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Investment Issues
Equities
After a shaky April, UK equities delivered a return of 5% over the quarter, with the FTSE100 index finishing above 5,100 as shown in the table below. This was the ninth consecutive quarter of advance, although the market remains significantly below its highs of five years ago.
Growth across the economy has held up well and corporate profit growth has been strong. There has been a rise in capital investment, which has helped offset the slump in consumer spending. However, there are increased fears that the lower consumer spending may cause growth to be more subdued. Many commentators now expect the Bank of England's next interest rate change to be downwards.
Global equity markets also generated positive returns in Sterling terms across all the major markets. This was despite many of the economies across Europe, especially the German and Italian economies, showing little sign of life. The main area of weakness remains the subdued retail sector, which is a result of high unemployment rates in many European countries.
Bonds
Expectations that the next interest rate movement will be down rather than up led to a fall in bond yields generally, and at the long end in particular. This boosted bond prices, and long dated gilts outperformed UK equities slightly over the course of the second quarter 2005. The chart below shows how the yield on long-dated gilts changed over the quarter, finishing at just over 4.2% per annum.
Corporate bonds were supported by the strong gilt market and also performed well. Long dated AA corporate bond yields, used to measure pension scheme liabilities under the accounting standards FRS17 and IAS19, stood at around 5% per annum at the end of the quarter. Companies may find that much or all of the improvement in their pension scheme's asset values, caused by strong investment performance over the last year, has been cancelled out by increasing liability values, caused by falling bond yields. The net result may be that pension deficits as reported in company accounts have not improved as expected, or may even have got worse.
Yields on index-linked bonds reduced slightly over the quarter. The "risk free" yield on long dated index-linked gilts now stands at just 1.5% per annum. The break even inflation rate in long term bonds is now 2.7% per annum in the UK.
Economic Environment
Interest Rates
The Federal Reserve in the US (Fed) raised its interest rate by a further 0.25% twice during the quarter. While the increases had been widely anticipated, many investors were worried that the Fed's accompanying statement contained no hint that it was near the end of its rate tightening cycle. There was a feeling that the Fed considered longer-term inflation to be well-contained, but that high oil prices were posing an inflationary threat in the short term.
The Monetary Policy Committee (MPC) voted to keep the Bank of England's base rate at 4.75%, resisting pressure for an increase to 5.0%. Weakening consumer spending may have influenced the MPC's decision to leave rates unchanged as retail sales slowed over the quarter. At the end of the quarter, many expected the next change in UK interest rates to be downwards (as has since proved to be the case).
Recent performance of main asset classes
| Periods to 30 June 2005 |
3 months (%) |
1 year (%) |
3 years(% pa) |
| UK Equity (FTSE All Share) |
+5.0 |
+18.8 |
+7.8 |
| European Equity (FTSE World Europe ex UK) |
+5.5 |
+18.6 |
+6.9 |
| US Equity (FTSE World North America) |
+7.6 |
+9.4 |
+3.4 |
| Japanese Equity (FTSE World Japan) |
+1.8 |
-0.3 |
+2.1 |
| UK Long Gilts (FTSE-A Government Over 15 Year) |
+6.7 |
+14.4 |
+7.6 |
| UK Corporate Bonds (Merrill Lynch Over 10 Year) |
+6.1 |
+14.7 |
+8.3 |
| UK Index-Linked (FTSE-A Index Linked Over 5 Year) |
+4.4 |
+10.8 |
+8.0 |
Topical Issues
The Occupational Pension Schemes (Investment) Regulations 2005:DRAFT
The Department for Work and Pensions (DWP) consulted on the Occupational Pension Schemes (Investment) Regulations. Consultation closed on 20 June and we are waiting for the Government's response. The consultation seeks to amend the Pensions Act 1995 by making the following key changes:
- Review of the Statement of Investment Principles
The draft regulations incorporate the requirement for a triennial review of the statement, but otherwise largely reproduce the current requirements on the statement's contents. The one significant change is that trustees are required explicitly to disclose their risk management methodology, rather than simply their policy on "risk", in order to reflect the requirements of the EU Pensions Directive.
Restrictions on Borrowing by Trustees
-
The draft regulations prohibit trustees from borrowing and acting as guarantors, with the exception that trustees may borrow on a temporary basis to provide liquidity for the scheme.
Use of Derivatives
-
The draft regulations prohibit investment in derivative instruments unless used to:
- contribute to a reduction of investment risks; or
- facilitate efficient portfolio management,
and any such investment must be made so as to avoid excessive risk exposure to a single counterparty and to other derivative operations.
Scheme Exemptions
-
The draft regulations exempt schemes with fewer than 100 active or deferred members from some of the requirements. The regulation makes it clear that pensioner members do not count towards the total.
In general Barnett Waddingham LLP welcomes the proposals and we believe they facilitate a sensible approach to the adoption of the relevant sections of the Pensions Directive. However, we have expressed our concerns to the DWP about the possible impact of the regulation regarding investment in derivatives. Whilst we agree that Trustees need to be fully aware of the risks of using derivatives we feel that, as drafted, the Regulation requires some clarification as they may restrict the use of some perfectly reasonable investment strategies.
Pensions Protection Fund (PPF) - investment strategy
The PPF has appointed fund managers to invest its assets and has outlined its future investment strategy. It will invest solely in bond-type investments, making use of derivatives where appropriate to manage its interest rate and inflation exposures in order to better match its liabilities.
The assets will initially be actively managed by Insight Investment and PIMCO. Goldman Sachs has been given a deferred appointment.