One of the mega-stories of investing over the next two decades will be pensions. How they impact on society, funding them and working out how to prioritise scheme payouts over other stakeholders such as investors looking for their dividends. Oh and to what degree governments will raid, and misdirect, pension pots to serve their policy objectives.

The immediate short term story centres on the DB deficit, which looks a bit like the government’s fiscal deficit, in that sometimes it gets a bit better and then most of the time simply looks horrid. The longer term story is how we can collectively figure out ways to properly fund pensions, using a combination of more payments into the schemes and better investment returns. A clue as to the outcomes of both challenges come in reports this month from consulting firm Mercer.

So, to the short term challenge — how big are the DB scheme black holes? The good news from the first Mercer report is that they’re looking a bit better.

“Mercer’s Pensions Risk Survey data shows that the accounting deficit of defined benefit (DB) pension schemes for the UK’s 350 largest listed companies fell from £145bn at the end of April to £134bn on 31 May 2017. At 31 May 2017, asset values were £749bn (an increase of £10bn compared to the corresponding figure of £739bn at the end of April 2017), and liability values fell by £1bn to £883bn compared to £884bn at the end of April.

“The improvement in the funding level over May was predominantly due to an increase in asset values which reached another new high. Liability values remained substantially unchanged with a reduction in long-dated corporate bond yields being offset by a reduction in the market’s expectation for long-term inflation,” said Ali Tayyebi, Senior Partner at Mercer. “With stock markets around the world at all-time highs, trustees and companies should consider the merits of putting in place some downside protection for such assets.” continued Mr Tayyebi.

But there’s bad news to come!

Mercer’s European Asset Allocation Survey is another publication. It dives deep into the detailed portfolios to see what’s happening at the cash flow mechanics level of funds.

The latest version of this report suggests that “55% of the UK’s defined benefit (DB) pension schemes are now cash flow negative (up from 42% in 2016) with 85% of the remainder expecting to be cash flow negative by 2027. Cash flow negative schemes lack sufficient income from investments and contributions to pay member pensions, so typically need to sell assets to meet their liabilities. Consequently, they are more vulnerable to market corrections since they may be forced to disinvest during a period of market stress”.

But it gets worse!

What would you as a pension fund manager or trustee do if you felt you didn’t have enough cash coming?

One tactic might be to goose up returns by taking a bit more risk.

Where would look for those extra returns?

Equities rather than bonds?

Liquid stuff or illiquid stuff?

Hedge funds or cheap index trackers?

I’m afraid the grim, awful truth is that pension funds look like they’re taking the WRONG sort of risks. According to Mercer “pension schemes are investing in alternative assets that offer some additional return in exchange for reduced liquidity and greater complexity as well as providing a regular income stream. The average allocation to alternatives increased in 2017 to 22% compared to 21% in 2016 (up from 4% in 2008).”

In parallel, pension funds are also dumping what are in effect conventional ‘alternative ‘ assets with deep liquidity — shares to you and I — and investing in much less liquid stuff such as private debt finance for smaller companies.

According to Mercer’s “in terms of asset allocation (See Chart 1 below) since 2008, UK plan equity allocations have halved from 58% to 29%. Report participants see this continuing, expressing their intention to further cut equity allocations in the years ahead. Indeed, in 2016, equity allocations fell as some schemes took opportunities to de-risk in the latter part of the year as equity markets and bond yields rose. Equity allocations averaged 29% in 2017 — compared to 31% in 2016 — while allocation to bonds rose from 48% to 49%”.

Just when you thought it couldn’t get any worse than this…it does. Pension funds are also increasing their exposure to “ hedge funds (from 33% to 37% of investors covered by the survey) as investors respond to the challenging environment for traditional market exposures (such as equities and bonds)”.

Yes, after having made good money on bonds, pension fund managers are behaving like a bunch of ill-advised lemmings and jumping into really risky, illiquid stuff and hedge funds.

The uniting theme? High costs by specialist managers. I have no problem with encouraging pension funds to invest in long-term assets such as infrastructure but I do have a real worry that they’re chasing hedge funds and very illiquid debt providers. There’s a good reason why the banks withdrew from small bank lending and that’s because it was…risky…under Basle III rules. If it was too risky for banks, I struggle to understand how it’ll be OK for pension funds. Unless of course, you have a smart fund manager sticking their fee into the equation.

I predict blow ups aplenty come to the next downturn or financial meltdown, with pension funds taking a massive hit. Be afraid, very afraid.

The Mercer 2016 European Asset Allocation report can be found here: 2016 European Asset Allocation Report

Chart 1: Changes in broad strategic asset allocation for UK plans