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The Actuary The magazine of the Institute & Faculty of Actuaries

Pension funds failing to protect against tail risks, says Cardano

Cardano, the investment adviser and fiduciary manager, has warned that pension funds in the UK are leaving their investment portfolios unprotected against some very painful and quite likely economic scenarios in the form of tail risks.

Tail risks, or extreme risks, are too often overlooked by pension funds in the UK, the firm believes, with most pension funds focusing on the most likely scenario for investment returns and economic outcomes when setting investment strategy.

For example, the most common view is that economic growth will return, albeit at a lower level than the last decade, inflation will remain under control and equity and corporate bond markets will produce decent long-term returns. Cardano agrees, and predicts that there is a 55% chance of this ‘New Normal’ scenario being played out in the UK.

However, the concern is that many pension funds do not think about what will happen if a different scenario happens - a double dip recession, for example, which Cardano predicts is about 25% probable in the UK, or an inflationary environment, which Cardano believes is about 20% likely to occur.

Keith Guthrie, chief investment officer at Cardano UK, explained: "We only have to look at the last few years to see that extreme, difficult-to-predict scenarios do play out in the investment markets and economies, and the impact these can have on pension funds can be enormous. Even in the last few weeks we have seen how the tragic effects of the Japanese earthquake have impacted financial markets around the world.

"We are currently balancing on a knife edge between fears of very low economic growth and an inflationary environment. The significant debt problems of a number of countries, most notably in Europe, combined with severe government spending cuts and quantitative easing, make for a dangerous concoction.

"However, at the moment very few pension funds are thinking about ‘all weather’ investment strategies. It is important that pension funds have a balanced portfolio and invest something in assets expected to perform well if these ‘tail risks’ occur. This might include the use of derivatives to provide protection against markets falling or inflation rising, or specific assets or funds expected to do well in tail risk scenarios."