State Street subsidiary WM Company (WM) says strong equity performance, especially in the UK and continental Europe, meant UK pension funds enjoyed a solid return of over 11 per cent in 2004.
“The year-end results are positive, but they need to be put in perspective,” says Michael S. Walsh, managing director of WM. “Although 2004 was a second consecutive year of steady growth, pension funds are still suffering the effects of the severe equity bear market between 2000 and 2002. Full recovery will require more years of similar or better overall investment returns, higher employer contributions, or a significant increase in bond yields.”
For the year, UK equity returns reached double digits at nearly 13 percent, while overseas equities in aggregate rose over 10 percent in sterling terms. Europe ex-UK (over 13 percent) and Pacific ex-Japan (16 percent) equities did well, while Japanese equity performance recovered toward the end of the year to finish at 7 percent. North American equities gained around 12 percent in local currency terms, but the depreciation of the dollar – which fell by 7 percent against sterling in 2004 – meant that sterling investors netted only 4 percent for the year.
Despite rising interest rates, UK bonds and Index Linked performed relatively well, with 2004 returns of over 7 and over 8 percent respectively. Overseas bond returns were again affected by the weakness of the dollar and closed for the year up almost 5 percent.
Property continued its extended run of strong results to finish the year up almost 19 percent. Property is the top performing asset class over one, three, five and 10 years, but as the average fund only has exposure of about 7 percent, the diversification benefits of property have been largely missed. “Property remains a largely unexploited asset class, and funds looking at alternative investment opportunities such as hedge funds should bear these figures in mind,” says Walsh.
In terms of asset allocation, UK pension funds continued to shift from UK equities towards bonds and overseas equities. The funds included in the WM survey withdrew £10.6 billion from the UK equity market; of this, almost £5.6 billion was invested in UK government and corporate bonds, with £4.1 billion going to overseas equities (mostly in North America and Japan). Overall, the total equity allocation fell slightly, to 65 percent of pension fund assets – a reduction of 10 percent from five years ago – while the property weight rose to 7 percent on the back of the strong property returns. Bond weightings did not materially change. There was also some evidence of an increase in contributions, with £2.0 billion of additional capital introduced.
“FRS 17 accounting regulations and the closure of many defined benefit schemes to new members have brought the mismatch between assets and liabilities into sharp focus for many commentators,” says Walsh. “Although the pace of change may be increasing, last year’s asset shift from equities to bonds is very much in line with long-term trends. Over the last ten years, funds represented in the survey have released over £65 billion from UK equities, while bonds and overseas equities have had inflows of £48 billion and £30 billion, respectively.”
Also notable is the widening gap between the equity exposure of public sector funds (69 percent) and private sector funds (approximately 64 percent). “Maturity is a consideration, but this divergence largely reflects the input of accounting regulations and the strength of sponsor covenants,” concludes Walsh.