Sweeping regulatory changes, a lack of savings and a low-return environment present significant challenges for the UK pension industry. Over the next few years we anticipate these issues to escalate as funding challenges persist.
A greater focus on identifying optimal investment strategies is essential, particularly when achieving an adequate retirement income is in jeopardy.
In a low-return environment, what is an investor to do? Many are attempting to walk the fine line of increasing the overall return of their portfolio (or preserving savings), while limiting downside from markets exhibiting much higher volatility.
Investors who use duration-laden, benchmark-relative strategies can no longer count on realised gains from the decline in interest rates
In the past, fixed income has been able to serve as an anchor to an investor’s portfolio, providing a suitable and stable income stream. Yet with historically low yields, tight credit spreads, and an anaemic near-term GDP, how the UK pension industry generates wealth compatible with each person’s investment horizon can lead to the mismanagement of risks.
Rate hikes on the horizon
Over the past several years, declining interest rates have rewarded fixed income investors who maintained a long duration exposure – a common feature of conventionally managed portfolios.
However, consensus tells us that this cycle of declining rates is nearing an end and rate hikes are on the horizon, heralding a reversal of this tailwind.
Compounding this problem of likely rate hikes, the global financial crisis ushered in a swelling of global government balance sheets, worldwide quantitative easing, and zero or near-zero policy rates, which effectively lowered the carry in most fixed income portfolios.
The result is that investors face a lower total return potential from anticipated price depreciation, lower carry, and asymmetry of duration risk in traditional fixed income portfolios.
The UK sterling component of the Barclays Global Aggregate, for example, yields about 1.9 per cent, yet carries a duration, or sensitivity to interest rates, of 10 years.
Investors who use duration-laden, benchmark-relative strategies can no longer count on realised gains from the decline in interest rates. Put another way, investors are not being properly compensated for bearing duration risk.
Reassessing strategies
Investors must reassess their overall fixed income investment strategy to reflect the changing nature of risk in traditional fixed income portfolios.
Due to a steady decline in yields over the past 30 years, the UK pensions industry has been able to rely on fixed income to meet their spending needs.
However, in the current environment, investors who maintain the status quo of conventional fixed income approaches will likely be forced to take on greater volatility coupled with lower returns.
In these uncertain times, investors must take advantage of all appropriate return opportunities.
To mitigate the volatility associated with traditional fixed income, adopting a dynamic allocation process that responds to market conditions has the potential to produce higher risk-adjusted returns and better capital protection over business cycles.
Nick Maroutsos is portfolio manager at asset manager Janus Capital
