 2030s, according to analysis by Willis Towers Watson.
Given current funding levels, and typical asset allocations for UK schemes, the research shows that the average underfunded UK DB scheme requires equities to return 9% above cash rates on an annual basis for the whole of the next decade, or significant deficits will continue into the 2030s.
Comparing this requirement with historic returns from equities reveals how unlikely current allocations are to lead to full funding before the 2030s.
The required rates of return for equities are almost three times the historic equivalent. UK equities have averaged just 3.1% p.a. above cash rates since comparable records started in 1704. Throughout that time, UK equities have only matched the required 9% annual rate of return over cash in 1-in-20 previous ‘rolling decades’.
Other international comparators also suggest low odds of full funding by 2030. With equivalent data from US equities available from 1946, average 10-year returns still amount to just 6.2% p.a. relative to cash, and 9% p.a. returns have only been achieved by US equities in a quarter (27%) of rolling 10-year periods since 1946.
Katie Sims, head of multi-asset growth solutions at Willis Towers Watson, comments: “Underfunded DB schemes are effectively counting on a once-a-century equity performance if they’re to wipe out deficits this decade. Simply putting all your eggs in one basket and hoping for unlikely events will not be enough to solve the funding gap. Pension schemes need to either accept that it will take a lot longer to reduce deficits than people think, or they need to somehow increase expected returns. The best way to do the latter is to diversify the growth asset portfolio so that more can be invested there for the same level of risk, include private markets with higher expected returns and embrace active management if done well and at a reasonable cost.
“While caution is partly understandable, year by year this problem gets worse as returns will on average disappoint. Allocations that have such a low chance of delivering the right outcomes might also be seen as a form of denial. Trustees need to reimagine allocations.
“Many pension schemes and other institutional investors need to massively rethink how they anticipate creating the necessary long-term wealth to fund their future obligations. A much greater portion of portfolios need to be invested in practical real-world projects that are actively building the economy of the future. Listed equity certainly has a place in the investment mix, but schemes need to think beyond traditional allocations in order to meet the returns they need.”
Methodology:
The analysis is based on the PPF7800 index funding ratios of underfunded UK defined-benefit pension schemes as at 31 July 2020. The funding ratio is adjusted for and assumes that schemes are targeting full funding on a gilts flat liability basis (a proxy for targeting buy-out). The analysis assumes fixed income and liability returns are in line with the UK nominal yield curve at 31 July 2020 and that schemes are fully hedging their liabilities.
The findings also assume further, unbroken contributions averaging 2% of assets p.a. for seven years, consistent with the average contribution rate for UK DB pension schemes.
For the purposes of the analysis, a typical proxy for asset allocation is based on a 40% equity, 60% bond strategy – as a representation of Willis Towers Watson’s UK findings in the 2020 ‘Global Pension Assets Study’.
Willis Towers Watson (NASDAQ: WLTW) is a leading global advisory, broking and solutions company that helps clients around the world turn risk into a path for growth. With roots dating to 1828, Willis Towers Watson has 45,000 employees serving more than 140 countries and markets. We design and deliver solutions that manage risk, optimize benefits, cultivate talent, and expand the power of capital to protect and strengthen institutions and individuals. Our unique perspective allows us to see the critical intersections between talent, assets and ideas — the dynamic formula that drives business performance. Together, we unlock potential.
