Following the recent market recovery, the trend from allocation to equities by European pension funds continues.

Mercer, the international pensions consultants, said on Thursday that the move away from shares  is particularly evident in the more mature defined benefit markets such as the UK where the allocation has fallen from 54% in 2009 to 50% in 2010. In Ireland it has reduced from 60% to 59% and in the Netherlands from 28% to 23%. This trend is likely to continue, with 29% of UK schemes and 35% of European schemes (ex-UK) planning further reductions in domestic equity. A further 20% of UK schemes and 33% of European schemes (ex-UK) are planning a reduction in non-domestic equity.

“Although we believe it is appropriate for schemes to diversify away from their domestic markets, there is a danger that they will merely reduce domestic concentration as one type of risk, only to increase it with currency risk, as another. Many schemes hedge some or all of their foreign currency exposure to manage this risk, and recent currency volatility has prompted many schemes to review their current practices,” said Crispin Lace, senior consultant at Mercer. Looking at those schemes that have addressed the question of currency hedging, around 10% expect to introduce a target hedge ratio or increase their current target over the next year.

European pension funds are responding proactively to the likely reduction in fiscal and monetary stimuli and the subsequent impact on their investment strategy, according to Mercer’s annual European Asset Allocation Survey. The survey of over 1,000 European pension funds with assets of over €500bn found that 32% of schemes have explicitly considered the potential impact of current fiscal stimuli packages on their strategy and are mostly concerned about the effect an increase in inflation would have on their assets and liabilities.

Tom Geraghty, Mercer’s head of Investment Consulting for Europe, Middle East and Africa, commented: “With interest rates likely to remain low and national debt burdens increasing across European countries there is the potential for upward inflation shocks. An increase in inflation can lead to increased pension fund liabilities through higher salaries and increases to existing pensions.

“Schemes would traditionally protect themselves against inflation by purchasing inflation-linked gilts, which are currently quite expensive. But interestingly, many schemes are now taking action through the more creative route of increasing exposure to inflation-sensitive assets.”

Bonds continue to form the largest part of most European pension funds’ investment portfolios, and this looks set to continue. For example, following the significant rally in equity markets, a net 27% of European (ex UK) schemes plan to increase their exposure to government bonds. As for corporate bonds, there seems to be evidence that appetite is waning, with just 6% of European (ex UK) schemes looking to increase their exposure, compared to a 12% last year.

Investment in non-traditional asset classes remains strong with increases observed in many countries such as the UK and Ireland (both up from 6% to 9% in 2010), and Switzerland (up from 19% to 23%). In the UK, schemes favour hedge funds, GTAA (Global Tactical Asset Allocation) and private equity with 4% - 9% of schemes holding some form of strategic allocation to one or more of these opportunities. In the rest of Europe, schemes favour hedge fund of funds (8% have an allocation), high yield bonds (8%) and private equity fund of funds (6.6%).

The survey also noted that pension funds are increasingly seeking to capture the growth opportunities in emerging market economies. At least 16% of schemes looked to get exposure through emerging market debt and other assets, rather than through equities.

Crispin Lace commented: “It’s evident from this research that many schemes are becoming more proactive and creative in their approach to investment strategy. The last 18 months have represented a time of unprecedented opportunity and a large proportion of schemes were quick to identify good investment ideas such as corporate bonds towards the end of 2008.”

Noel Collins, senior consultant with Mercer in Dublin added: “The survey shows that Irish pension funds are at the forefront of trends in European investment. Not only have many Irish funds already taken steps to implement changes indicated in the survey, but a significant number have also improved their management and governance positioning them to avail of opportunities in a wider range of asset classes.”