Investment returns in 2007 for the top six pension markets in the world were the lowest in four years, according to estimates by consultants.
Ending a streak of double-digit returns since 2003 around the world, 2007 proved distinctive for a robust first half and a big step backward during the second half of the year, consultants said.
“Returns were looking pretty good in the first six months the year,” said David Carruthers, principal at Mercer LLC’s investment consulting practice based in Melbourne, Australia. “The subprime crisis affected (returns) a little by the third quarter, but it was still looking pretty good. By November and December, pretty poor performances out of the equity markets around the world put a real dampener on things.”
Steven J. Foresti, managing director and head of the investment research group in the consulting division of Wilshire Associates Inc., Santa Monica, Calif., added: “It was as if somebody blew a whistle … and many investors went from exuberance to fear very quickly. That’s what happened somewhere in the middle of the year.”
Average investment returns for pension funds in all six pension markets — the U.S., the U.K., Australia, the Netherlands, Canada and Japan — declined compared to the previous year, with Japanese pension funds reporting a negative return for the first time since 2002.
• The median U.S. pension fund finished 2007 with an investment return of 7.9%, or 5.8 percentage points lower than 2006 although still among the best performers globally, according to estimates by Callan Associates Inc., San Francisco.
• U.K. pension funds tied with the U.S., also returning 7.9% in 2007, a 2.1-point decrease from the previous year, according to estimates from WM Performance Services, Edinburgh.
• Returns for Australian pension funds averaged 6%, less than half of the 14.5% return figure in the previous year 15.1% in 2005, according to Mercer. Australian pension funds were hurt by losses in overseas equity investments mainly due a strong Australian dollar and listed real estate investments, which returned -8.4% for the year.
• Pension funds in the Netherlands returned 3.8% in 2007, about half of the 7.2% reported in 2006 and more than a quarter of the 14.7% tallied in 2005, according to estimates by WM’s Amsterdam office.
• The median Canadian pension fund gained 2.9%, or a drop of 10.1 percentage points compared against 2006. The strong Canadian dollar eroded returns from many overseas markets, including the U.S. However domestic stocks, led by those in the materials and energy sectors, helped pension funds to recover some of the overseas losses.
• Japanese pension funds fared the worst, losing 0.8% in 2007, according to estimates by Russell’s Tokyo office. The setback was mainly due to a relatively high exposure to domestic equity, which lost 10.2% for the year. The average Japanese pension fund had returned 5.3% in 2006 and a whopping 17.1% in 2005.
Patience is important
“The Japanese equity market after the subprime shock may be the most miserable market in the world in terms of performance,” said Noriyuki Oharazawa, senior consultant for Russell based in Tokyo. “But this will not last forever, and patience is very important right now.”
Consultants used different methods in estimating investment returns, but in general, actual performance data is used for a portion of the year when it is available. Otherwise, index returns are projected to the most recently available asset allocation mix to produce the data.
Despite a general movement to diversify into alternatives within the past several years, pension fund returns still largely echo equity markets, which were shaken by the summer’s return of volatility. Globally, the average asset allocation for pension funds in major markets is about 60% in equities, 30% in bonds and the rest in alternatives and cash, according to data from consultant Watson Wyatt Worldwide.
“We’ve had a period to reflect on the subprime crisis,” said Roger Urwin, Watson Wyatt’s global head of investment consulting based in Reigate, England, “and pension funds are substantially re-evaluating strategies. But they’re not making any big-scale changes at all.”
“For most pension funds (globally), the extent to which equity outperforms bond determines whether they have had a good year,” Mr. Urwin said. “Equities have had a decent year in total,” he added, “as a result, quite a lot of pension funds have posted a respectable year. On our estimates, global pension assets grew by about 9% in 2007, slightly ahead of the trend line since 2000.”
The Standard & Poor’s 500 index returned 3.5% while the Morgan Stanley Capital International Europe Australasia Far East index returned 8.6% (in dollar terms) for the year in 2007. U.S. pension funds squeezed extra returns from a declining dollar. For example, the dollar lost 10% against the euro, 6% against the yen and 15% against the Canadian dollar in 2007. However, the greenback gained 2% against the British pound.
The market “has been very turbulent, but the impact overall has been benign in term of returns,” Wilshire’s Mr. Foresti said. “This is a reflection of diversification. If we were to compare (the same environment) back 20 years, the results would have been much more negative. Investors have been moving equity outside of the U.S. and building out some of the other alternatives.”
Compared with 2006, U.S., pension funds’ average asset allocation remained relatively unchanged, with a slight increase in exposure to international equity. Domestic equity accounted for about 45%, while international equity increased by one percentage point to 18%, according to data as of Sept. 30 provided by Callan. Fixed income and alternatives remained stable at 27% and 10%.
Mixed returns
Returns of alternative investments were mixed in 2007, consultants said. Real estate, which had been one of the most important factors in strengthening returns worldwide over the past four to five years, was one of the weakest performers across the board. Returns from hedge funds and private equity varied widely and results were often dependent on manager or fund selection. Commodities and infrastructure generally outshone other alternatives, but pension fund exposures to these asset categories remain relatively small.
However, with a 4.1% rise in the U.S. Consumer Price Index — the highest since 1990 — any exposure to assets such as commodities and other inflation-protected asset classes have played a more important role in diversification. Liability-driven investing approaches also featured more prominently among U.S. corporate pension funds in 2007.
“Some of the funds are taking a closer look at maturity and duration, and understanding what’s appropriate for the long-term needs (of the fund),” Mr. Foresti said.
U.K. pension funds fared the best of the top six pension markets after accounting for inflation. The real return for U.K. pension funds stood at 5.8%, according to WM data.
A gradual shift to international and global equity strategies away from a domestic bias also boosted returns, Watson Wyatt’s Mr. Urwin said.
“International (equity) diversification actually worked for U.K. pension funds in 2007 and pushed the (return) figures up to a respectable level,” Mr. Urwin said. The average pension fund allocates about half of its equity portfolio to foreign stock markets while the other half is invested in domestic shares.
At the same time, corporate bond yields — which are used to determine pension liabilities — have increased, helping to lower deficits or to push funds further into surplus. “U.K. pension funds are pretty well funded (on this accounting measure) and I feel most are in good shape for whatever conditions lie ahead,” Mr. Urwin added.
Opposite effect
Exposure to foreign equities had the opposite effect for the median Canadian pension fund, which logged modest gains mainly because of strong performances of domestic stocks. The S&P/TSX Composite index, which tracks the largest companies listed on the Toronto Stock Exchange, added 9.8% in 2007. In contrast, the S&P 500 lost 10.5% and the MSCI EAFE lost 5.3% in terms of the Canadian dollar.
“The median Canadian pension fund does have a significant allocation to the Canadian equity market; this is about 23%,” said Timothy Hicks, Toronto-based chief investment officer of Russell Investments in Canada. “Foreign equity allocation is at or slightly above 35% of all assets. On an unhedged basis, it did not fare very well at all.”