FT letter discussing why switching to bonds is likely to prove unwise for pension funds with large deficits
by Dr. Ros Altmann
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The recent lemming-like rush of pension funds into long bonds is an attempt by trustees to ‘reduce risk’, but is extremely worrying. Of course, pension fund assets should bear a more direct link to their liabilities and the traditional over-reliance on equities was wrong, because there is little economic rationale for expecting equities to match pension liabilities. However, switching from equities to bonds is too simplistic and unlikely to solve the problems pension funds face, because they are not a proper match for these liabilities either. Buying bonds can help protect against inflation and interest rate risks of pension liabilities, but other risks remain, such as mortality, duration, salary inflation and limited price inflation, none of which are perfectly matched by gilts and using corporate bonds still carry credit risk. Switching into bonds entails a significant reduction in expected returns, and guarantees underperformance of liabilities unless trustees can generate extra investment returns to meet these other risks. The answer may be found in the swaps market and structured products, which can immunise a pension fund against interest rate and limited price inflation changes, within a structure that still allows trustees to achieve substantial extra returns from ‘skill-based’ managers. The swaps market is far more flexible and liquid than gilts and, if pension fund investment advisers can help trustees understand the benefits of such an approach, the pressures on gilts should ease. In combination with high alpha absolute return investments, hedge funds and other strategies, structured products offer the potential to deliver sufficient long term returns, to help trustees actually pay the pensions, in a way that chasing index-linked gilts or switching to bonds is extremely unlikely to achieve.