The WM Company, the Edinburgh-based performance measurement consultancy owned by Deutsche Bank, confirmed today what everybody knew already: UK pension funds had another year of negative returns in 2002.
However, at minus 14.0 percent it is the worst annual return since 1974, and caps three years of negative returns which amount to -8.2 per cent on an annualised basis. This is the first time funds have gone south for three years in a row since WM began measuring performance in the mid 1970s. Short, medium and long term returns fell further in both nominal and real (net of inflation) terms.
“Negative investment returns have placed considerable pressure on pension fund finances,” says Eric Lambert, Head of WM Client Consultancy. “Asset values have been falling while liabilities continue to rise, not least due to low bond yields and improving life expectancy. This financial strain has been exacerbated by the accelerating maturity of funds and by regulatory, Minimum Funding Requirement (MFR) and accounting standards (FRS 17). As a result, a growing number of schemes have been closed to new entrants and, in some cases, are closing for future benefits to current members.”
WM adds that the negative investment returns have been driven mainly by weak equity markets around the globe – to which UK pension funds are heavily exposed. It says that defensive assets, such as bonds and property, have held up relatively well.
The UK equity return of a typical fund last year was -22.5%, broadly in line with the FTSE All Share. This follows two years of fund outperformance. A feature of the UK equity market was the high volatility. Few market sectors bucked the pervasive negative sentiment with Tobacco and Personal Care & Household notable exceptions, both giving a positive return of about 20%. While there was relatively modest difference in performance by size of stocks held, value style investing outperformed growth by a significant margin.
In aggregate, international equities returned about -24%, slightly worse than the UK. While the mature western markets performed very similarly (North America -30%, exacerbated by a weak US dollar which fell 10% against sterling; Continental Europe -26%, improved by a strong Euro, up 6% against sterling), the eastern markets fared rather better at about -18% for both Japan and Pacific ex Japan.
Reflecting the increasing globalisation of investment markets, UK pension funds have been actively rebalancing their exposure between domestic (UK) and international equities. A typical fund’s split between UK and international equities has moved from 70:30% to nearer 60:40%. We believe this split to be heading for 50:50% in the next few years. In the short term such rebalancing will have had little effect on returns as the international regions which receive increased exposure are those of the US and Europe where returns are broadly similar to the UK.
Supported by a reasonable macro-economic backcloth: decent economic growth, low and stable inflation and interest rates either static or falling, bonds performed positively. Both UK gilts and corporate UK bonds returned about 9.7%, with overseas bonds just behind at 9.3%. During 2002 UK pension funds continued the disinvestment from overseas bonds which has been evident for the past three years. Index-linked bonds returned 8.5%.
Funds have been seeking greater diversity within bonds: investing in corporate bonds as an alternative to UK gilts and capitalising on the more attractive yields from international, rather than UK, index-linked bonds.
Property, which returned 8.9% over the year, again demonstrated its investment credentials in providing a high level of income and diversification to weak equity markets. This brings the three year annualised property return to almost 9% pa and makes property, at 11.0% pa, the leading major asset over 10 years.
The maturity of pension funds is evidenced by aggregate fund disinvestments as benefit outgoes exceeded the money coming into funds from the combination of (employer and employee) contributions and investment income. Large funds led further purchases of index-linked bonds to more closely match non-active member liabilities.
However, during 2002 there was net positive investment by funds in equities, with more invested internationally than was disinvested domestically. This is in sharp contrast to, for example, Insurance funds which actively reduced their equity commitment in favour of bonds to support solvency. Many UK pension funds are true long term equity investors and are prepared to accept the inherent volatility in such a strategy to secure additional long term return. The aggregate equity purchases came mainly from existing liquidity, built up during market uncertainty, and sales of bonds, especially overseas. Despite aggregate equity purchases during the past couple of years, relative market movements and the move to scheme-specific, liability-led benchmarks have reduced typical fund equity exposure from over 80% at its peak in the mid 90s to about 65% by the end of 2002. Within this average there is now greater dispersion.
While some sponsoring employers have lost faith in final salary pension schemes, there remains a strong belief that significant equity investment is appropriate – indeed is possibly a pre-requisite – in making final salary schemes affordable.