Mercer’s 2019 European Asset Allocation Survey shows that 73% of UK defined benefit (DB) pension schemes are now cashflow negative, up from 66% in 2018. This means that for three out of four DB schemes the amount of benefits paid out annually is higher than the amount of new contributions received. The key driver behind the year-on-year increase is the maturity of such plans, most of which are now being closed both to new members and new accrual of benefits.
The survey also looked at plans across the whole of Europe (incl. UK) and found that, overall, 64% are cashflow negative. Of the 36% of plans that remain cashflow positive, 72% expect to become cashflow negative within the next 10 years. Whilst a normal scenario for a DB scheme approaching maturity, being cashflow negative presents some specific challenges as assets need to be properly managed in order to meet cashflow and collateral needs.
Disinvesting assets remains the most common way for survey participants to meet cashflow requirements, with 91% of respondents using this method. However, this year has seen increases in alternative methods of meeting liabilities, including 48% (43% in 2018) of respondents leveraging investment managers to distribute income from held investments, and 9% (5% in 2018) employing cashflow matching approaches (ie, buying specific investments that distribute cashflows at periods matching required outflows from a portfolio). Having a clear strategy is increasingly important as 27% of UK DB plans (24% in 2018) now have annuity buy-out, meaning the transfer of pension assets and obligations to an insurer, as their long-term target.
Matt Scott, Investment Consultant at Mercer, said: “Strong equity returns in 2017 and rising yields in 2018 have helped many DB plans to move closer to their endgame. Investors should consider developing a strategy to meet cashflows, to avoid relying solely on disinvestment which can be complex and expensive. We believe that cashflow matching techniques, where portfolios are specifically designed to align income and principal receipts, will be more widely adopted in the coming years, as DB plans continue to mature.”
Mercer’s 2019 European Asset Allocation survey – the 17th edition of the research – surveyed 876 institutional investors across 12 countries, reflecting total assets of around €1 trillion. In addition to investment trends, the report explores the drivers behind environmental, social and corporate governance (“ESG”) integration, sustainable investment and the investment risks and opportunities posed by climate change.
Sustainability is gathering momentum among European institutional investors with 55% now considering environmental, social and governance (ESG) risks in their schemes, up from 40% in 2018. Of these, 60% of respondents cite regulatory pressures as the primary driver. Mercer expects this trend to keep strengthening as a result of the introduction of the 2017 European Pensions Directive, IORPII, and the UK’s Department of Work and Pensions Investment Regulations, which will come into force in October 2019. These regulations will require pension funds to take ESG factors, including climate change, into account when making investment decisions.
Jo Holden, UK Chief Investment Officer at Mercer, said: “While 2019 has so far been marked by cautious optimism, investors need to be very aware of an ever-evolving macro-economic and political backdrop. Mounting evidence of overextension of credit, possible liquidity implications as central banks rein in their market involvement, and continuing political fragmentation, all mean investors should consider effectively positioning their portfolios to weather possible market volatility. We expect the increasing focus on sustainability to continue and anticipate it will soon be seen as an integral part of investment idea generation and risk management.”
Mercer’s survey found that investors across Europe and the UK have continued to diversify their strategies away from equity exposure, with the average equity holding falling to 25% this year (from 28% in 2018). To diversify their schemes and in the hunt for returns, investors have increased allocations to real assets (4% increase) and hedge funds (6% increase).
While allocations to equities have reduced across Europe, they have also changed in nature. The shift towards passively managed equity mandates continues, with the average proportion of a plan’s passive equity holding increasing to 55% in 2019 (53% in 2018). There was also increased focus on investing with explicit focus on exposure to different factors, eg. value, low volatility, profitability, and momentum, that drive equity returns above that of the broad equity market (‘factor-aware investing’). This follows a continued shift in governance focus to strategy-related issues and other areas of growth, particularly in the alternatives universe.
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