Investment Update: The Case for Gold in UK DB 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 a number of investment implications. In this paper, we examine how pension schemes can seek to maintain the ground they’ve 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.

Our analysis suggests that 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
• 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 (Chart 1). With the present value of liabilities rising and asset values falling, aggregate DB schemes’ deficits widened to lows of 92% by July 2020. 

Chart 1: COVID-19 created significant challenges for UK DB pensions

Historical aggregate funding position and funding ratio of schemes in the PPF universe*

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.

Managing outcome certainty

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 (Chart 2).

Chart 2: Pension schemes should seek to increase the certainty of achieving their endgame

Hypothetical development of DB funding levels based on different strategies

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. Past experience suggests that this will be difficult; tightening has often preceded downturns.

Chart 3: Fed funds rate hikes have usually resulted in a US recession

Six out of the past eight hikes have followed this pattern*

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 (Chart 3). 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.

What makes gold a strategic asset for DB pension funds? 

Our analysis shows 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 (Chart 4).

Chart 4: Gold has outperformed most broad-based portfolio components over the past two decades

Annualised returns of key global growth-oriented assets in GBP*

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 (Chart 5).

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 (Chart 6).

Chart 5: Gold becomes more negatively correlated with equities in extreme market selloffs

Correlation of global equities vs. gold in various market environments*

Chart 6: Gold provides downside protection

Gold returns (in GBP) during periods of systemic risk (10 worst quarters of performance for the MSCI World index)*

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 (Chart 7), giving them more time to recover.

Chart 7: Post mini-budget returns (in GBP) for gold vs. UK bonds and UK equities

The gold market is large, global and more liquid than several major financial markets (Chart 8). 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.

Chart 8: Gold trades more than many other major financial assets

Average daily trading volumes over the last 5 years in US dollars*

At first glance schemes 1 and 2 may look attractive, with both strategies closing their deficit (Chart 9). But the goal of our hypothetical plan is not only to meet the funding ratio objective but also to limit the risk of falling back into deficit. Our analysis shows that the strategy with gold exhibits less dispersion of future funding levels, increasing the probability of reaching full funding within the 10-year period.

Chart 9: The uncertainty of reaching the chosen endgame could be reduced with an allocation to gold

Paths taken by two hypothetical schemes to become fully funded*

Moreover, funding level volatility can have a material impact on pension schemes. We witnessed this during the market turmoil of March 2020. Next, we compare how our two hypothetical schemes would have fared over that period – assuming no leverage for simplicity and an initial funding ratio of 100%.

The hypothetical scheme with a gold allocation did see a reduction in the funding ratio volatility, reaching a level of 93% vs. 91% for a scheme without gold (Chart 10). The benefits of this scheme’s shallower drawdown are twofold: assets are not required to work as hard to recover, and the management of a sponsoring employer’s balance-sheet risk is also helped.

Chart 10: An allocation to gold could have reduced the funding ratio volatility during the COVID-19-induced crisis

Funding ratio of two hypothetical schemes with and without gold*