Pension funds hit by weak returns in 2011

Average investment returns in 2011 for pension funds in major markets globally were anemic at best, ranging between -3% and 3%, according to estimates by consultants and global custodians.

Driven by sharp falls in global equity markets in the third quarter of 2011, some of the losses were subsequently reversed with “the fourth quarter casting a little sunshine on a dreary year,” said Gregory Stewart, managing director and regional product manager at BNY Mellon Asset Servicing based in Pittsburgh.

Despite ongoing efforts by pension funds to diversify away from equities, returns in 2011 were still closely tied to the fortunes of global stock markets, consultants said.

Meanwhile, bonds helped to cushion “the wild swings” in equity markets, said David Cullinan, vice president and head of performance consultancy at State Street Investment Analytics, Edinburgh.

The average U.S. pension fund grew an estimated 1.4% in 2011, compared to 12.9% the previous year, according to BNY Mellon Asset Servicing, which combined actual returns data for the first 11 months of the year with a December estimate.

In Japan, which is the second-largest pension fund market, the average pension fund lost 2.7% in 2011, compared to a gain of 1.6% the previous year, according to Russell Investments.

U.K. pension funds, which make up the third-largest pension market globally, also saw lower average estimated returns in 2011 at 3% — compared to 13% the previous year, according to State Street Investment Analytics. However, returns are likely to be considerably lower for the majority of funds because they maintain large exposures to equity, Mr. Cullinan said.

High exposure to domestic equity markets hurt Australian pension funds. The S&P/ASX 300 index returned about -11% in 2011 and as a result, the average Australian pension fund returned about -2.5% in 2011 compared to 3.5% the previous year, according to Mercer.

Canadian pension funds returned about 2.4% in 2011, according to Russell. Swiss pension funds averaged an annual return of about -0.6% in the same period, according to the Credit Suisse Swiss Pension Fund index. (The index tracks actual pension fund data from Credit Suisse Group AG's custody business.) In comparison, average returns in 2010 were about 10% and 3% for Canadian and Swiss funds, respectively.

“Equity has been a drag on performance” this year, said Edouard Stucki, senior investment consultant at Towers Watson & Co., Zurich.

In the U.S., the gap between average returns for corporate pension funds and public funds is becoming more apparent, with corporate plans adding an average 2.76% for the year compared to 1.36% for public funds, according to data from BNY Mellon.

“We have seen corporate asset owners attempting to manage to their liabilities, for example, with a significant number having adopted (liability-driven investing),” Mr. Stewart said. “As a result of fixed-income returns faring relatively better than equities during the year, corporate funds that have taken steps to immunize (investment) risk have benefited.”

The S&P 500 index returned 2.1% on a total return basis and near zero when dividends are excluded. In the last three months of 2011 alone, the index added 11.15%. Global stocks, on the other hand, fell sharply. The Russell World ex-U.S. Large Cap index returned -12.02% in 2011; the MSCI Emerging Markets index declined 20.4%.

Investors turned to the relative safety of highly rated government bonds. Despite Standard & Poor's downgrade in August of the U.S. long-term sovereign credit rating to AA+ from AAA, Treasuries remained highly favored in 2011. The Barclays U.S. Aggregate Bond index returned 7.45% for the year, helped by its safe-haven status, sources said.

Uncertainty surrounding the euro and the related political response to those problems underpinned the volatility in the foreign-exchange market, which affected returns in 2011, sources said. The U.S. dollar gained about 3% against the euro and declined about 5% vs. the Japanese yen for the year.

“Concerns around the euro zone were a big driver of returns in 2011,” Mr. Stewart said. “The other thing that continues to drive markets is how fragile the global economy is. The good news in 2011 was that returns (for U.S. pension funds) were in the black and not in the red.”

In Japan, as with other major pension markets globally, performance was negatively affected by a domestic bias in equities. Japanese equities lost 16.58% in 2011, according to Konosuke Kita, Tokyo-based director of consulting for Japan at Russell Investments.

Japanese bonds returned 2.03%, while overseas bonds returned 6.19% on a hedged basis and 0.88% on an unheeded basis because of a strengthening yen. Because Japanese pension funds largely invested in domestic bonds, investors “will have to begin to think about diversifying the bond portfolio,” Mr. Kita said.

For U.K. pension funds, a key performance indicator in 2011 was the equity exposure, Mr. Cullinan of SSIA said. For example, while the average fund returned about 3%, SSIA estimates the average public-sector fund with relatively higher equity exposure probably returned -2% in 2011.

“The equity portfolio contracted and the bond component increased during 2011, with the key driver being purely down to the relative performance of those markets,” Mr. Cullinan said. On average, allocations to equities among U.K. pension funds fell by six percentage points to 44% during the year, while the bond portfolios grew to 39% from about 34% for the average fund a year ago.

However, choppy equity markets and rapid changes in bond yields have meant that many corporate plans struggled with falling funding levels even as returns were positive in 2011. “A strong bond market is bad news for the value of (pension) liabilities, which increased. At the same time, weak equity markets constrained growth in the value of assets,” Mr. Cullinan said. “It's a double whammy, if you will.”

On the opposite end of the scale, Australia is largely a defined contribution market with investments more skewed toward growth assets such as equities, said David Carruthers, principal at Mercer, and based in Melbourne.

“Investors have historically been rewarded by their allocations to Australian equities,” he said, “but in 2011, Australian equities did worse (compared to global markets). What we're looking at now is should investors be looking at investing more overseas.” At the same time, alternatives did not reduce the equity volatility as much as investors expected, Mr. Carruthers added.

When inflation rates are taken in account, pension funds in most major markets fared worse in terms of real returns. Canadian pension funds “earned an absolute return close to inflation,” said Bruce Curwood, director of investment strategy for Canada at Russell Investments, Toronto, referring to the estimated average Canadian pension fund return of 2.4% compared to an inflation rate of about 2.5% for a real return of -0.1% in 2011.

Ongoing market volatility has led some pension funds to find better ways of reducing risk through diversification, whether it is through asset allocation changes such as shifting into alternatives or globalizing the investment portfolio.

“Plans were seeking new directions and herding strategies (from the past) seemed less appropriate,” Mr. Curwood said.

For Swiss pension funds, one bright spot in 2011 was a relatively large allocation to domestic real estate, historically invested mostly in residential housing for capital appreciation and income, said Mr. Stucki of Towers Watson. While the Swiss Market index lost about 7.7% in 2011, many residential real estate funds registered positive, single-digit returns.

However, like their peers elsewhere, executives at Swiss pension funds are also doing some soul-searching following a difficult year. Concerns surrounding the euro zone debt crisis are pushing institutions to seek more diversification within their fixed-income portfolios. Mr. Stucki said: “There's a clear recognition that European sovereign bonds aren't as safe as they used to be, and (investors) are looking for ways to rejiggle their portfolio to account for this development.”