The traditional Defined Contribution (DC) investment portfolio made up of equities and bonds has worked well for investors for a long time. For much of the last 15 years, the environment that has afforded this success has been driven by central bank actions such as ultra-low interest rates and quantitative easing.
Shortcomings of government bonds as a diversifier
For many DC investors, high quality government bonds, such as UK Gilts, have long fulfilled the traditional role of diversification in investment portfolios, offering protection during periods when risk assets have come under pressure.
Moreover, investors have been unusually well compensated for protecting balanced portfolios by the generous legacy coupons on government bonds and the sheer strength of the bull market in sovereign bonds over the last 15 years. Today’s meagre yield, however, means government bonds’ long-term ability to function as a “shock absorber” has greatly diminished.
At current yields, the scope is, broadly speaking, limited for yields to be able to move down circa 2% and replicate moves of past crises such as during the global financial crisis (GFC) or the COVID-19 induced crisis (Chart 1).
In addition, high quality government bonds were also favoured as a safe-haven asset during the last 20 years because inflation was subdued and quantitative easing distorted bond markets. But risks invariably exist. Having benefitted from enormous fiscal and monetary policy stimulus in 2020 and 2021, the world economy will have to adjust to a new policy reality going forward. And with the inflationary flare-up proving far more intense and persistent than predicted, major central banks have turned decidedly more hawkish. The Bank of England, for example, hiked again in February and is poised for additional rate increases this year.
As Chart 2 shows, higher inflation weakens the appeal of government bonds as a diversifier. At inflation levels below 2%, the correlation between global equities and global treasuries has been negative, providing diversification. At levels above 2%, this relationship has historically started to break down.
The lessons here are twofold:
- the downside to bond prices is now, potentially, much greater than the upside
- there is no guarantee that bonds and equities will remain negatively correlated with one another, particularly considering the inflation outlook.
It is important, therefore, to have assets that can help in these scenarios and not rely solely on government bonds as your diversifier.
Gold as a diversifier and an inflation hedge within DC investment portfolios
We have thus far outlined the issues that represent a challenge for DC investors trying to design well-balanced portfolios. They need to be cautious of the risks of inflation and take account of the low yielding environment.
Our analysis shows gold is a clear complement to equities, bonds, and broad-based portfolios. A store of wealth and a hedge against systemic risk, currency depreciation and inflation, gold has historically improved portfolios’ risk-adjusted returns, delivered positive returns, and provided liquidity to meet liabilities in times of market stress.
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, as seen in Chart 3, increases as these assets sell off.
With few exceptions, gold has been particularly effective during times of systemic risk, delivering positive returns and reducing overall portfolio losses (Chart 4).
With inflation surging to multi-decade highs, DC scheme members may be most concerned about increases to their cost of living, which are likely to outpace salary growth. Members in the early part of their savings journey will likely continue to focus on growth assets, but those closer to retirement may need guidance about what higher inflation means for their retirement plans and how their investment strategy can protect the real value of their savings.
And gold has long been considered a hedge against inflation, with the data confirming this (Chart 5). Also, the annualised return of 9.1% in GBP over the past 50 years has outpaced the UK and world consumer price indices (CPI).
Case Study – The impact of gold within a DC asset allocation
From current levels, a traditional equity/bond portfolio may not deliver the type of diversification and returns achieved historically, as the major central banks have lowered interest rates towards zero over the past 20 years. As a result, we believe DC investors should consider alternatives to high quality government bonds, such as gold.
What is appropriate at different stages of DC investing and where could gold fit?
A core belief of the DC pension industry centres around the fact that risk will be rewarded over long horizons, while effective risk management is needed to support good outcomes for those closer to retirement (Chart 6). As such, in the accumulation phase, members are a long way from retirement and have time to ride out the ups and downs of the stock market. In this phase, and despite the fact that gold has delivered some healthy returns over the last 50 years, short-term risk mitigation through diversification of asset classes, and the addition of gold, could be seen as a headwind to potentially higher long-term returns. We are, however, of the opinion that gold has a role to play in consolidation and retirement phases, as protecting against negative returns is important because a member’s outcome could be significantly impacted by a market downturn, with little time left for recovery.
With member outcomes being a key factor in setting all aspects of DC strategy, we assess how an allocation to gold can impact the future retirement incomes of investors.
Using long-term asset class forecasts (see Appendix for more details) and assumptions (Table 1) around starting salary, salary increases and contributions, we’ve projected the range of potential pension outcomes for a glidepath with and without gold (see Chart 8 and Chart 9 in the Appendix for details). The glidepath with gold has a modest but meaningful 5% allocation to gold built over the consolidation phase of the retirement journey.
Table 1: Monte Carlo assumptions*
| Assumptions | |
|---|---|
| Starting salary at age 21 | 30k |
| Annual salary increases | 2% |
| Annual pension contributions | 10% |
*As of 31 December 2021.
Source: World Gold Council
These forward-looking projections provide us with a number of key insights (Chart 7):
- the distribution of outcomes at retirement (age 65) for a glidepath with gold is skewed towards the right-hand side, meaning the median portfolio at retirement is higher and the potential worst outcomes are reduced
- a 5% gold allocation throughout retirement can also provide a more secure income in retirement, as a portfolio following a glidepath with gold will exhaust its assets after a portfolio without gold.
Conclusion
In short, there are several advantages to diversifying the sources of safety in an investment portfolio beyond just high quality government bonds. The way gold and government bonds perform going forward is likely to be different from one another. That feature alone should appeal to DC investors.
As demonstrated in the case study, gold can help mitigate the key risks faced by DC investors – investment risk, inflation risk and longevity risk – by providing diversification that works, protection against high and extreme inflation, and enhancing risk-adjusted returns.
Appendix
Asset class forecasts:
- Gold: the World Gold Council has developed a framework to better understand gold valuation. Our Gold Valuation Framework powers our web-based tool, Qaurum, which allows users to assess the potential performance of gold under customisable hypothetical macroeconomic scenarios provided by Oxford Economics.
- Equities & bonds: we have used State Street Global Advisors’ long-term asset class forecasts. These forecasts are forward-looking estimates of total return, generated through a combined assessment of current valuation measures, economic growth, inflation prospects, ESG considerations, yield conditions, as well as historical price patterns.
