PI Partnership – Ruffer LLP
James Fouracre: Director – UK Institutional at Ruffer LLP
THE GREAT REWIRING – CREATING A DC PENSION PORTFOLIO FIT FOR TOMORROW’S WORLD
Annus horribilis
There was nowhere to hide for defined contribution (DC) pensions schemes in 2022 – balanced portfolios were uncere- moniously knocked off their perch as equities and bonds fell together. And the damage wasn’t confined to main- stream asset classes. Most others – from credit to infrastructure to property, across public and private markets – also suffered severe losses. The assets that DC inves- tors were relying on to provide offsetting returns became correlated with the rest of the portfolio – diversification did a disap- pearing act.
Halcyon days
The 40 years following peak inflation in the 1980s were dominated by geopolitical peace, supercharged globalisation and the integration of China’s workforce into the world economy – all of which have been key drivers of falling inflation, interest rates and volatility.
These trends have underwritten a golden era for capital, but they are now in reverse. This presents a fundamental challenge to the assumptions which have underpinned the approach of investors for nearly half a century. The world has changed, but have DC portfolios changed too?
A nostalgic view of the future As inflation falls back this year, you’re
24 | portfolio institutional | March 2023 | Issue 121
going to hear a lot of people saying: “So inflation was transitory after all – back to the ways of old.” This would be a mistake. Inflation falling sharply this year is con- sistent with a world in which inflation vol- atility reigns supreme, not just higher inflation. It’s a more complex environ- ment for which to build a portfolio but one which presents opportunities as well as challenges. History shows that, when inflation aver- ages above 2.5%, most assets are positively correlated with one another – as we saw in 2022. Most notably, conventional bonds which formerly protected clients against falls in equity markets, have had their protective power supressed by ankle- high interest rates.
The challenge in this new environment is that inflation will not only be higher on average, but also volatile. Higher inflation will therefore challenge most DC diversi- fication strategies.
Looking ahead, investment fundamentals and valuation now matter significantly more than they did a year ago, and we expect to see a greater divergence in returns across assets, regions and curren- cies. Crucially, the old ways may no longer be the best ways. The key question for those responsible for DC investments is clear: what is your plan for this new regime? Seeking to achieve positive returns in a DC pension scheme portfolio, whatever happens in financial markets, means allo- cating to a diversified investment strategy with an ability to find and own assets which respond differently to changes in the investment environment – and cru- cially, owning assets which respond dif- ferently to each other.
Member lifecycle
It would be remiss not to highlight the dis- tinctly diverse needs of scheme members across the DC lifecycle in relation to mar- ket conditions. Equities are the dominant asset class for most of a DC scheme mem- ber’s investment lifecycle, given the long-
term investment horizon. But bonds are increasingly called into play as members are ‘de-risked’ as they approach retirement and into the decumulation (post-retire- ment) phase. Government bonds, or gilts, are (or at least, were) generally regarded as a more cautious and protective source of returns – lower risk, ostensibly, than equi- ties. But as we witnessed last year, owning certain bonds can be speculative too. Many individuals intending to retire in the near future will have suffered material losses to their capital as a result of the dra- matics of late September last year, as the UK gilt market shook many DC pension schemes to the core. Some members sim- ply will not have time to recover that lost ground. The drastically shortened invest- ment time horizons of scheme members in the ‘pre-retirement’ phase and even more so in the decumulation period, changes
the construction.
As individuals and organisations inspired by driving better outcomes for DC mem- bers, what do we learn from the lessons of late September? Are bonds still the low- risk, low-volatility investment tool they once were? Amidst a regime of higher inflation volatility, we think, perhaps not. As we saw throughout 2022, the pain is greatest for investors when all assets fall together. Consequently, the call to action across the DC pension industry has been deafening.
There will be times when investors will want exposure to bonds, and the duration that comes with them. But the key is being able to turn the dial on that expo- sure when necessary – ensuring an alloca- tion to a strategy that boasts the agility that the prevailing market conditions will demand. Furthermore, allocations that use unconventional instruments as a source of uncorrelated returns – think derivatives in credit, equity protections and alternate currency positions. Investment allocations in the de-risking and decumulation stages in particular will need a relentless focus on the preser-
psychology of portfolio
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