Pension funds across Europe expect to go into the next recession with their finances weaker than ever, according to a report by Amundi Asset Management.

Its latest annual report, in association with Create Research, which surveyed 153 pension funds (€1.88trn AUM) across Europe, along with 38 pension consultants (€1.4trn AUM), found that 71 per cent of defined benefit funds have funding levels below 100 per cent, and 24 per cent have funding levels below 90 per cent. Currently, only 33 per cent have a positive cash flow and 40 per cent have a negative one.

“The numbers are all the more worrying against the backcloth of the longest bull market in history. The main culprit is falling interest rates. They mean lower cashflows, as plans typically rely on bonds to fund regular pay-outs to their retirees. To cover the resulting shortfall, they have to invest even more,” the report noted. Amundi estimated that a 1 per cent fall in interest rates increases pension liabilities by 20 per cent and decreases the funding ratio by 10 per cent.

As a result, pension funds are relying on two avenues to improve their funding levels – cash injections from their scheme sponsors and an investment approach that favours equities, illiquid assets and emerging market assets.

A third of schemes are targeting net returns in excess of 5 per cent, with the rest aiming for up to 5 per cent, the survey found. However, the report stated that as quantitative easing (QE) has borrowed against future returns, it will be a challenge to obtain anything in excess of 5 per cent without leverage and/or aggressive risk taking.

“Pension plans expect to go into the next recession with their finances weaker than ever. Hence, their current aims are to conserve capital, manage liquidity, plan for mean reversion and reduce mark-to-market volatility. They are investing in a range of quality public and private market assets and increasing their holding periods to avoid the episodic dearth of liquidity,” the report stated.

The report said QE has had unintended side effects by undermining the financial viability of pension investors. However, 67 per cent of respondents agree the stabilisation of financial markets after the Lehman collapse can be attributed to QE. Despite this, there are now strong concerns that QE is running out of steam in all the key regions where it has been undertaken since the crisis, Amundi said.

Eighty per cent of respondents agree that QE has inexorably inflated global debt and sown the seeds of the next crisis. Two thirds of respondents agree that QE has overinflated pension liabilities via zero-bound interest rates, whilst half say governments have used QE as an excuse to backslide on growth-friendly supply-side reforms.

Three avenues have been identified to help pension plans avoid suffering a major portfolio loss in falling markets and conserve their capital. The first seeks greater time alignment between asset allocation and the maturity profile of pension liabilities, as cited by nearly nine in every 10 respondents. The second treats liquidity management as the primary risk management tool (62 per cent) and the third is duration management (37 per cent), with a focus on under-valued assets across the yield curve (37 per cent).

Amundi group chief investment officer, Pascal Blanqué, said: “Pension plans are facing a host of challenges in this post-QE environment. As volatility rises and markets fall, liquidity management has become paramount, as has capital preservation for pension investors.”

At a time when markets remain distorted, pension plans are taking the necessary steps to tackle implementation leakage: errors made by pension plans themselves in designing and implementing their portfolios that only become evident in hindsight.

Two thirds of respondents consider cost minimisation as a key source of outperformance. As such, they are raising the share of passive funds as a low-cost option in their core portfolio and negotiating lower fees for active funds.

As QE has side-lined much of the conventional investment wisdom, trustee boards are having to make big judgement calls without the normal navigational tools. Therefore, strong investment expertise on pension trustee boards (59 per cent), a deep talent pool among professional staff (53 per cent) and a nimble governance structure (44 per cent) are seen as having a big impact on portfolio returns.

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