Pensions investment outlook 2025: US policy uncertainty clouds road ahead

The coming year will likely be characterised by three main drivers: the US’s politically driven polices; structural economic weaknesses and political uncertainty in Europe; and China’s restructuring of its troubled property market.

Overall, our forecasts suggest global growth looks set to continue its 2024 pace of 3.2% in 2025, before easing in 2026 to 2.9%.

This outlook could be compounded by the implementation of trade tariffs on China and Europe by US President-elect Donald Trump, potentially leading to emerging countries’ growth suffering as a result.

Political uncertainty in major European countries such as Germany and France, coupled with growing nationalism in Europe, is expected to make it increasingly challenging to coordinate pan-European policies regarding economic reforms, migration, and European defence.

This uncertainty is becoming a significant driver of market sentiment. Increased government spending is leading to higher debt and government bond issuance in Europe. Notably, as of late November, German sovereign bonds (Bunds) had a positive spread versus the swap yield curve¹  for the first time, while France had already turned positive some time ago. The European Central Bank’s (ECB) reduced buying of sovereign debt is part of the equation to balance supply and demand.

German Bunds’ high yield is noteworthy, considering the country's zero-tolerance policy towards a central government budget deficit. This might be one of the topics under discussion in the country’s upcoming elections in early 2025. In this environment, European sovereign bonds could reach attractive yield levels in 2025, with the ECB expected to lower its policy rate, potentially leading to a steeper yield curve in Europe.

ESG headwinds

Sustainable investments are anticipated to face further headwinds in 2025, with the Trump administration driving a negative sentiment towards environmental, social and governance (ESG) related investments in the US. This could potentially spill over into European markets, if it has not already done so, and global asset managers may need to navigate different sustainability ambitions of their US and European clients.

Sustainable investments, as defined by Sustainable Finance Disclosure Regulation (SFDR) standards as Article 9 funds (i.e., products which have a sustainable objective and therefore target specific sustainability outcomes alongside financial returns) are still niche in the world of pension funds. In fact, most funds no longer accept Article 6 investment funds - those which only assess and address sustainability risks.

Biodiversity is increasingly being viewed as the most important environmental theme, more than climate change, and one that also has great influence on social development topics. European pension funds are increasingly investigating ways of implementing biodiversity in their portfolios.²

Emerging market allocations

Against this backdrop, pension funds in Europe may be contemplating their strategic allocations towards emerging markets, including equities and debt denominated in local and hard currencies.

However, investments in emerging markets might face challenges given the potential for slower global growth, trade wars between the US and other countries, increasing geopolitical stress and ambitious sustainability agendas.

Local currency emerging market debt has not performed well over the last decade, and emerging market dollar denominated debt must compete with the US high yield bond market. What’s more, excluding countries like China and Saudi Arabia from an emerging markets universe on sustainability grounds leaves limited investment options. This also holds true for listed companies in emerging markets, apart from Taiwan and South Korea. An allocation to these emerging market equities alongside developed markets could be made via an all-country world index mandate rather than as a separate allocation, while excluding certain countries on sustainability grounds.

US equity market still attractive

Historically, the US market has often acted as a perceived safe haven for capital in times of uncertainty, something that could well continue in 2025. The dollar is already on the rise compared to the euro - and hedging dollar assets will likely become more costly next year.

US companies’ profitability is likely to underpin current equity market levels. Large-cap technology companies might be best equipped to weather an international trade storm, given strong momentum in artificial intelligence (AI) and US companies’ leadership position in technology more broadly. It is unlikely that this will change in the near future, positioning US companies well to benefit and given the lower valuation of the domestic companies making the US equity market still attractive. The risk is of course that the implementation of high trade tariffs on foreign goods will hit the exports of US companies in 2025.

Balancing risk and return

Pension investors' appetite for US high yield bonds may be influenced by their quest for income. The search for income-generating assets may lead pension funds to consider high yield bonds as an alternative to traditional fixed income securities. In particular, short duration high yield bonds offer the potential for higher yields compared to investment-grade bonds, which can be appealing for pension investors seeking to enhance portfolio income and manage interest rate risk.

However, pension funds will carefully assess the credit quality, default risk and market conditions associated with US high yield bonds. While the potential for higher yields is attractive, pension investors will remain vigilant about credit fundamentals, liquidity considerations and the impact of economic cycles on high yield bond performance. Furthermore, ongoing monitoring of default rates and issuer-specific factors will be essential for pension funds evaluating US high yield bond opportunities as spreads are historically tight.

We expect pension investors’ appetite for emerging markets equities and government bonds, as well as US high yield bonds, to be influenced by a balance of return potential, risk considerations and diversification objectives in 2025. Pension funds will likely seek to strike a balance between pursuing investment opportunities that offer attractive yields and managing the associated risks effectively, aligning their investment decisions with long-term portfolio objectives and risk management principles. Equities seem set to deliver more favourable returns in 2025 compared to bonds.

Below we highlight and explain the current backdrop for three Europe’s largest pension markets:

UK: Positioning to secure funding ratios

In the UK, there are large undercurrents in the regulatory frameworks across defined contribution, local government and potentially in private defined benefit pension schemes. UK defined benefit schemes are now well funded, and the biggest theme continues to be the trend towards buy-ins and buy-outs where a proportion - or all - of the pension fund’s assets are sold to insurance companies who then manage the assets. The focus on risk management and liability-driven investment strategies, which aim to secure funding surpluses and fulfil long-term pension obligations, will continue, as will the higher allocation to credit assets to match insurer pricing. Potential regulatory changes around the use of the surplus can also be expected in 2025.

The UK government is planning to mandate the merger of local authority funds into larger entities with a minimum valuation of £25bn-£50bn, by March 2026. As of the end of 2023, these 86 funds collectively managed £354bn (€425bn), with individual fund sizes ranging from £300m to £30bn. The government has projected that if each fund were to allocate 5% of its assets exclusively within the UK, it would result in an additional £20bn in investments.³

The Netherlands: Biodiversity in focus

In the Netherlands, pension funds are navigating the shift from defined-benefit to defined-contribution arrangements under the new pension system. This transition is expected to prompt changes in asset allocation (less long-dated swaps and government bonds and more investment grade credit), risk-sharing, and member communication. Dutch pension funds are keeping their focus on sustainable investing and ESG integration, in line with the country's commitment to responsible investment. Additionally, they are exploring innovative approaches to governance and member engagement to adapt to the new regulatory landscape starting from 2025.

By 1 January 2025, three Dutch pension funds will be the first to adopt the new pension system, involving nearly 200,000 participants and €12bn. While 25 funds initially planned to transition, many have postponed doing so for various reasons.⁴

Germany: Ensuring pension payments

Against a backdrop of the current interest rate environment and demographic challenges - including an ageing population and a shrinking workforce - and consequently declining pension contributions - German pension funds may pursue long-term income-generating instruments. There is a growing interest towards implementing cash flow-driven investment solutions, switching from liability-driven investing, and to align investment income with payment liabilities and reduce the risk of forced sales of assets. Pension funds will be focusing more on safeguarding existing assets and ensuring the stability of pension payments, rather than solely maximising investment returns. Alongside of it, German pension funds will prioritise the integration of ESG factors into their investment decision-making processes and will be focusing on low-carbon strategies based on MSCI Low Carbon data.

Additionally, German pension funds may explore collaboration opportunities, including joint investment initiatives and cost-sharing arrangements, to enhance their operational efficiency and investment capabilities.

Overall, the evolving pension fund landscape in Europe underscores the importance of adaptive investment strategies, sustainable practices, and innovative governance models. By embracing these principles, pension funds in these countries can position themselves to navigate the complexities of the investment environment in 2025 and beyond.