Pension fund savers have had a turbulent few years. From the annus horribilis of 2008, when Irish pension funds lost a third of their value, to the collapse in the property market, to the current concerns about a potential bubble in the tech sector, it hasn't been an easy ride.
Another potential problem looms on the horizon. This time around, could the ticking time bomb in your pension fund be your purportedly risk-free triple-A bonds? And is the much-vaunted “lifestyling” approach to saving for your retirement broken, as one commentator suggests?
Outlook for bonds
Across the world, bond yields are at historic lows. It's not just the Irish Government
that is benefiting from low funding costs. German 10-year bonds are yielding about 1.4 per cent, and across the Atlantic 10-year US treasuries have a yield of about 2.5 per cent. "Bond yields have never really been this low," says Oliver Sinnott, global investment strategist with Davy Stockbrokers. "The one other time in history when they were this low was during the second World War."
This environment is creating risks for investors. Yes, the risk of a triple-A bond defaulting may be very low, but investors can lose their money in other ways too. “Many investors do not appreciate that bonds, even AAA, could lose money,” says Sinnott.
For pension fund investors – and savers – the risk is twofold, and may be exacerbated depending on the duration of the bonds in which you are invested.
Firstly, a yield of 1.4 per cent is extremely low, compared with what an investor might earn in another asset class, even if it is beating Irish inflation. “On average, a 10-year bund [German bond] since 1990 would have given you a yield of 4.8 per cent. Now you’re only getting 1.4 per cent,” says Sinnott.
Secondly, with yields at such extreme lows and growth improving around the world, there is a big risk that yields could rise from here. If they do, it could impact the capital value of your portfolio.
“When we get global growth – and while it is slow it is certainly improving – there is a risk that yields could rise,” says Sinnott, noting that rates are close to an inflection point in Britain and the US, with the first rate rises since the financial crisis expected in Britain by early 2015 and in the US thereafter.
As a result, longer bonds are starting to price in interest rate increases. “With the low-rate environment, pensioners who buy bonds (or annuities which are priced off of bonds) will find it difficult to fund their retirement. Unfortunately, those who are primarily invested in bonds could see their retirement fund lose value as yields return to more normal levels,” says Sinnott.
Added to this are warning signs of what might happen in the case of sell-off in bonds. Last year, between May and August, a big sell-off in bonds saw yields on 10-year US treasury bonds rise by 130 basis points (bp). If the yield on a German bund rises by 1 per cent, the price will have lost about 9 per cent, says Sinnott (see graphic).
Indeed last year German 10-year bonds finished down by 7.8 per cent – an investor with €1,000 invested would have lost €78 in their “risk-free asset”.
Perils of 'lifestyling'
The last crash for Irish pension funds came with the onset of the global financial crisis in 2007/08. With, according to Mercer, an average allocation to equities of 78 per cent in December 2006 – and one pension fund as high as 94 per cent – when the crash came, Irish pension funds plunged with the markets.
And, given their overweight position in Irish equities, at an average of 20 per cent of total, and one fund as high as 28 per cent, Irish funds suffered more than most with the collapse of some of the major names in the Iseq. (Since then, pension funds have moved away from Irish equities, with an average allocation as of the end of March 2014 of 5 per cent.)
Despite the sharp shock pension funds were delivered back then, fund managers have not lost their faith in equities, with an average allocation of 77 per cent in March of this year according to Mercer.
Investment in fixed-interest assets such as bonds may have increased – 14.4 per cent in March 2014 compared with 12.3 per cent in December 2006, or as much as 45 per cent for Deutsche Bank funds – but the greatest risk for Irish investors, given the outlook for bonds, might be “lifestyling”. Under this approach a fund manager moves an individual’s pension fund assets into lower risk investments – typically bonds and cash – as they approach retirement. For example, New Ireland’s Individual Retirement Investment Strategy transitions a portfolio from an allocation of 50 per cent in equities and 45 per cent in bonds with 15 years to go to retirement, to 75 per cent in “long bonds” and 25 per cent in cash at retirement.
According to Niall O'Callaghan, partner and defined-contribution leader with Mercer, the majority of companies running defined-contribution pension schemes will have a lifestyling option in place, and it's typical for 75-80 per cent of employees, or sometimes more, to opt for this default option. "It's the traditional approach and it's an accepted norm," he says, which comes from the perception that, at retirement, an individual will use 75 per cent of their fund to buy an annuity and will avail of their tax-free allowance to take 25 per cent in cash.
“If an individual was doing that, it makes sense to de-risk into annuities,” he says, because bond yields are related to annuity prices. These days, however, the reality “is something very different”. People with large pension pots are taking 25 per cent tax-free and putting the remainder into an ARF (approved retirement fund).
“There is no doubt but that annuities represent poor value. At the current level of bond yields, it’s not attractive and we’re definitely seeing a move away from annuities,” he says. Last year, the average amount put into an annuity in a Mercer-administered scheme was just €40,000.
But transitioning into bonds and then putting your funds into an ARF may not make sense, because you will want to hold on to some assets that offer a decent rate of return, particularly given that in the years immediately following retirement your nest egg is at its peak. This means an extra 1 per cent investment return will have a greater impact.
“A 1 per cent of level return, close to retirement, could be the same as a whole year of contributions in your 20s,” says O’Callaghan.
He says lifestyling has become inconsistent with the benefits available at retirement; highly exposed to an increase in bond yields; and potentially too conservative. “The lifestyle model is broken. At 65, you shouldn’t have this amount in Government bonds,” he says.
"The longer-term future return is the most important indicator. The problem with lifestyle funds is that they ignore valuations. They ignore a return of 1.5 per cent on bonds."
What
to do?
Taking charge of your pension fund is the obvious answer, but for
DC members, this is often left to their trustees.
“The reality is that a lot of individuals will stay in the default option, so you have to rely on trustees to de-risk to the right end point,” says O’Callaghan, adding that they need to avoid “de-risking too quickly”.
If you take charge yourself, Sinnott suggests three options:
1) reduce the duration of your bonds – “the shorter the maturity, the less impacted the bond should be from rising rates”;
2) sit it out in cash until yields rise to more normal levels; or
3) his preferred option, diversify into a multi-asset class portfolio, including property, absolute-return funds, equities etc.
The silver lining, says Sinnott, is that while pensioners in the US and the UK are at risk in the short-term, “there is still time for pensioners to do something about it in Europe”.
