Aon Hewitt Retirement and Investment Re-thinking Income Risk. Reinsurance. Human Resources.
Executive summary We are in a low yielding, low return environment and this is posing a challenge to pension schemes trying to balance the need for return and income from their portfolios. Attractive opportunities are available which can help address these challenging times but this will involve pension schemes continuing to diversify portfolios away from the more traditional asset classes which have historically been the main source of return and income. In this paper we have highlighted the following opportunities that Trustees may wish to consider as a way to enhance portfolio income and/or return. Private credit Global corporate bonds High yield and emerging market debt Introduction The fall in yields has had a significant impact on pension schemes. Pension scheme deficits have mostly stayed the same, despite strong asset returns and continued contributions over the past few years. In addition pension schemes are becoming more mature as most are now closed to new members and also future accrual. As schemes mature their near term liability cash flows are increasing and they are becoming cash flow negative, i.e. contributions and/or investment income do not cover annual benefit commitments. With increased pressure on pension scheme deficits one of the (many) difficulties facing trustees is balancing the portfolio so that it can deliver the performance needed to close the deficit but also provide income without forcing sales of assets during down markets to meet cash obligations. The opportunities identified in this paper can potentially improve the income and/or return profile of a pension scheme portfolio. Low yield Pension schemes have typically relied on gilts, UK investment grade credit and property to provide income, with UK investment grade credit and property also providing a return in excess of gilts. However, the collapse in yields is having a major impact on the ability to meet the desired level of income whilst maintaining the necessary level of return. Yields on traditional assets are at or near historical lows. Fall in yields UK investment grade corporate bonds UK gilts 10.0 Yield (%) 8.0 6.0 4.0 2.0 0 30/06/1998 30/06/2000 30/06/2002 30/06/2004 30/06/2006 30/06/2008 30/06/2010 30/06/2012 30/06/2014 30/06/2016 Source: iboxx, Aon Hewitt Aon Hewitt Re-thinking Income 2
To illustrate the impact that the fall in yields has had on income the chart below shows the investment required in a 20 year gilt in order to generate 100,000 in income per annum. We can see in the chart below there has been a steady increase in the investment amount required to generate an income of 100,000 per annum. At the start of 2009 an investment of 2m in a 20 year gilt would have generated 100,000 per annum in income whereas now an investment of 5m would be required to generate the same level of income and this was as high as 8m in 2016. Investment required in 20 year gilt to generate 100,000 in annual income 9,000,000 8,000,000 7,000,000 6,000,000 5,000,000 4,000,000 3,000,000 2,000,000 1,000,000 31/12/08 31/12/09 31/12/10 31/12/11 31/12/12 31/12/13 31/12/14 31/12/15 Source: Bank of England, Aon Hewitt Lower returns The yield on investments is an important component of asset returns. The continued fall in yields (increasing asset values) has been a key contributor to the strong asset performance experienced over the past few years. The combination of a lower starting level on yields and strong historical asset returns has led to lower expected returns going forward (see chart below). How our return assumptions fell away (10 year capital market assumptions) 10.0% 6 years ago 3 years ago 30/09/16 8.0% 6.0% 4.0% 2.0% 0.0% UK equities Source: Aon Hewitt Capital Market Assumptions Global equities Gilts (15yr) UK corps US high yield Emerging market debt UK commercial real estate Global fund of hedge funds Aon Hewitt Re-thinking Income 3
The lower expected return on traditional assets is making it challenging for pension schemes to close their deficits while the low yield on assets is making it more difficult to generate the income that schemes require. In addition the need for income from the portfolio is increasing as schemes mature. How do we square that circle? However, all is not lost! Despite this being a challenging time, it is also creating opportunities which pension schemes are ideally positioned to benefit from. We see opportunities for pension schemes to improve returns, increase income, reduce risk or the combination of all three through adding more alternative strategies and continuing to diversify portfolios away from the traditional asset classes which have historically been the main source of return and income. We discuss a few of these opportunities next. Private credit Private credit is a growing area and one that offers a very unique and compelling investment opportunity to pension schemes due to its attractive risk-return characteristics and income it provides. New bank regulations implemented in response to the global financial crisis have led to a reduction in bank lending activity which has long-term implications for the way businesses and consumers borrow (see our previous note Bankers lose interest April 2015). Many companies used to rely on banks to raise capital for refinancing, growth, acquisitions and restructuring. As banks reduced lending, institutional investors like pension schemes have the opportunity to step into the role traditionally played by banks and capture the enhanced returns for providing finance in private markets. Two opportunities that we see currently in private credit are property debt and direct lending strategies. Property debt strategies focus on the real estate market and direct lending strategies focus on small to midsized companies. The table below summarises the characteristics of these strategies. Property debt Direct lending Expected return 3.5% - 10% depending on strategy 6% - 14% depending on strategy and leverage Cash yield 4% - 6% per annum 4% - 8% per annum Distributions Typically quarterly Typically quarterly Return type focus Income Income Term life 7-10+ years 6-8 years Risk Low to moderate Moderate to high Liquidity Low Low Typical minimum investment 10m 10m Fees 0.4% - 1.25%, usually with performance fee 0.75% - 1.5%, usually with performance fee Source: Aon Hewitt We see value in these private credit strategies relative to other traditional assets due to the following: Higher potential returns which should help close deficits. Income generation, which can help meet cash flows. Increasing diversification of sources of risk. These strategies are comparable with Diversified Growth Funds (DGFs) in terms of risk level. These strategies are not risk free and the two main risks for them are default risk and liquidity, however we believe both of these risks are mitigated for the following reasons: Default risk: These loans are typically secured, backed by say an underlying property, or rank high in the company s capital structure and therefore benefit from better recovery rates than traditional bond investments. Liquidity risk: Most pension schemes have adequate liquidity in their portfolio and can benefit from capturing the illiquidity premium from these strategies. In addition the term of these strategies, <10 years, fits within the recovery period for most pension schemes. Aon Hewitt Re-thinking Income 4
How to fund these investments? Pension schemes have benefitted from diversifying their portfolios over the past few years. One particular area has been into DGFs which typically target LIBOR + 4%-5%. In an environment of increased volatility, lower expected asset returns and yield, these strategies may not deliver the absolute returns that they were expected to deliver when originally implemented. Given the potential return, income and the complexity / liquidity premium that private credit strategies offer, pension schemes may want to consider reducing their allocations to DGFs in favour of these private debt strategies. Going global with corporate bonds Most pension schemes allocation to corporate bonds is in the form of sterling denominated investment grade credit. Although schemes have been diversifying their portfolios globally the allocation to corporate bonds has remained UK focussed. The chart below compares the yield pickup above the risk free rate (the spread) for global corporate bonds and sterling non-gilt bonds. Corporate bond spread vs government bond Global corps Non gilts Option adjusted spread (%) 6.0 5.0 4.0 3.0 2.0 1.0 0 Nov 2006 Nov 2008 Nov 2010 Nov 2012 Nov 2014 Nov 2016 Source: Barclays Global corporate bonds offer a marginal improvement on yield compared to UK non-gilts. Although in isolation this improvement may not make an overwhelming case to switch to global bonds, when factoring in the following we think the case becomes much stronger and more compelling for pension schemes from a strategic perspective to switch to a global corporate bond mandate. Greater diversification: The global corporate bond market is 12x as large as the sterling corporate bond market and has over 9,000 more issuers which allows for greater diversification within the portfolio. Improved liquidity: Global corporate bonds are better positioned to withstand a liquidity squeeze due to size. Improved return potential: More opportunities for managers to add value. Lower interest rate sensitivity: The lower duration on global corporates compare to UK corporates will be a benefit if yields increase. Aon Hewitt Re-thinking Income 5
Global corporate index Non-gilt index Number of issues 10,076 945 Market value ( bn) 6,738 527 Yield 2.7% 2.4% Credit spread 1.3% 1.2% Duration (yrs) 6.6 8.2 Rating A3 A1 Consideration would need to be given to transaction costs, hedging currency exposure, a slightly lower overall credit rating etc prior to switching to a global mandate (see our previous note Corporate Bond Liquidity September 2016). However, we believe pension schemes should start to explore switching their UK corporate bond mandates to a global corporate bond (100% sterling hedged) mandate and in the longer term would benefit from this move for the reasons highlighted above. Source: Barclay, 31 December 2016 High yield and emerging market debt Higher yielding fixed income assets such as high yield credit and emerging market debt (EMD) can increase the overall income within a pension scheme portfolio and these strategies should be considered as part of an overall well diversified portfolio. High yield credit is a higher coupon paying bond with a lower credit rating than investment-grade bonds. EMD is issued by governments, municipalities or corporations within developing economies. EMD can be further classified into Hard (issued in a developed market currency, typically USD) or Local (issued in the domestic currency). Similar to debt issued by developed economies or investment grade rated corporates the principal risk for EMD and high yield investors is whether an issuer will default on their debt obligations. Because of the higher risk of default, these bonds are priced at a higher yield. High yield debt is currently yielding 6% and EMD is yielding 5.4% to 6.8% depending on the specific strategy. How to fund these investments? From a risk perspective, as measured by volatility, EMD and high yield are comparable to most growth assets already in portfolios, for example equities, property, hedge funds or DGFs. EMD and high yield could be funded from further diversifying the portfolio and reducing the allocation to core growth assets, without necessarily increasing the overall risk of the portfolio while improving the income generation. Alternatively these strategies could be funded from current investment grade fixed income assets as a way to improve the income and expected return of the overall portfolio. EMBI global diversified (Hard EMD) GBI-EM global diversified (Local EMD) CEMBI broad diversified (Hard EMD) Global corporate high yield Issuer type Sovereigns and Government agencies Sovereigns Corporates Corporates Sources of return US treasury yield + spread Local government yield +/- currency movements US treasury yield + spread Government yield + spread Market cap ($bn) 445 707 406 1,844 Yield 5.8% 6.8% 5.4% 6.0% Average credit rating Ba1 Baa2 Baa3 Ba3 % of issuers rated investment grade 52% 75% 61% 0% No. of countries 65 15 51 53 Duration (years) 6.5 4.9 4.8 3.9 Source: JPMorgan, Barclays, Data as of 31 December 2016 Aon Hewitt Re-thinking Income 6
Summary Many opportunities are available, and we have only highlighted a few here, which we believe can improve the income and/or return profile of a pension scheme portfolio however it will mean schemes continuing to diversify away from the traditional strategies they have relied on. Contacts Jeffrey Malluck Senior Consultant +44 (0)131 456 3841 jeffrey.malluck@aonhewitt.com Disclaimer This document and any enclosures or attachments are prepared on the understanding that it is solely for the benefit of the addressee(s). Unless we provide express prior written consent, no part of this document should be reproduced, distributed or communicated to anyone else and, in providing this document, we do not accept or assume any responsibility for any other purpose or to anyone other than the addressee(s) of this document. Notwithstanding the level of skill and care used in conducting due diligence into any organisation that is the subject of a rating in this document, it is not always possible to detect the negligence, fraud, or other misconduct of the organisation being assessed or any weaknesses in that organisation s systems and controls or operations. This document and any due diligence conducted is based upon information available to us at the date of this document and takes no account of subsequent developments. In preparing this document we may have relied upon data supplied to us by third parties (including those that are the subject of due diligence) and therefore no warranty or guarantee of accuracy or completeness is provided. We cannot be held accountable for any error, omission or misrepresentation of any data provided to us by third parties (including those that are the subject of due diligence). This document is not intended by us to form a basis of any decision by any third party to do or omit to do anything. Any opinions or assumptions in this document have been derived by us through a blend of economic theory, historical analysis and/or other sources. Any opinion or assumption may contain elements of subjective judgement and are not intended to imply, nor should be interpreted as conveying, any form of guarantee or assurance by us of any future performance. Views are derived from our research process and it should be noted in particular that we cannot research legal, regulatory, administrative or accounting procedures and accordingly make no warranty and accept no responsibility for consequences arising from relying on this document in this regard. Calculations may be derived from our proprietary models in use at that time. Models may be based on historical analysis of data and other methodologies and we may have incorporated their subjective judgement to complement such data as is available. It should be noted that models may change over time and they should not be relied upon to capture future uncertainty or events About Aon Hewitt Aon Hewitt empowers organisations and individuals to secure a better future through innovative talent, retirement and health solutions. We advise, design and execute a wide range of solutions that enable clients to cultivate talent to drive organisational and personal performance and growth, navigate risk while providing new levels of financial security, and redefine health solutions for greater choice, affordability and wellness. Aon Hewitt is a global leader in human resource solutions, with over 30,000 professionals in 90 countries serving more than 20,000 clients worldwide. For more information on Aon Hewitt, please visit: aonhewitt.com Follow Aon on Twitter: twitter.com/aon_plc Sign up for News Alerts: http://aon.mediaroom.com/index.php?s=58 Aon Hewitt Re-thinking Income 7
About Aon Aon plc (NYSE:AON) is a leading global provider of risk management, insurance brokerage and reinsurance brokerage, and human resources solutions and outsourcing services. Through its more than 72,000 colleagues worldwide, Aon unites to empower results for clients in over 120 countries via innovative risk and people solutions. For further information on our capabilities and to learn how we empower results for clients, please visit: http://aon.mediaroom.com/ This document and any enclosures or attachments are prepared on the understanding that it is solely for the benefit of the addressee(s). Unless we provide express prior written consent, no part of this document should be reproduced, distributed or communicated to anyone else and, in providing this document, we do not accept or assume any responsibility for any other purpose or to anyone other than the addressee(s) of this document. Notwithstanding the level of skill and care used in conducting due diligence into any organisation that is the subject of a rating in this document, it is not always possible to detect the negligence, fraud, or other misconduct of the organisation being assessed or any weaknesses in that organisation s systems and controls or operations. This document and any due diligence conducted is based upon information available to us at the date of this document and takes no account of subsequent developments. In preparing this document we may have relied upon data supplied to us by third parties (including those that are the subject of due diligence) and therefore no warranty or guarantee of accuracy or completeness is provided. We cannot be held accountable for any error, omission or misrepresentation of any data provided to us by third parties (including those that are the subject of due diligence). This document is not intended by us to form a basis of any decision by any third party to do or omit to do anything. Any opinions or assumptions in this document have been derived by us through a blend of economic theory, historical analysis and/or other sources. Any opinion or assumption may contain elements of subjective judgement and are not intended to imply, nor should be interpreted as conveying, any form of guarantee or assurance by us of any future performance. Views are derived from our research process and it should be noted in particular that we can not research legal, regulatory, administrative or accounting procedures and accordingly make no warranty and accept no responsibility for consequences arising from relying on this document in this regard. Calculations may be derived from our proprietary models in use at that time. Models may be based on historical analysis of data and other methodologies and we may have incorporated their subjective judgement to complement such data as is available. It should be noted that models may change over time and they should not be relied upon to capture future uncertainty or events. Aon Hewitt Limited is authorised and regulated by the Financial Conduct Authority. Registered in England & Wales. Registered No: 4396810. Registered Office: The Aon Centre The Leadenhall Building 122 Leadenhall Street London EC3V 4AN Copyright 2016 Aon plc aon.com Risk. Reinsurance. Human Resources.