A pensions time bomb nobody will defuse

Pensions are a time bomb that everybody knows is ticking away, but few seem willing to defuse.

Most politicians have over the years been happy to hope that when it does explode they will be long gone from the scene.

Irish private pension funds have had a good year. This comes on the back of several horrible years. The year was good not just in terms of returns, 27% over the last four years or 6% per annum. It was also good in terms of inflows.

This is important as the raid by the Government on private pension assets has and had the potential to instil a lack of confidence. Yet we saw an inflow of 11%. Irish pension funds now stand at just over €80bn. In a low interest rate environment €80bn will not yield much more than 4% per annum. This amounts to, gross of tax, about €6,400 per person.

Thus, pension funds need to either up the rate of return they will get or increase the amount of money under management, or both.

The recent review of the Irish pension system by the OECD suggests that the private pension industry is not overly expensive in terms of fees, measured internationally. What is problematic is that it is small. Smaller financial firms can find themselves at a disadvantage. While big is not always better, the efficiency of the pensions industry is probably best enhanced by it growing.

To get more returns is problematic. The strong 5-6% growth era is over. We have not had that real growth since the mid 1990s and those conditions are not coming back. We have seen how problematic this can be when we chase that growth from credit pumping and/or property ponzi schemes.

Thus pension funds that wish to increase growth in the long term will need to consider their asset allocation strategy very carefully.

If we examine Irish funds against European funds we find significant differences. Irish funds tend to have the highest allocation to equities and among the lowest to property. This is strange.

Commercial property should form a solid part of a pension fund. The nature of this asset class is that it is long term. To some extent this under-weighting is a reflection of the cycle we are in but Irish pension investors should consider if 2% is appropriate for the long term.

Second, within this heavy equity allocation Irish pension funds are grossly overweight in holdings of domestic equity. They hold 32% of all assets in the form of Irish company shares. The market capitalisation of Irish shares is approx. 0.2% of world shares.

This overweighting in essence is a gigantic bet on the health of the Irish stock exchange. The domestic focus continues on the bond side, where only 5% of bond assets are non-domestic government bonds. While Irish Government bonds have performed very well over the last couple of years, falling yields being indicative of rising prices, pension fund investment is a long-term investment.

The UK has shown a consistent drift to greater allocation of investments in alternative (to stock and bonds) assets over the past decade, with now 11% of all assets allocated. For Ireland this is 3%. The UK is leading a field in which we are lagging. Alternative investments are not an asset class — they are a series of asset classes ranging from emerging market debt to copper futures. The main elements tend to be commercial property, hedge funds, commodities, and classes of debt. Looked at over the last decade or so, certain kinds of alternative investment classes have performed spectacularly well.

Among the top performers have been global infrastructure funds, commodities especially gold, and global private equity funds. Gold in particular has shown a remarkable sustained growth since 2000, even allowing for an element of froth. So also infrastructure, a trillion dollar market.

Irish pension funds will get increased levels of assets as the governments mandatory policies come on stream. This is good, in the long term. But it will only show the full benefit if the domestic equity focus is scrapped and a much more imaginative asset allocation policy is put in place. Irish pension funds having weathered the worst of the crisis should now look outwards.



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