Ideas & Debate

Pension schemes penchant for fixed assets risks returns

zamara

Zamara Group Chief Executive Officer Sundeep Raichura (right) and the group’s project head mass and wider market pension, insurance and saving solutions Reginald Kadzutu at the release of second annual publication of the Zamara Pension Performance Watch 2019 in Nairobi in October. PHOTO | DIANA NGILA | NMG

Providers should go beyond the traditional areas to reduce exposure.

Defensive positioning makes sense in this market. Maybe too much sense, according to one industry consultant Zamara.

In their latest pension watch report, retirement schemes are noted to have a continuous bias towards fixed income assets (71 percent) over the last 10 years.

Equities had only 22 percent allocation in the same period and of the 415 schemes in the survey, 141 had invested in offshore investments (with an average exposure of 4.2 percent) and only 86 had property investments (with an average of 26.4 percent). Well, that may not be bad strategy after all.

Fixed income triumphed over other asset classes. It provided the highest average return over the 10-year period at 13.1 percent with lowest standard deviation (6.6 percent) and the highest Sharpe ratio (0.4 percent).

A lower standard deviation means the investor is rewarded with the same average return but with lower volatility. A higher Sharpe ratio means the investor gets more returns per unit of risk.

Equities, on the other hand, have been nothing but lackluster. Average returns of 12.9 percent over 10 years, high standard deviation at 26.6 percent and a very small positive Sharpe ratio of 0.1 means equities have had the highest level of volatility over the years and have not compensated investors for risk.

Similarly, offshore investments (predominantly equities) produced the worst average returns of 9.2 percent (which was lower than that of the risk-free rate) with a negative Sharpe ratio (shows that investors could have earned a higher return by taking less risk).

That said, the study revealed an underlying weakness – poor risk return profile. This is easily seen by schemes overall performance.

Despite an average median return of 12.5 percent, standard deviation stood at 11.1 percent and Sharpe ratio at 0.2 meaning pension scheme returns varied significantly over the survey period.

Actual returns ranged as high as 28 percent and as lower as -9.9 percent. Additionally, the exceptional long-term performance by fixed-income securities could create a false sense of confidence in the power of this asset class. Consequently, pension plans could become reluctant in making appropriate changes that may be necessary to better position schemes for continued success – a dangerous move considering that we are about to enter into a high-rate environment.

On these issues, pension plans would need to think about bettering diversification. Essentially, this would involve introduction of non-traditional asset classes such as private equity and hedge funds in order to enhance the return and risk profile for pension schemes. Simple re-allocation to equities may not work.

In fact, it’s possible that in future, for the same return, equities may need three times the amount of risk.

In other words, a 12.5 percent expected return may not come with a 26 percent standard deviation. The other alternative is to keep the status quo and be content with a sub-optimal risk return profile.

Ideally, going forward, pension boards will need to go beyond current investment returns and begin some tough conversations around spreading the risk even wider.

Amending the current asset allocation may affect returns in the interim but holds the promise of boosting the risk-return profile of the schemes.