New analysis by Willis Towers Watson says underfunded defined benefit (DB) pension schemes in the UK are “over-dependent on historically improbable equity returns, if they are to avoid carrying over funding gaps into the 2030s.”
Willis Towers Watson said that given current funding levels and typical asset allocations for UK schemes, its research shows that the average underfunded UK DB scheme requires shares “to return 9% above cash rates on an annual basis for the whole of the next decade” or significant deficits will continue into the 2030s.
It said that comparing this requirement with historic returns from equities reveals how unlikely current allocations are to lead to full funding before the 2030s.
“The required rates of return for equities are almost three times the historic equivalent,” said Willis Towers Watson.
“UK equities have averaged just 3.1% p.a. above cash rates since comparable records started in 1704.
“Throughout that time, UK equities have only matched the required 9% 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% p.a. relative to cash, and 9% p.a. returns have only been achieved by US equities in a quarter (27%) of rolling 10-year periods since 1946.”
Katie Sims, head of multi-asset growth solutions at Willis Towers Watson, said: “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 either accept that it will take a lot longer to reduce deficits than people think, or they need to somehow increase expected returns.
“The best way to do the latter is to diversify the growth asset portfolio so that more can be invested there for the same level of risk, include private markets with higher expected returns and embrace active management if done well and at a reasonable cost.
“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.”