Underfunded DB schemes over-reliant on 'once in a century' equity returns - WTW

Underfunded defined benefit (DB) pension schemes are over-dependent on “once-a-century” equity returns in plans to close funding deficits by 2030, according to Willis Towers Watson (WTW).

The research revealed that, given current funding levels and the typical asset allocations for UK schemes, the average underfunded UK DB scheme requires “improbable” equity returns of 9 per cent above cash rates on an annual basis for the whole of the next decade to avoid facing continued “significant deficits” in the 2030s.

WTW emphasised that it is unlikely that current allocations will lead to full funding before the 2030s, when comparing this requirement against historic returns from equities.

The required rates of return for equities would be almost three times the historic equivalent, with UK equities averaging just 3.1 per cent per annum above cash rates since comparable records started in 1704.

Furthermore, during this time, UK equities have only matched the required 9 per cent annual rate of return over cash in one of the 20 previous ‘rolling decades’.

WTW highlighted that other international competitors have also suggested low odds of full funding by 2030, with equivalent data from the US equities available from 1946 showing average 10-year returns of 6.2 per cent relative to cash.

Commenting on the findings, WTW head of multi-asset growth solutions, Katie Sims, stated: “Underfunded DB schemes are effectively counting on a once-a-century equity performance if they’re to wipe out deficits this decade.

"Simply putting all your eggs in one basket and hoping for unlikely events will not be enough to solve the funding gap."

Sims emphasised that pension schemes should look outside of listed equities and "adopt the mindset of an endowment investor", in order to embrace a broad range of assets, such as private markets, to improve their return profile.

She added that whilst caution is "partly understandable", the problem will get worse year-on-year as returns will on average disappoint, warning that allocations that have such a low chance of delivering the right outcomes could also be seen as a form of denial.

Sims continued: “Many pension schemes and other institutional investors need to massively rethink how they anticipate creating the necessary long-term wealth to fund their future obligations.

“A much greater portion of portfolios need to be invested in practical real-world projects that are actively building the economy of the future.

“Listed equity certainly has a place in the investment mix, but schemes need to think beyond traditional allocations in order to meet the returns they need.”

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