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De-risking has been a prevalent concept in the realm of UK pension professionals for over two decades. However, it is arguably one of the riskiest terms in the investment vocabulary.
Firstly, let’s consider what de-risking entails in practice. For individuals in defined contribution pension schemes, where the pension size is determined by investment returns and contributions, de-risking involves transitioning the pension balance towards retirement from volatile assets like equities to supposedly safer assets such as gilts.
In defined benefit schemes, where pensions are linked to salary and years of service, de-risking means embracing so-called “liability-driven investment”. This strategy involves holding assets, primarily nominal or index-linked gilts, that generate cash flows aligned with pension payouts, thus minimizing interest rate and inflation risks.
This process leads to an endgame where risk is transferred to an insurer through a buy-in, bulk annuity purchase, or buyout, where the scheme transfers all liabilities to the insurer.
It is important to acknowledge that the actuarial consultants who advocated for de-risking were not entirely misguided. It makes perfect sense to minimize risk as individuals near retirement. Facing a market downturn and a diminished pension pot at retirement is a dire situation. Therefore, reducing exposure to market volatility is a logical move.
In mature defined benefit schemes with a significant amount of cash flow going towards pensions, the liquidity provided by seemingly safe assets becomes crucial. Liability matching also decreases a fund’s vulnerability to deficits. However, the challenge lies in defining what constitutes safe assets. Traditionally, government bonds are considered the safest of safe assets in actuarial and economic circles.
However, from the financial crisis of 2007-09 to the recent rise in interest rates due to inflation, government bond markets experienced an unprecedented bubble. In the post-crisis era of low growth, a secular decline in real interest rates was exacerbated by factors like the Asian savings surplus and negative policy rates in various central banks.
The belief was that by penalizing banks for holding excess cash at the central bank, they would be incentivized to lend out those funds to stimulate growth post-crisis. Consequently, yields on government debt turned negative, leading investors to pay governments for lending while borrowers received money for borrowing.
At one point in 2021, the yield on 10-year index-linked gilts was over 3% in the negative territory – a significant penalty for investing in what was deemed the safest asset. The decline in yields and increase in prices in the UK were notably worse than in the US, attributed to greater regulatory pressure on UK pension funds to match their liabilities with gilts.
As highlighted by experts in evidence to the House of Commons work and pensions committee, the impact of ultra-low interest rates over two decades led to substantial pension liabilities for companies with deficits. The influx of money into gilts distorted the market, while low nominal interest rates led to an increase in household savings due to negative real interest rates.
One detrimental consequence of this de-risking trend was the shift of pension funds away from equities, contributing to the undervaluation of the UK equity market compared to other markets. The decline in risk appetite within the financial system had adverse effects on investment in the real economy.
Contrary to popular belief, bonds are not foolproof safe assets. Historical data shows that UK government bonds lost a significant portion of their value during certain periods. The myth of bonds as safe assets has led to misconceptions among economists, actuaries, and regulators regarding risk and return.
This has particularly impacted older members of defined contribution pension schemes, who often opt for default options managed by trustees. However, during the period from 2008 to 2021, these default options led individuals into an overvalued bond market, resulting in substantial losses as interest rates normalized.
For defined benefit scheme members, adopting liability-driven investment poses its own risks. It limits the return-seeking portion of the portfolio, affecting the fund’s ability to enhance benefits and reduce contributions. Transferring a scheme to an insurer may reduce the chances of pensioners receiving discretionary increases.
Despite the challenges, there are some positive developments for defined contribution scheme members. Proposals for expanding collective defined contribution schemes could enhance retirement incomes by offering exposure to higher return investments for a longer duration.
While there is room for improvement in de-risking strategies, it is crucial to recognize that defined contribution schemes are essentially tax-advantaged savings funds rather than traditional pension schemes. This distinction must not be overlooked.
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