Pension schemes must earn more – and assume greater risk

Our society is experiencing a “senior surge” that brings sweeping changes in consumer behavior, healthcare, infrastructure, politics – and in the investment strategies of many pension schemes. In the future, pension funds will have to achieve higher returns and therefore assume greater risk. 

The senior surge represents a predicament for our pension schemes. They must often pay a higher pension, to more pensioners, for a longer period than their original calculations allowed for. Here there are only three responses, which may be combined: 1) deficit guarantees, 2) pension cuts or 3) higher investment returns.

Naturally, higher investment returns would be the preferred solution. But they come with a catch – they require higher equity allocations. This would certainly make sense, in terms of both economics and investment policy, since it would shift financial market risks where risk tolerance is greatest – in our pension planning. There, the risk premiums from equities could, over time, translate in an ideal fashion into higher pension fund returns.

Equities Perform Better over the Long Term

Impossible? Who knows. But consider the following three points.

First, the average net return on Swiss equities over the last 100 years has been +6.7% p.a. This highlights the reward available to the patient equity investor.

Second, consider the winning strategy of the world's most successful pension fund – that of the Church of England. Over the last 20 years, it has reported net performance of +9.5% p.a. – in 2016 alone, the rate was +16%. How did they achieve that? With an 80% allocation in sustainably selected global equities.

Why are institutional equity allocations so low? Because we are still traumatized by the financial crisis of 2008.

Burkhard Varnholt 

Pension Funds Are Risk-Averse

And third, consider that from 1960 to 2008, Swiss pension funds maintained an equity allocation of more than 40% on average – today the rate is below 30%. Why are institutional equity allocations so low? Because we are still traumatized by the financial crisis of 2008. When Janet Yellen recently remarked that she did not expect another comparable financial crisis “in our lifetimes”, she was not making a statement about her age. Rather, she was qualifying that crisis as a traumatic, once-in-a-century event. This is why investors are still today, ten years later, more risk-averse than before.

Things may get tricky once higher equity allocations translate into new guidelines on fluctuation ranges and liability issues. These should be designed to strengthen the resilience of the entire pension system without triggering negative incentive mechanisms. Here the devil is in the details. But necessity often leads to change. This necessity explains why the current need for higher equity allocations is even greater than we think.

Pension Funds Are Investing in Long-Term Bonds

And here's another detail: since we are living longer, our pension schemes must also invest in bonds on a longer-term basis. This is why Austria, Belgium, Japan and even Argentina were recently able to issue 100-year bonds. In other words, the longer our lifespan, the greater the institutional demand for long-term bonds. This will continue to exert additional pressure on global capital market returns.

So our aging is both a blessing and a curse: it forces us to assume more global risks, but in doing so it also gives a boost to the bond markets and, subsequently, the equity markets.