Mind the gap

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Mitchell Fraser-Jones 27 August 2016 Est. reading: 9 min read

With bond yields tumbling across the world, worries about the ability of UK pension funds to provide income for retirees are growing. Here we explore the complex world of pensions to find out how we’ve ended up with such a significant amount of unfunded liabilities and why it matters.

Pensions can be complicated to the point of being almost impenetrable. We’ll do our best to explain the main types of pension schemes in the UK and how the market has evolved. Historically, many large employers have run defined benefit (DB) pension schemes, which offer pension benefits to employees throughout their retirement, based on the length of their service and typically, their final salary. Many people currently in retirement are on such schemes that are administered by pension fund trustees. These trustees make decisions on behalf of the scheme’s retirees, with the aim of ensuring that it has enough assets to meet its liabilities, or in other words, the income needs of its pensioners now and in the future.

This is where it gets complicated. The ‘assets now’ part of the equation is easy to calculate on the basis of prevailing market valuations. The ‘liabilities now’ bit is also reasonably straightforward, being a product of all of the scheme’s pensioners’ current income benefits.

Forecasting the future value of these assets and liabilities is somewhat more difficult and is the product of actuarial science. These forecasts rely on a number of assumptions, including the life expectancy of retirees and the future returns from the various asset classes in which a scheme invests. The value of these assumptions can influence the outcome of the forecasts greatly.

Furthermore, pension funds use a blend of government bond and investment grade corporate bond yields to discount the value of their long term liabilities. In short, when bond yields go down, the predicted value of pension schemes’ liabilities goes up.

For a variety of reasons, therefore, defined benefit schemes have come unstuck over the past 20 years. Not only are people living longer than had initially been expected, but asset returns have not, in broad terms, lived up to expectations, with gilts outperforming UK equities for much of this period. The biggest problem, however, has been the progressive decline in bond yields, most recently exacerbated by the Bank of England’s decision to cut interest rates in the aftermath of the UK’s decision to leave the European Union. Clearly the UK’s pension deficit challenge has nothing to do with Brexit – it’s been building in the background for years. Recent estimates, however, now suggest that the UK’s corporate pension scheme liability shortfall may exceed £1trn, more than half of Britain’s GDP.

Infographic showing how ultra-low interest rates are causing bond yields to tumble across the world, adding to the long-held fears that UK pension funds will not be able to provide the income necessary for their retirees.

But why does all this matter? At the stock level, an increasing number of companies face mounting challenges in tackling their pension deficits. In particular, previously nationalised businesses have substantial amounts of unfunded pension liabilities on their balance sheets. At the margin, concerns about their pensions has reduced the level of conviction that we have in stocks such as Royal Mail, BT and BAE Systems. The presence of a substantial pension deficit is therefore a consideration for investors and could put further pressure on the cash available for distribution via dividends, particularly in an environment where the balance between deficit reduction and shareholder returns is being called into question.

The growing scale of the pension deficit problem has led to the closure of many DB schemes in recent years to new members, but they continue to service the income needs of employees in retirement. New employees tend to join a defined contribution (DC) scheme under which the responsibility for saving lies with the employee.

Regardless of a pension scheme’s structure though, DC savers and DB trustees alike face the same conundrum: how do we save enough and make those assets work hard enough to deliver the income that we want (or have promised employees) in retirement? The chart below may, in our view, help to answer that question.


The current relative yield attraction of UK equities is obvious. Indeed, we would argue that the yield on UK equities is so attractive right now that it can serve a dual purpose for investors. Savers that are still some way from retirement can reinvest income and benefit from Einstein’s eighth wonder of the world, long term compounding. Those that are in retirement can, in a brave new world of pension freedoms, enjoy an attractive income stream from UK equities and hope to see that income grow over time – after all, that is why equities are called growth assets.

This all just begs the question, why are DB schemes doing the opposite? Rather than investing in the growth assets that would give a scheme the best chance of meeting the future income needs of its pensioners, asset allocation has instead become an exercise of ‘liability-matching’, ‘de-risking’ and reducing scheme volatility. This has contributed to a profound change in pension fund asset allocations in recent years, with DB schemes significantly reducing their exposure to equities in favour of other asset classes, with fixed interest heading the list.

To us this doesn’t make sense. If the age-old relationship between risk and return continues to hold true, ‘de-risking’ must also mean ‘de-returning’. By reducing equity exposure, DB schemes have exacerbated the UK’s pension deficit problem by making it even harder for the gap between assets and liabilities to close in the future.

Clearly, there is a strong case to be made for investing in growth assets, namely equities, for any pension investor. But it is, of course, important to remember that the asset class is not without risk. Not all dividends were created equal. As we have previously highlighted, there remains a risk of dividend cuts in some parts of the market and there is a need to be vigilant and selective in order to avoid dividend disappointments. We will of course, continue to manage the CF Woodford Equity Income Fund actively, aiming to deliver an attractive yield and consistent and dependable dividend growth in the years ahead. As such, we are extremely confident that risk will be rewarded in the long term, as has been shown to be the case throughout the history of financial markets.

What are the risks?

  • The value of the fund and any income from it may go down as well as up, so you may get back less than you invested
  • Past performance cannot be relied upon as a guide to future performance
  • The ongoing charges figure is charged to capital, so the income of the fund may be higher but capital growth may be restricted or capital may be eroded
  • The fund may invest in other transferable securities, money market instruments, warrants, collective investment schemes and deposits – some of these security types could increase the fund′s volatility and increase the level of indirect charges to which the fund is exposed
  • The fund may invest in overseas securities and be exposed to currencies other than pound sterling – as a result, exchange rate movements may cause the sterling value of investments to decrease or increase
  • The fund may invest in unquoted securities, which may be less liquid and more difficult to value, because they are generally not publicly traded – the lack of an open market may also make it more difficult to establish fair value

Important information

Before investing, you should read the Key Investor Information Document (KIID) for the fund, and the Prospectus which, along with our terms and conditions, can be obtained from the downloads page or from our registered office. If you have a financial adviser, you should seek their advice before investing. Woodford Investment Management Ltd is not authorised to provide investment advice.

The Woodford Funds (Ireland) ICAV (the “Fund”) has appointed as Swiss Representative Oligo Swiss Fund Services SA, Av. Villamont 17, 1005 Lausanne, Switzerland. The Fund′s Swiss paying agent is Neue Helvetische Bank AG. All fund documentation including, Prospectus, Key Investor Information Documents, Instrument of Incorporation and financial reports may be obtained free of charge from the Swiss Representative in Lausanne. The place of performance and jurisdiction for all shares distributed in or from Switzerland is at the registered office of the Swiss Representative. Fund prices can be found at www.fundinfo.com.

Woodford Investment Management Ltd is authorised and regulated by the Financial Conduct Authority (firm reference number 745433). Incorporated in England and Wales, company number 10118169. Registered address: 27 Old Gloucester Street, London, WC1N 3AX.

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