Gold in UK

Gold in UK/Pension Schemes
With the rapid growth in funding ratios over the past two years, an increasing number of UK defined benefit (DB) pension schemes have been contemplating their investment approach for the endgame, the point at which a plan moves from being underfunded to being fully funded or even having a surplus. This transition has several investment implications. Let us examine how pension schemes can seek to maintain the ground they have gained over the recent past, as one of the driving forces behind the rise in interest rates and improved funding status, inflation – has become a source of asset price volatility. Gold is an effective addition to a DB portfolio, helping a plan achieve its desired endgame by contributing to long-term growth, providing diversification that helps reduce funding level volatility and enhancing overall portfolio liquidity.
How have UK DB pension schemes fared recently? To answer that question, we examine the evolution of the PPF 7800 index published by the Pension Protection Fund (PPF) since 2020. The index indicates the estimated funding position for the DB pension schemes in the PPF’s eligible universe and is based upon compensation paid by the PPF, which may be lower than full scheme benefits.
At the start of 2020, the aggregate scheme funding ratio was 96%. In the first half of 2020 one immediate consequence of the COVID-19-induced crisis was that yields collapsed, along with equity markets. Together, these two developments were challenging for UK DB pensions. With the present value of liabilities rising and asset values falling, aggregate DB schemes’ deficits widened to lows of 92% by July 2020. Since then, funding levels have steadily risen. Strong returns from growth assets were a key driver of the large improvements in scheme funding levels over 2021, with global equity markets reaching new highs following a strong economic recovery across the globe.
Over 2022 and 2023, for a traditional DB plan, particularly a closed plan, a much higher yield curve, commensurate with rising inflation, has provided a further welcome tailwind by decreasing the present value of liabilities.
At the end of August 2023, the PPF 7800 index shows funding levels were at 146%, levels just off the July record. And while disaggregating the data reveals that there is significant dispersion in the funding ratios among schemes, it is important for DB plans to seek to maintain the funding status gains made over recent years. This is especially so as worries surrounding the global economic environment continue to mount.
Taking into consideration recent improvements in the funding status of UK pension schemes and the breadth of macroeconomic challenges, we believe DB schemes should consider ways to protect their growth portfolio and narrow the range of potential outcomes. This would increase the likelihood of achieving their chosen endgame.
Identifying a target return to be achieved within a specific timeframe to cover all liabilities is important for DB schemes. But achieving that outcome with any level of certainty can be difficult. One of the most important questions for investors today is whether the tighter monetary conditions can indeed bring about a “soft landing” for the global economy. Experience suggests that this will be difficult; tightening has often preceded downturns.
Since 1976, for example, the Fed has only twice succeeded in hiking rates without subsequently pushing the US economy into a recession in the following couple of years, in 1983 and 1994. Only time will tell whether the Fed’s latest hiking cycle will succeed in combating inflation without a recession, or if a recession will be needed to kill high inflation.
Gold is a clear complement to equities and broad-based growth portfolios. A store of wealth and a hedge against systemic risk, gold has historically improved portfolios’ risk-adjusted returns, delivered positive returns, and provided liquidity to meet short-term cashflow requirements in times of market stress.
Investors have long considered gold a beneficial asset during periods of uncertainty. Yet, historically, gold generated long-term positive returns in both good and bad economic times, outperforming many other major asset classes over the past 20 years. The diverse sources of demand give gold a particular resilience and the potential to deliver solid returns in various market conditions. Gold is, on the one hand, often used as an investment to protect and enhance wealth over the long term (counter-cyclical demand), but on the other hand it is also a consumer good, via jewellery and technology demand (pro-cyclical demand).
Furthermore, while effective diversifiers are sometimes hard to find, with many assets becoming increasingly correlated as market uncertainty rises, gold is different in that its negative correlation to equities and other risk assets increases as these assets sell off. With few exceptions, gold has been particularly effective during periods of systemic risk, generating positive returns in 8 of the 10 worst quarters of performance for the MSCI World index. Of the remaining two quarters, gold outperformed the MSCI World index in both cases reducing overall portfolio losses.
Lastly, the UK 2022 gilt crisis served as a reminder that schemes need to be confident, they have sufficient liquid assets in their portfolio and can rebalance quickly across their funds while continuing to meet their return objective. In fact, utilising a gold allocation during this episode as a source of liquidity could have reduced the amount of forced selling in other assets already subject to price pressures, giving them more time to recover.
The gold market is large, global and more liquid than several major financial markets. In stark contrast to many financial markets, gold’s liquidity does not dry up, even at times of financial stress, making it a compelling addition to a DB portfolio.
Following significant funding level volatility over the last two years, there is a sharper focus on risk management among DB schemes. The potential higher returns from an equity exposure will continue to be important, particularly for schemes looking to reduce the time to their long-term funding target, close any funding gaps, and provide a buffer against longevity risk. Nevertheless, schemes focused on maximising outcome certainty should prefer an asset mix that provides a higher level of certainty of achieving those returns over a specified timeframe.
As demonstrated in our hypothetical case study, an allocation to gold can help mitigate the key risk faced by DB schemes, namely, uncertainty of being able to pay pension benefits, by providing long-term growth potential, diversification that helps reduce funding level volatility, and liquidity when it’s most needed.