UK Defined Benefit Schemes/Gold

UK Defined Benefit Schemes and the case of Gold in it.
An increasing number of UK defined benefit (DB) pension schemes have been contemplating their investment approach for the endgame, with the rapid growth in funding ratios over the past year, the point at which a plan moves from being underfunded to being fully funded or even having a surplus. Gold is an effective addition to a DB portfolio, helping a plan achieve its desired endgame by contributing to long-term growth, and providing diversification that helps reduce funding level volatility.

In order to be able to answer the question of how UK DB pension schemes have fared recently, we examine the evolution of the PPF 7800 index published by the Pension Protection Fund (PPF) since 2019. The index shows the estimated funding position for the DB pension schemes in the PPF’s eligible universe and is based upon compensation paid by the PPF, which may be lower than full scheme benefits. At the end of 2019, the aggregate scheme funding ratio (the ratio of a scheme’s total assets to liabilities) was 99.4%.

In the first 6 months of 2020 one immediate consequence of the COVID-19-induced crisis is that yields collapsed, along with equity markets. Together, these two developments were challenging for UK DB pensions. With the present value of liabilities rising and asset values falling, aggregate DB schemes’ deficits widened to lows of 92% by July 2020.
Since then, funding levels have steadily risen. Strong returns from growth assets were a key driver of the large improvements in scheme funding levels over 2021, with global equity markets reaching new highs following a strong economic recovery globally.

More recently, for a traditional DB plan, particularly a closed plan, a higher yield curve, commensurate with rising inflation, has provided a further welcome tailwind by decreasing the present value of liabilities.
At the end of June 2022 the PPF 7800 index shows funding levels were at 120%, levels not seen in a decade. And while disaggregating the data reveals that there is significant dispersion in the funding ratios among schemes, it is important for DB plans to seek to maintain the funding status gains made over the past year especially since worries surrounding the global economic environment continue to mount and growth-oriented assets remain under pressure.

Considering recent improvements in the funding status of UK pension schemes and the breadth of macroeconomic challenges, we believe DB schemes should consider ways to protect their growth portfolio and narrow the range of potential outcomes. This would increase the likelihood of achieving their chosen endgame.

Identifying a target return to be achieved within a specific timeframe to cover all liabilities is important for DB schemes but achieving that outcome with any level of certainty can be difficult. One of the most important questions for investors today is whether the higher interest rates that are arriving hard and fast can indeed bring about a “soft landing” for the global economy. Past experience suggests that this will be difficult; tightening has often preceded downturns.

Since 1976, for example, the Fed has only twice succeeded in hiking rates without subsequently pushing the US economy into a recession in the following couple of years, in 1983 and 1994. Only time will tell whether the Fed’s latest hiking cycle will succeed in combating inflation without a recession, or if a recession will be needed to kill inflation.

Gold is a clear complement to equities and broad-based growth portfolios. A store of wealth and a hedge against systemic risk, gold has historically improved portfolios’ risk-adjusted returns, delivered positive returns, and provided liquidity to meet liabilities in times of market stress. Investors have long considered gold a beneficial asset during periods of uncertainty. Yet, historically, gold generated long-term positive returns in both good and bad economic times, outperforming many other major asset classes over the past 20 years.

The diverse sources of demand give gold a particular resilience and the potential to deliver solid returns in various market conditions. Gold is, on the one hand, often used as an investment to protect and enhance wealth over the long term, but on the other hand it is also a consumer good, via jewellery and technology demand. Furthermore, while effective diversifiers are sometimes hard to find, with many assets becoming increasingly correlated as market uncertainty rises, gold is different in that its negative correlation to equities and other risk assets increases as these assets sell off.

With few exceptions, gold has been particularly effective during times of systemic risk, delivering positive returns and reducing overall portfolio losses.

Following significant funding level volatility over the last two years, there is a sharper focus on risk management among DB schemes. The potential higher returns from an equity exposure will continue to be important, particularly for schemes looking to reduce the time to their long-term funding target, close any funding gaps, and provide a buffer against longevity risk. Nevertheless, schemes focused on maximising outcome certainty should have a preference for an asset mix which provides a higher level of certainty of achieving those returns over a specified timeframe. An allocation to gold can help mitigate the key risk faced by DB schemes, namely, uncertainty of being able to pay pension benefits, by providing long-term growth potential and diversification that helps reduce funding level volatility.