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Mind the gap

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UK pensions counting on “once-a-century” equity performance to close funding gaps by 2030

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It is “historically improbable” that UK defined benefit pension schemes will reach the equity returns necessary to avoid carrying over funding gaps into the 2030s, according to analysis by Willis Towers Watson.

Given current funding levels, and typical asset allocations for UK schemes, the research shows that the average underfunded UK DB scheme requires equities to return 9 per cent above cash rates on an annual basis for the whole of the next decade, or significant deficits will continue into the 2030s.

Comparing this requirement with historic returns from equities, Willis Towers Watson says it is “unlikely” that current allocations will lead to full funding before the 2030s.

The required rates of return for equities are almost three times the historic equivalent. UK equities have averaged just 3.1 per cent per annum above cash rates since comparable records started in 1704. Throughout that time, UK equities have only matched the required 9 per cent annual rate of return over cash in 1-in-20 previous ‘rolling decades’.

Other international comparators also suggest low odds of full funding by 2030. With equivalent data from US equities available from 1946, average 10-year returns still amount to just 6.2 per cent per annum relative to cash, and 9 per cent per annum returns have only been achieved by US equities in a quarter (27 per cent) of rolling 10-year periods since 1946.

Katie Sims, head of multi-asset growth solutions at Willis Towers Watson, comments: “Underfunded DB schemes are effectively counting on a once-a-century equity performance if they’re to wipe out deficits this decade. Simply putting all your eggs in one basket and hoping for unlikely events will not be enough to solve the funding gap. Pension schemes need to look outside of listed equities and adopt the mindset of an endowment investor, embracing a broad range of assets including private markets, to improve their return profile.

“While caution is partly understandable, year by year this problem gets worse as returns will on average disappoint. Allocations that have such a low chance of delivering the right outcomes might also be seen as a form of denial. Trustees need to reimagine allocations.

“Many pension schemes and other institutional investors need to massively rethink how they anticipate creating the necessary long-term wealth to fund their future obligations. A much greater portion of portfolios need to be invested in practical real-world projects that are actively building the economy of the future. Listed equity certainly has a place in the investment mix, but schemes need to think beyond traditional allocations in order to meet the returns they need.”

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