Buy bonds now,
pay later
Summary
As a pension trustee, you invest in shares
and other risky assets to grow your pension
money faster. As years go by, you gradually
sell shares to buy bonds, which are more
stable and hence a better match for
pension payments.
Because of this, you are exposed to a double
investment risk — falling share prices, and
rising bond prices.
The risk of rising bond prices is not small.
We estimate that by the time all members
have retired, the typical trustee plans to buy
around twice as many bonds as the shares
they hold currently.
So this is the trustee’s dilemma. Sell the
shares now, and there isn’t enough money
to buy all the bonds needed to match all the
pensions. Sell the shares later, and run the
double risk of falling share prices and rising
bond prices.
However, asset managers now offer a third
way for pension schemes of all sizes. Keep the
shares and buy the bonds now but pay for
them later.
Contact:
Yves Josseaume FIA Partner
+44 (0)20 7086 9157
More bonds
More and more pension schemes are closed and freezing accruals. The average member is getting older and the amount being paid to pensioners is rising.
Matching pension payments with stable cash flows from assets is ever more important. Bonds pay stable cash flows which are ideal to match pensions.
Bonds come in many different shapes: fixed bonds to match fixed pensions, inflation-linked for inflation-linked pensions, short-dated for old members’ pensions, and long-dated for young members’ pensions.
By the time all members have retired, most trustees plan to invest nearly all the assets into bonds. Matching is the safe thing to do.
Make me safe, but not yet
Most schemes do not have enough money today to buy all the bonds needed to match all their pensions. Investing just in bonds today would force employers to make unaffordable cash injections.
The Plan
A large percentage of the money needs to be invested in investments such as shares, which are riskier than bonds but expected to grow faster than bonds.
In a recession, share dividends may be cut and share prices may fall. But shares are generally expected to grow faster than bonds. In particular, money in shares is expected to broadly double within 10 years (when dividends are reinvested).
Ten years is the average time a typical trustee expects to invest in shares. Trustees plan to sell shares gradually and buy bonds instead, so some money will be switched earlier and some money will be switched later.
Investing in shares is a necessary risk that you often take willingly.
Hidden risk
However, you are also exposed to the risk of rising bond prices. If bond prices rise, you cannot buy as many bonds as you planned to.
Once you buy a bond you will normally hold it until its last payment, unlike shares which pay dividends forever and need to be sold at some point. Once bought, the price of a bond does not matter anymore.
But you have a lot of bonds to buy. For most trustees not buying bonds now is at least as big as a risk as investing in shares. Shares today Growth Bonds to be bought Bonds
Too big to ignore
Yet bonds are discussed much less than shares. Share prices are regularly reported on television and radio, not bond prices. Your monitoring systems focus on what you have bought, but ignore what you plan to buy.
Bond prices are volatile
* Real return on long-dated inflation-linked UK government bonds
You should spend most of your time thinking about your biggest risks. Bond risk is one of your biggest risks, if not the biggest risk.
Taking action
Thankfully asset managers now provide a third way. This is to keep the shares and buy more bonds now but pay for them later.
Managers now offer a range of funds to suit the needs of most pension schemes, big or small. Some funds are simple, off-the-shelf and cheap. Others are sophisticated, tailored and more expensive.
We believe all trustees should consider investing in these funds. Each pound invested allows the manager to buy a pound’s worth of bonds, and then to ‘buy now, pay later’ another two to three pounds of extra bonds.
A few trustees may be sure that bond prices will fall and so they may be hesitant about buying now. We believe even these trustees should invest some money into these funds, to start reducing their bond risk and be ready to reduce it more later. You wouldn’t want to miss the opportunity of the next bond sell-off.
No regrets
What about the risk of bond prices falling after investing? Our central forecast is indeed for lower bond prices in five years, by about 10%. However, a forecast is not a guarantee.
And, once you have bought enough bonds, changes in bond prices become irrelevant.
Your trustee duty is to ensure pensions are paid, not to chase every opportunity to create an unusable surplus. If your plan is to grow faster with shares, why run the bond risk too?
And if you hope that bond prices will fall, then you need not buy so many shares. Otherwise you are running too much risk.
Either way, bond risk is too big to ignore. The safest approach is to start now to reduce it over time.
Conclusion
As a trustee you are running a double investment risk — falling share prices and rising bond prices. We believe you should consider reducing this double investment risk. You should consider investing in funds which allow you to buy more bonds now while still investing in shares.
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Disclaimer
Nothing in this document should be treated as an authoritative statement of the law on any particular aspect or in any specific case. It should not be taken as financial advice and action should not be taken as a result of this document alone.
Unless we provide express prior written consent, no part of this document should be reproduced, distributed or communicated. This document 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 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 any third party. 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 opinion or assumption in this document is not intended to imply, nor should be interpreted as conveying, any form of guarantee or assurance by us of any future performance or compliance with legal, regulatory, administrative or accounting procedures or regulations and accordingly we make no warranty and accept no responsibility for consequences arising from relying on this document.
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