In the following interview, Mike Amey, managing director and head of sterling portfolio management, and Will Allport, vice president and business development manager for defined contribution, discuss the risks faced by UK pension savers preparing to take a retirement income and how such risks might be managed through PIMCO’s UK Retirement Strategy.
The recent changes to pension withdrawal rules announced in Chancellor George Osborne’s March budget mark a huge increase in the flexibility with which assets can be taken from a DC pension. While past investment approaches were generally characterised by DC schemes solely targeting annuity rates as the key objective for savers, such approaches are no longer valid. Nowadays, the key risk faced by DC savers in the years before retirement is dichotomous: On one hand, their pension investments may not be appropriate for generating a sustainable income throughout retirement; on the other, savers may be considering “cashing out” their portfolio, in which case their risk is closely anchored to the absolute cash value of their savings.
Therefore, DC pension schemes should focus on an investment portfolio reflective of the need to generate a sustainable income for retirees, while at the same time equally pursuing an approach that reduces overall volatility and the risk of negative returns for their members.
PIMCO’s UK Retirement Strategy looks beyond a simplistic allocation to traditional UK government and credit benchmarks, seeking to build a portfolio reflective of long-term income generation, protect against adverse market environments that may hurt portfolios and achieve enhanced returns when DC savers have their greatest money-weighted return opportunity.
Q: What is your investment approach in PIMCO’s UK Retirement Strategy?
Amey: In line with our aim to generate a return that reflects the need for a long-term income stream while simultaneously protecting against adverse market events, we employ a three-pronged investment approach. First, we use an optimised benchmark designed to best reflect the factors inherent to generating a sustainable income stream through retirement (e.g., longevity), which we revalidate annually. Second, we take an active management approach against that benchmark using our best ideas in high quality sterling-denominated and global fixed income securities of varying maturities, designed to improve returns and reduce risk. And third, we apply a protection overlay designed to defend the nominal value of the portfolio in the event of material interest rate rises.
Historically, DC schemes in the UK have sought to match their members’ assets to the costs of purchasing annuities, through focusing only on strategies that emphasised long duration UK government or corporate bonds. However, these traditional strategies are no longer valid for the future. Our research also suggests such strategies experienced relatively high levels of absolute and relative volatility (versus the cost of purchasing an annuity), combined with a unattractive Sharpe ratio (a measure of risk-adjusted performance), the appropriateness of which is clearly questionable. We think it is critical to pursue an active investment approach that provides the necessary flexibility to adapt to the prevailing market environment – be it to flex the credit exposure of the portfolio or to shorten overall duration in the event of a rising rate environment.
Q: Where do you find value for the strategy?
Amey: We take a diversified approach to building our portfolio by complementing high quality core UK gilt and corporate bond exposure with modestly higher-yielding securities and alternative fixed income sectors.
Given the current strength of the economic recovery in the UK and despite recent changes to Bank of England (BoE) guidance, we believe policy rates are likely to remain low, albeit with heightened uncertainty. We currently see value in bonds of shorter maturities whose prices have been depressed by market expectations of interest rate hikes and that should benefit from price appreciation while monetary policy remains on hold. Longer-dated bonds seem less attractive given that yields are low relative to the encouraging signs coming out of the UK economy and the uncertainty of predicting longer-term growth and inflation. However, if interest rates on longer-dated bonds should rise, we may use this as an opportunity to extend the average maturity of our portfolio.
We also continue to see select opportunities in both UK and global asset-backed securities (ABS), which benefit from attractive income potential combined with high credit quality. Our research found that a number of securities in the residential mortgage and commercial real estate markets have seen their investor base eroded since the start of the global credit crisis in 2008. This has created an imbalance between demand and supply, one in which you classically tend to find good opportunities to invest in high quality assets with relatively low capital risk.
Looking at securitised credit, we see a number of select opportunities that continue to offer attractive returns for a slight liquidity premium. Detailed analysis of individual securities is critical to achieving this return, both in the quality of the bond collateral and seniority within the capital structure in the event that economic conditions should deteriorate beyond our expectations. For example, we have taken exposure to senior tranches within the capital structure of select UK residential mortgage-backed securities (RMBS) backed by pools of high quality, low loan-to-value UK mortgages. When investing outside of the more traditional unsecured corporate bond markets, the depth of resources and the ability to understand more complex securities are paramount. Combining PIMCO’s extensive resources with our rigorous bottom-up security selection allows us to develop the required degree of comfort that the additional yield available within this asset class remains attractive.
Finally, the BoE’s aggressive use of monetary policy tools continues to depress local bond market volatility, allowing protection against the threat of future rising interest rates to be structured efficiently and at reasonable cost to the portfolio. Given the potential threat to DC savers posed by annuity prices not adjusting in line with rises in future interest rates, combining interest rate protection with a high quality bond portfolio is currently very attractive.
Q: What is your approach to credit quality in the strategy?
Amey: Despite the current uncertain economic environment, we believe there are many opportunities to invest in high quality securities that offer consistent yields and attractive total returns. As such, we are being highly selective in our high yield purchases. If we go through a period in which markets start to worry again about a return to decelerating or negative growth, we will likely see opportunities to buy lower-quality assets at attractive prices. Conversely, there will be periods when markets will price in strong growth.
Overall, the strategy maintains a predominately investment grade credit quality portfolio.
Q: How should pension schemes measure the performance success of the strategy?
Amey: Given the recent legislative changes to UK pensions and the potential for savers to pursue income drawdown or “cash-out” their pensions, the total return and volatility of the portfolio are clearly the primary success measure. However, while few DC savers are likely to purchase an annuity, we still recognise annuities rates as a ”risk-free” rate for retirees, given that an annuity represents a guaranteed income stream for life. In addition to monitoring returns and volatility, we also encourage pension schemes to consider returns relative to changes in average annuity prices, thus enabling success to be adjudged against all potential manners in which savers may withdraw assets from their pension scheme for retirement.
Q: How may schemes incorporate PIMCO’s UK Retirement Strategy into their default investment options?
Allport: Default options should reflect the variety of risk tolerances, savings behaviour and possible pension withdrawal preferences present within a scheme membership; they are, by definition, a compromise. For default savers at retirement, “income drawdown”, “cashing-out” and annuitisation are all possible; hence, a scheme’s default option should invest in a manner that reflects the best hedge against all of these possible asset withdrawal methods. More importantly, whether savers are approaching retirement or are already retired, they require a diversified, high quality investment portfolio that can deliver stable, long-term cash flows. The UK Retirement Strategy delivers just that.