Pension funds warned to prepare for most difficult decade

The report from Hermes Investment Management, which focused on asset allocation if rates remain at near-zero levels, pointed to the problems created by this unconventional monetary policy, such as bonds yielding less than zero.

Saker Nusseibeh, chief executive officer of Hermes, said: “All else being equal, a lower natural rate will lead to diminished return expectations across all asset classes.” 

This comes at a time when bond-heavy pension funds are under tremendous pressure to generate returns amid record low yields, and Mr Nusseibeh said the implications of extreme monetary policy on pension funds and other investors are not good. 

He said the returns delivered throughout the so-called ‘Great Moderation’, a period of market calm between the mid-1980s to 2007 which was thought to be a permanent fixture, now look “anomalous”.

Savers were dealt another blow last month when the Bank of England decided to cut the base rate for the first time in seven years, intensifying the struggle for any level of return.

“Interest rates are arguably lower than at any point in history,” Mr Nusseibeh said, pointing to assertions from the Fed governors that we are in a new era of naturally low interest rates. 

 In an unconventional world, we believe that long-term investors need a radical response  Saker Nusseibeh

In a standard portfolio, where 60 per cent is allocated to equities and 40 to bonds, most investors wouldn’t expect a return of more than 3 per cent, the report stated, while a heavier allocation to bonds would push the expected return even lower.

This standard global 60/40 strategy is expected to offer roughly only one-quarter of the 4.5 per cent return which had been previously scooped up on an annual basis between 1986 and 2015. 

In order to get anywhere near this level of return now, the report said the portfolio would need to strip out any exposure to US equities, US investment-grade bonds, commodities and inflation-linked bonds, all of which have an expected return of 1 to 2 per cent.

Pension funds, it said, could be compelled into making significantly higher allocations to private equity, infrastructure and other unlisted assets, which could increase real returns to up to 6 per cent.

Mr Nusseibeh said extraordinary measures from central banks have created severe distortions in capital markets, with long-term implications for banks, insurers and pension funds. 

He also said the relationships between different asset classes, particularly equities and bonds, are likely to change, and fund managers will have to make ambitious decisions to get a decent rate of return.

“In an unconventional world, with a lower natural rate suppressing expected returns from all asset classes, we believe that long-term investors need a radical response: go for growth.” 

He said this means rejecting exposures to low or negative-yielding bonds in favour of listed and unlisted assets with strong prospects of generating positive real returns.