What’s the Answer to Low Returns for Pension Programs? Alts
Art by Tim Bower
The discount rate is headed down, propelled by lower interest rates and, as investors are finding out painfully lately, a tanking stock market. Stocks may yet rebound at some point, once the coronavirus scare subsides, but the era of basement-dwelling interest rates appears locked in for a long time.
So can pension funds meet even the lower bar that’s being set? Yes. By expanding their investment horizons beyond traditional stocks and bonds, which make up the biggest part of portfolios. That is, by moving into alternative investments.
Otherwise, “it’ll be hard getting to 7.25%,” said Anton Pil, global alternatives managing partner at JP Morgan Asset Management, referring to a common discount rate. “What can they do? Private equity. Private credit. Hedge funds, with low exposure to equities.”
Certainly, pension plans are increasing their exposure to alts, just not by an enormous amount. A tally from State Street Global Advisors showed that over the decade since the financial crisis, public funds shifted their allocation, with a rise in alts to 5.2% from 2.6%. Real estate advanced to 6.3% from 5%. A grab bag of other alts went to 4.8% from 3.1%. Meanwhile, domestic equity grew to 16.1% from 7.5%. (The big falloffs came from Treasuries, shrinking to 22.2% from 30.2%.)
Sliding discount rates are no friend to defined benefit pension plans, which overall have for some time been struggling with funding shortfalls—assets don’t match the liabilities they incur for still-working plan participants and retirees.
By the Numbers
The discount rate is the long-term estimated return on the assets that plans hold, and the tool they employ to figure out the amount they will need to generate in the future to meet obligations. The median discount rate at public plans is 7.5%, a decrease from 8%, by the count of the National Conference on Public Employee Retirement Systems (NCPERS). What’s more, in a survey the organization did, 64% of public plans had either lowered their discount rates or planned to do so.
Sigh. A lot still didn’t meet their goal. In February, the 100 largest US corporate funds lost $71 billion in funding, according to actuarial and consulting firm Milliman. Their funded ratio dropped from 85.5% to 82.2% from the previous month. That marks the lowest level in more than three years. The funded level is now off nearly 10 percentage points from 12 months before, when it was 91.9%.
Much of that had to do with the stock market’s virus-related slide, which began in the final third of last month. Tiny bond interest income was no help. March, of course, stands to be even worse, as rates keep falling and stocks are in a power dive.
“It’s tough to adjust downward,” said Sean Kurian, head of institutional solutions at investment management firm Conning. “Now, 10-year Treasuries are below 1%.”
Different Paths
But …. outperformance is possible. The Ohio Police & Pension Fund, for instance. dropped its discount rate in late 2017 to 8.0% from 8.25%. Turns out that it had no trouble meeting and exceeding that target.
For 2019, the pension program came in with a 17.2% gain. What’s more, for 2017 through last year, the fund’s investments returned 9.8% annually, which encompasses the entire time the lower discount rate was in effect. In other words, they really didn’t need that reduced objective.
Ash Williams, CIO of Florida’s State Board of Administration, shows how thorough diversification, especially into alts, can bear fruit. He returned to the SBA, after working at a hedge fund, in 2008 amid the devastation wrought by the financial crisis.
He rebuilt the pension program, in his words, by getting the legislature’s OK to “expand investment authority to include almost everything from Treasuries to frontier equities, including real estate, private equity, venture capital, distressed debt, infrastructure.”
The Florida Retirement System’s pension fund assets returned 8.98% for the fiscal year ended last June 30, outpacing its benchmark of 8.22%. Total market value reached was $160.4 billion. Tellingly, the strongest gainer was private equity with 15.5%, followed by real estate with 7.1%.
Marcus Frampton, CIO of the Alaska Permanent Fund, is a big fan of private equity. He plans to increase the organization’s allocation to PE to 19% from 13%, convinced that its superior returns will pay off. “Private equity is the one area where this outperformance can move the needle the most,” he said.
Indeed, PE can be a variable creature, he indicated, with the performance difference between the field’s top and bottom quartile a stunning 10 percentage points. The Alaska fund’s long-term target (it doesn’t use the term discount rate) is the Consumer Price Index plus five percentage points. This would make it 7.25%.
PE is expected to do the best over the next 10 years, by the estimates of investment consulting firm Callan. And in the meantime, it returns a solid 9.6% over the previous year. Real estate comes in second, at 6.25%. By contrast, broad US equity is 7.1% and US Treasuries, 2.7%.
To be sure, the extremely unsettled nature of the markets, for equity and bonds and other asset classes, may continue for a while. Once the coronavirus threat is lifted, everything may spring back, with a V-shaped recovery. Or there might be a longer U-shaped one. The most important question is how long the crisis will last. So right now, the future has become harder to model for.
The 2008 financial crisis and the Great Recession hurt a lot of pension plans, as Florida’s Williams can attest. But smart allocation to assets not hitched to traditional investments may well be the path to eventual salvation, once again.
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