Pensions and Fixed Income: A Window of Opportunity to De-risk

1 / Status Quo Positioning for Pensions

1.1  Concentrated Position in Equities at the Expense of Fixed Income

Although different pension plans would take a different investment approach, the goal is to pay off their liabilities. In theory, they would therefore rely on asset liability management to match their long-dated liabilities with cash flows. A prolonged period of low yields prior to 2022, coupled with a shift to a growth portfolio approach and the promising returns of US Equities in 2023, however, has motivated pensions to increase allocations to equities and alternatives in order to achieve target portfolio returns to cover their liabilities (e.g. Korea NPS, as shown in Figure 1). While these riskier asset classes have historically helped pensions compensate for lower yields in the fixed income market, they are exposing pensions to increased duration risk.

1.2 Lower Expected Return on Assets

Closely linked to the prolonged period of low interest rates is the fact that pension funds have adapted by lowering their return assumptions over the last 20 years, driven by lower return forecasts for many asset classes. As an example, target return on assets of most US public DB plans has declined from 8% to 7% over the last 20 years (Figure 2). After a series of rate hikes by central banks globally in 2023, pensions can now obtain a relatively attractive return from high-quality core fixed income instruments, which could potentially make the 7% targeted return more achievable with lower investment risks.

1.3 Funding Ratios improve, but not across all regions and countries

Not only do interest rate hikes have an impact on the return on assets, but they also lead to a decline in the present value of pensions’ liabilities because a higher discount rate is applied to the expected pension payment to plan members in retirement. This decline in the present value of pensions’ liabilities has led to an improvement in funding ratios for DB pensions, particularly in the US and Europe. The funded status of the US' 100 largest corporate pension plans stood at 102% as of the end of 2023 (Figure 3), indicating the assets of the US corporate DB plans are sufficient to cover their future liabilities, and they are now in a better position to reduce exposure to yield-enhancing assets (e.g., equities and private equity) and invest in hedging portfolios that could better match their duration risks.

Although interest rates have generally increased for most economies across the globe to combat inflationary pressures in 2023, it is also worth noting that not all economies have decided to increase their policy rates. This is particularly true for Asia, where various APAC countries are often in different business cycles (Figure 4). Japan, for example, still maintains a negative policy rate as of January 2024, implying the funding status of Japanese pensions is likely still under pressure. This might improve slightly after April 2024 when the market widely expects the BoJ to drop its yield curve control policy and start raising interest rates gradually in 2025, which could bring the present value of liabilities down for Japanese pensions.

1.4 Hedging costs remain elevated in key APAC countries

A unique challenge facing investors in Asia is often the high hedging costs arise from interest rate differentials between USD or EUR and the local currencies, which have intensified significantly in 2023 after the Federal Reserve (Fed) and European Central Bank (ECB) begun the hiking cycle. This is the key obstacle for asset managers to market foreign offerings to investors in APAC especially in Japan where the hedging cost is close to 6% (Figure 5). Although there is always a diversification argument to invest in overseas assets, elevated hedging costs would eat into the return of foreign investments especially for foreign fixed income, making them very unattractive for APAC investors.