How Pension Investing Has Changed In 40 years
A typical 1980s pension scheme would have held 40-60% in equities (mainly UK Blue Chip shares like HSBC, Marks and Spencer, Rio Tinto and the Prudential), 40-50% in bonds mostly UK gilts, some UK corporates bonds and some cash. Around 80% of the fund would have been in Pound based assets.
The pension investment landscape has changed dramatically in the last 40 years. This has been driven by a combination of:
- Quantitative easing, which depressed bond returns encouraging investors to invest more heavily in equities over bonds;
- The rise of the US stock market and the strength of the US Dollar, which has driven global equity investors towards the US stock market;
- The flight to passive investing index tracking funds, which allocated investment capital towards the largest companies.
The impact this has had on equity markets in the last 15 years is highlighted by the Financial Times below.
If we look under the bonnet at today’s MSCI’s world equity index, we see the following top 10 companies attracting a disproportionate amount of each Pound invested.
Passive World Equity Index – Top Ten Holdings
All top 10 companies are American, so 100% of your Pounds are invested in Dollar-based assets. Nine out of 10 of the companies are ‘big tech’, although it’s a moot point whether most of these companies should be described as technology businesses.
To see just how skewed this index has become, and how passive investors’ funds are driven into the shares of these biggest companies, we can see the first 10 companies making up the first quarter of the index. In the next quarter there are just 75 companies. 227 make up the third quarter and 1,060 companies’ shares make up the bottom 25% of the index. Future returns of index funds are going to be heavily impacted by the performance of the shares in the 100 biggest companies in the world, and the top 10 in particular.
If we take the Polaris 3 fund from St James’s Place (SJP) as a good example of what a modern mixed asset pension fund looks like, we can see how dramatically the pension investment process has changed for UK investors. Note that this was only launched two years ago, and SJP advisers have poured in over £30bn in that time, already making it the UK’s biggest retail fund.
SJP - Polaris 3 Constituents
Of course, not all pension funds are the same, but the trends seen here are, in our experience, widespread in the UK’s wealth management and defined contribution pension market.
There has been a steady shift from bonds to equities, a massive reduction in Pound-based investments, and a massive shift towards US equities. In this fund’s allocation we can see less than 11% of the portfolio in Pound based investment assets and 40% in US shares, which no doubt will be heavily focused on the index’s biggest companies. The fund also produces negligible income with a yield of just 1.2% per year which will be mostly, if not totally, consumed by fees.
This St James Place fund is designed for the accumulation market, but the question is how many pension savers are in similar funds approaching retirement, heading into income drawdown and already in income drawdown?
Are these investors taking too much risk with their pension funds?
Three Big Implicit Investment Risks
Pension investors today investing in the type of fund we discussed above (or any passive or quasi-passive multi-asset funds) are effectively taking three big investment bets:
- That equities will continue to outperform bonds
- That the Pound will continue to fall relative to the US dollar
- That the top 10 biggest companies in the world will have the best performing shares for the next 10 years.
This cartoon in my LinkedIn feed during the March correction in US equities summed up the position nicely – excuse the language!
Are These Sensible Risks to Be Taking with Your Pension Fund?
Let’s look at each of the three big risks in the context of the pension investment tasks as outlined above:
Risk 1: That equities will continue to outperform bonds
It’s generally accepted that equities out-perform bonds in the long term, but if you are unlucky with your timing with equities, ‘long’ can be a very long time.
Now, and since quantitative easing ended, we have very attractive returns available from corporate bonds, which are now also above the rate of inflation.
I look at the opportunities for corporate bond investors later in this paper.
Bonds do well when interest rates are steady or falling. Equities do well after big corrections, when prices are depressed and when the economy is strong. If the conditions are good for investing in bonds and bad for equities, it can take 20 years for that risk to pay off. Look what happened for investors in 1997.
If you were in your 30s in 1997 and in the accumulation phase, investing in equities would have been fine. For wealth preservers and drawdown investors, bonds would have been a much better bet.
We certainly have not had a big recent correction in equities as I write. Interest rates are relatively elevated, and the economies around the world are OK.
Risk 2: That the Pound will continue to fall relative to the US dollar
Judging exchange rate risks is one of the hardest tasks in investment management.
Generally accepted practice is to match the currency you invest in with the currency of your cash liabilities. So, if most of your expenditure will be in Pounds, investing in Pounds is the safest option.
Whilst the long term trend has been for the Pound to decline against the Dollar, the chart shows the shorter-term risk in investing in Dollars when you need to spend in Pounds. In1985 the Pound rallied 70% against the Dollar and more recently, post the Millennium, there was a 40% rally. These would equate to the equivalent losses in Pound spending power.
Risk 3: That the top 10 biggest companies in the world will have the best performing shares for the next 10 years.
Here there is compelling long term historic evidence that this generally does not happen.
The chart below shows that, historically, nine out of the top 10 stocks go on to underperform the index in the following year.
The next chart shows that, since 1957, top 10 companies have consistently underperformed the top 500 companies invested in in equal measure rather than by value.
Interestingly, this does show that in the run up to the dotcom crash and in the last 12 years, the reverse has been true. However, in all other previous reversals the trend prevalent for the last few years has ultimately strongly reversed.
Acting on this supposes that we can find active managers who can pick the companies that will do better than the top 10, which is less easy.
My take on this is that it’s a pretty defeatist approach to continually bet on a losing risk.
Opportunities presented by Corporate Bonds
With these risks in mind, let us look at corporate bond returns and the opportunities they present post-quantitative easing.
Corporate bonds are loans to big companies that, like shares, trade daily. Unlike shares, corporate bonds generally have:
a) a fixed maturity date when you get your capital back, and
b) a known interest rate payable on the bond, so that you can calculate the exact return you will make on a corporate bond from when you buy it to when you sell it.
If you want to sell a bond before maturity, you can do so on most days the stock exchange is open. Fewer bonds change hands daily than shares, so we see the market as a little less liquid than equity markets, but it’s still pretty good. It takes a major financial collapse to prevent the daily trading in bonds and, most likely, when this happens equity markets will also be heavily marked down or even suspended.
The Returns
UK Corporate bond returns are generally at a premium to UK gilt returns for the same term. With the end of quantitative easing in 2022, these returns (or ‘yields’, as we refer to them) have become much bigger and, we believe, more normalised.
As can be seen above, it’s now possible to earn between 4% – 5.3% on UK gilts depending on the term of the gilt bought. A shorter-term gilt will pay less than a longer-term gilt, and this is now what we consider a more ‘normal’ yield curve. Investors earn more interest for committing to longer terms.
Corporate bonds give a premium return above these yields. If you buy AAA-rated bonds, which would be deemed a lower risk, then the ‘risk premium’ is around 1%. Higher risk bonds can give a premium of around 4% or more.
These are known as ‘credit spreads’ – the higher risk the company you lend to, the bigger the spread.
The High-Yield Spread Over Time
(Grey bars are NBER dated recessions. Dotted line is the current level of spreads.)
Adding the credit spreads to the gilt yields. You will see that corporate bonds are now offering us certain returns of between 6% and 9% per year. This is well above inflation, even allowing for some investment costs.
What are the risks?
The two big risks are:
a) interest rates, if we want to sell a bond ahead of maturity;
b) default risk if a company we have lent money to goes bust – and it does happen. Think Barings, Enron, Lehman Bros, and quite a few more.
To manage these risks, we want to invest in lots of bonds to avoid a significant impact of any corporate failure, and we want to only invest in longer duration bonds when it’s clear that interest rates aren’t likely to rise. Rising interest rates cause falls in bond values in order to compensate for the higher interest investors want. 2022 was the worst year for many generations for this.
Actively Managed Bond Funds
To address these risks, we believe it’s best to invest in collective funds rather than individual bonds, and with active managers who can manage the risk of both default and interest rates.
Active managers also find it easier to add value in bond markets, which are generally considered less well priced than equity markets.
Additionally, assessing whether a company will go bust to avoid buying its bonds is generally an easier task than trying to find companies who are going to surprise investors with profits ahead of forecasts.
With higher interest rates and the big adjustment of 2022 in the rear window, these managers are producing returns that might surprise you.
The next chart shows that, since 1957, top 10 companies have consistently underperformed the top 500 companies invested in in equal measure rather than by value.
Tideway’s Higher Yield Fixed Income Portfolio Vs Global Equities Since the Start of 2023
As can be seen, returns are much less volatile than equities, and over the last two and a quarter years have been in line with equity returns. Based on the current UK yield chart we see good reason to expect returns on this portfolio to be in the 6-8% range in coming years. This is something we can forecast with way more certainty than the return on equity markets, in Pounds, in the next few years.
If 6-8% as return gets the job done for you in terms of beating inflation and generating the pension income you need in Pounds, then this will be a much lower risk way to achieve that return than speculating on currencies and equity markets over relatively short time frames.
The Importance of Time Horizons and Cash Flow in Considering Risk
It is often said that timing is everything when it comes to investment. As the Bonds vs Equities chart showed, if you get the timing wrong with equity investment you can suffer a lot of volatility for a long time before a premium return over bonds materialises.
This is a particular issue with today’s equity markets after such a long bull run from the trough created by the financial crisis in 2008/9, and (as highlighted by the cartoon) as investor time horizons shorten. Under 20 years is not a particularly long time horizon in equity investing to ensure a better return than bonds. The shorter the time frame, the higher the risk of bonds outperforming equities.
In addition to time horizon, the cash flow of your fund is also critical. When you are adding to your fund you get to buy more shares, or fund units, when equity markets decline, so volatility can actually help your return.
The reverse is true when you are regularly withdrawing from your account. Then, volatility is your worst nightmare and can make you a forced seller of investments when prices are depressed. You can read more about this particular risk and how it impacts drawdown investors and makes it one of Drawdown’s Biggest Risks on our website.
Conclusions
Key Points
There has been a general shift in pension and other investment portfolios:
- To equities from bonds driven by QE 2012-2022
- To US equities, by past performance and strength of the US Dollar
- From Active investing to passive index tracking which exaggerates past performance-based investing
This has led pension investors and other investors, whose primary objective is to deliver long term income, to take considerable risks:
- That equities will outperform bonds
- That the pound will keep depreciating against the dollar
- That shares in the biggest companies in the world – mainly big US tech companies will continue to outperform other shares
UK Corporate bonds now offer real returns above inflation allowing such investors to meet their key objective of beating inflation with considerably less risk.
This is most important for a) later life pension investors, and b) pension investors who want to protect what they have accumulated and as they move into drawdown.
Action to Take
Now is a great time for pension investors to review the risks they are taking. Several factors have combined to create the perfect catalyst for this – namely, the combination of increased geopolitical risks emanating from the new Trump administration, high US equity and currency values, and the great opportunity in Sterling corporate bonds.
This is especially important for those either already in the capital preservation phase, heading into income drawdown, or already in drawdown. For these investors, drawdown will be riskier than it needs to be if they remain in many mainstream multi-asset funds, due to capital volatility, currency risks, and a lack of portfolio income.
