Pension Funds

Returns strong in 2016 despite scary beginning

But pension funds' comeback stalled by increasing liabilities

Alan Glickstein
Alan Glickstein said rising markets after the U.S. election saved the fortunes of many funds.

An eventful year filled with geopolitical drama, market volatility and diverging monetary policy gave rise to some impressive returns for pension funds in seven of the world's largest retirement markets. The average investment returns for pension funds in Australia, Canada, Japan, the Netherlands, Switzerland, the U.K. and the U.S. were higher in 2016 than the year before and ranged from the U.K.'s 20% to a 2.8% average for Japanese funds.

The year started with a stock market crash in China and an increasingly accommodative monetary policy from the Bank of Japan, followed by the U.K.'s shock vote to leave the European Union. Commodity prices began to regain ground, and the year ended with the election of Donald Trump as U.S. president.

But the volatility created by these events looks to have played to the advantage of pension funds, at least at first glance, said sources.

The U.K. was by far the market with the highest average return, at an estimated 20%. That compares with a range of zero to 2% for 2015.

“Brexit was the more significant (event) for U.K. pension funds,” said Phil Edwards, Bristol, England-based principal and European director of strategic research at Mercer Ltd. “There was a large devaluation in sterling, a large fall in gilt yields and the FTSE 100 rose fairly materially after that event.”

Between June 24 and the end of the year, the pound sterling fell 17.05% against the dollar, while the FTSE All-Share index rose 5.52% in dollar terms. For the year, the pound dropped 16.26% vs. the dollar, while the FTSE All-Share gained 16.75% in dollar terms.

U.K. pension funds that had little or no currency hedge on their overseas assets will have reaped richest benefits of currency moves. But “almost all schemes will have benefited to some extent,” Mr. Edwards said.

Allocations to growth fixed-income assets such as local currency emerging market debt and high-yield bonds “will have seen decent returns from that part of the portfolio,” he said.

However, there is a counterpoint to the stellar returns for U.K. pension funds: A drop in gilt yields after the Brexit vote has pushed liabilities up. Mr. Edwards estimated liabilities are probably up around 20% to 25% for the year. “Even though assets rose over the course (of 2016), with strong returns overall, funding levels will have moved much less than that as liability valuations” also were up.

But there would have been moments of opportunity in inflated asset levels for pension funds. “Defined benefit schemes are on a path to gradually derisk away from equities toward lower risk portfolios. More and more schemes now have derisking triggers in place,” said Mr. Edwards, meaning as a funded level rises to a certain point, assets are moved into bonds and less risky exposures. Given equity rallies toward the end of the year and increased yields, “we will have seen a number of schemes going through derisking triggers.”

Flat funded status

Little movement in funded levels was also a theme in the Netherlands, said Mercer principals and investment consultants Edward Krijgsman and Dennis van Ek, both based in Amstelveen. Pension funds started the year 102% funded, and finished at the same level. “However, the 102% we started with went below 95% in March but recovered,” said Mr. Krijgsman.

A decrease in interest rates in 2016, pushing fixed-income allocations into positive performance, was beneficial to Dutch pension funds but did harm funding levels. Mr. Krijgsman said these funds have a relatively high interest rate hedge, around 40% of the market rate of liabilities. Messrs. Krijgsman and van Ek put the average pension fund return at 7.3% vs. 1.1% in 2015. “That lies very close to the performance of the average Dutch pension fund on their fixed-income portfolio, about 6.8%,” said Mr. Krijgsman. Equities also performed well, with the MSCI Europe index gaining 3.1% in dollar terms.

An average 50% currency hedge will also have helped bolster returns, as the euro fell about 3% against the dollar. Executives at Mercer have and will be encouraging clients to look carefully at their currency hedges going forward. “We don't favor 100% hedges on all currencies, or any one hedge. The U.S. dollar can offer some favorable (advantages) when there is a problem in the eurozone,” said Mr. van Ek. And with important elections coming up in European countries and ongoing accommodative monetary policy, “even with the unrest in the U.S. with (Mr.) Trump, we see certain exposure may be desirable, simply from a risk strategy,” he added.

However, the fall in sterling makes that currency less attractive, and “it would be wise to have a large hedge on that,” he said.

Australia improves

Australian pension funds came next in the ranking, with an average 7.2% return, up from 5.6% a year earlier, showed data from SuperRatings Pty Ltd. The so-called Santa rally in December contributed 2.1% to overall returns, and the Australian dollar fell 1.1% against the U.S. dollar.

The Australia stock market, the ASX 200, also gained 11.79% in 2016 in U.S. dollar terms.

U.S. pension funds clearly benefited from the strong U.S. dollar, and returns reached 6.7% according to Willis Towers Watson PLC. That compares with -0.8% for 2015.

Last year was a “pretty good year for equities,” said Alan Glickstein, a senior consultant at Willis Towers Watson in Dallas. The Russell 3000 gained 12.74% over the year. That would have benefited U.S. funds, which had an average 63% allocation to domestic equities at year-end 2015.

But it was not all clear sailing. The funded status of the average plan hovered around 80%. Also noteworthy is “how dramatically different things would have been if we ended the year the day before our elections,” Mr. Glickstein said, referring to the Nov. 8 U.S. presidential election. “Things would have been much worse,” with a funded status probably around 75% or a little less, the lowest level Willis Towers Watson has seen in its analysis. Equities were not performing as well, and rates were much lower. “Immediately after (the election) liabilities dropped a bit and equities were up. So that sort of saved us from what would have been an ugly year from a funded perspective, to one that looks pretty flat,” added Mr. Glickstein.

Canada rebounds

Moving north, Canadian pension fund returns came next, with an estimated 6.5% return on the typical 60-40 portfolio, said Bruce Curwood, director, investment strategy at Russell Investments Canada in Toronto. While volatility hit global markets, Canadian plans fared well based on three major, interrelated issues: rebounds in material and energy prices; a resulting 21.08% gain in U.S. dollar terms for the Canadian stock market, the S&P/ TSX; and increased Canadian bond yields.

“Even with a soft economy, subdued domestic growth and low inflation, Canadian bond yields increased across the board this past year, decreasing pension liabilities, yet still managing to provide a positive investment return” of 1.7% for the FTSE TMX Universe in Canadian dollar terms, said Mr. Curwood.

Last year “was almost a complete reversal from the poor year Canada experienced in 2015 for commodities, the Canadian stock market and domestic Canadian interest rates,” he added. He said Canadian funds will have “gained ground in their fight for 100% solvency funding,” as rising interest rates decreased liabilities, while assets increased in value.

Swiss pension funds also made a marked improvement on their 2015 returns, hitting an estimated 4.2% vs. 0.7% a year previous, estimated Daniel Blatter, senior analyst at WTW in Zurich. Pension funds made small shifts out of bonds in favor of alternatives and real estate, and equities saw a small increase in terms of the proportion of overseas exposure. “The key driver of decisions on investment strategy in 2016 has been the low/negative interest rate environment with Swiss government bond yields below zero for much of the curve,” Mr. Blatter said.

This, along with fears of the effects of negative interest rates on fixed-income portfolios, has led to moves away from bonds, he said. “Given the subdued return expectations together with high risks associated with equities, our clients have sought to improve portfolio diversification by moving into alternative assets such as insurance-linked securities.”

Japan lags

The final pension fund market analyzed by Pensions & Investments was Japan, with an average 2.8% return for Russell Investments' universe of corporate pension funds. That compares with a less than 2% estimate for 2015. Fixed income was also a focus for pension fund executives, thanks to the unexpected introduction in January of a negative interest rate by Haruhiko Kuroda, governor of the Bank of Japan. “As a result, the yield of the 10-year JGB became negative, and dealing with domestic fixed income became the most interesting topic in 2016,” said Konosuke Kita, director of consulting at Russell Investments in Tokyo. Investors moved out of Japanese fixed income and into assets such as hedged international fixed income and alternatives, or took steps to control the risk level in Japanese fixed income, he said. 

Derisking has remained a theme for corporate plans in Japan, with decreasing domestic and international equity allocations. Public plans, however, have been increasing their equity allocations, adjusting them to meet 2015-set policy allocations of 50%

This article originally appeared in the January 23, 2017 print issue as, "Returns strong in 2016 despite scary beginning".