Equities give pension funds worldwide a leg up

Strong performance across most equity markets in 2013 bolstered estimated average investment returns for pension funds in six major markets, delivering a degree of optimism for the year ahead.

“2013 was clearly a banner year for equities,” said John Gruber, head of product strategy for BNY Mellon's global risk solutions group in Boston.

Good performance from U.S. equities in particular, with the Russell 3000 index returning 33.6% over the calendar year, led to four quarters of positive results for pension funds. U.S. funds returned an estimated 13% for 2013, up from 12.4% the previous year, according to data from BNY Mellon Asset Servicing, New York.

The good year wasn't confined to the U.S. The MSCI World index returned 27.4% in 2013, up from 16.5% in U.S. dollar terms for 2012, the MSCI Europe Australasia Far East index returned 23.6%, up from 16.9%.

Unlike in 2012, fixed income was a negative for returns last year. The Barclays Capital U.S. Aggregate Bond index returned -2.02%, after posting 4.2% a year earlier. The Barclays Capital Corporate Investment Grade index returned -1.53% vs. 9.8% for 2012. And while the Credit Suisse High Yield index returned 7.5% for the year, it was a fall from 14.7% in 2012.

U.K. pension funds had a solid year, with Mercer estimating an average 10% return for the year, while the WM Defined Benefit Pension Fund Universe, managed by State Street Corp., showed expected average returns of about 11%.

“Most of that return will have come from equity market performance; U.K. schemes invest around 40% of their assets in equities on average,” said Phil Edwards, Bristol, England-based principal at Mercer. The U.K. FTSE All-Share index gained 21.3% for the year, while the Barclays U.K. Gilt 15+ Year index returned -5.97% in sterling terms.

One fly in the ointment was emerging markets, which shocked investors in 2013 with poor performance after years of positive numbers. The MSCI Emerging Markets index returned -2.4% in U.S. dollar terms for the year, after an 18.6% increase for the previous year.

“Emerging markets were down around 5% to a U.K. investor,” said Mr. Edwards. “Local currency emerging markets debt, which is an area that a large number of U.K. pension schemes have allocated to over the past few years, was down about 10% in sterling terms last year after a few years of strong returns.” But Mercer executives still believe the strategic case for emerging markets assets is strong “and last year's weakness might provide an opportunity for pension schemes that haven't yet added an allocation to do so at a fairly attractive level,” he said.

Pension funds in the Netherlands produced 4.8% in the year ended Dec. 31, according to Mercer, in keeping with averages for the past five years. 2013 was “the last year of the (five-year) recovery plans for the Netherlands, and quite a few of the funds were tied with the possibilities of what they could invest in,” said Edward Krijgsman, Amstelveen-based principal at Mercer. “Within those constraints the movements were typically toward equities and out of the interest rate hedge, and we still see that.”

Positive contributors for Dutch funds were developed market equities, private equity and hedge funds. Dennis van Ek, principal at Mercer, said the average fund is about 5% invested in private equity, 3% in hedge funds and close to 10% in real estate.

But for Swiss pension funds, real estate was a negative. “For once real estate exposure had a negative impact — we had very strong yields in 2011 and 2012, but in 2013 we saw a decrease in real estate funds, at -3% for the whole year,” said Christian Bodmer, Zurich-based head of investment consulting for Switzerland at Mercer. That performance was largely at home, since more than 80% of Swiss pension fund exposure to real estate is domestic.

Swiss equities returned almost 25% for the year, “the biggest contributor to every plan in 2013 and the strongest performance of all asset classes,” Mr. Bodmer said.

Switzerland was the only market to show a slight decline in pension fund return — 6.2% in 2013 vs. 6.3% a year earlier, according to Towers Watson & Co. “Overall it was pretty smooth performance except the second quarter (of) 2013, especially in June which was the worst month with a median return of -2.54%,” said Daniel Blatter, Zurich-based retirement solutions consultant at Towers Watson. “The reasons for that were increasing interest rates, decreasing equity prices and weakening currency against the Swiss franc.”

Australian pension funds had another strong year. According to David Carruthers, principal at Mercer in Melbourne, the estimated average balanced growth superannuation fund returned 17% in 2013, while research firm SuperRatings estimates a return of 15.5% for the year.

“We have been seeing more focus on the level of expenses in super funds in Australia, and on the value for money that investors are getting,” said Paul Sweeting, London-based European head of the strategy group at J.P. Morgan Asset Management. Regarding asset allocation, “my sense is that it is still driven by peer groups — there have been very few moves away from that. One exception is QSuper, which has been trying to drive a more outcome-driven approach. It is providing default funds which are driven by individuals' own circumstances rather than just assuming that everybody should have the same asset allocation.”

Canadian pension funds gained an estimated 16% for the year, according to Russell Investments. That was a healthy increase from 9.5% for the previous year even though the S&P/TSX index returned 13% for 2013 in Canadian dollar terms, less than half the return of the MSCI World index's 36.2% in Canadian dollar terms.

“Canada has a big materials sector (accounting for about 19% of the S&P/TSX Canadian stock index at the beginning of 2013) and materials got hurt last year,” returning -31%, said Bruce Curwood, director investment strategy at Russell Investments in Toronto.

In line with improved asset returns was a three percentage point decrease in liabilities, said Mr. Curwood. “As a result, the typical defined benefit pension fund significantly improved their funded status by about 13% from the beginning of the year,” he said.

Japanese corporate funds returned an average 15% for the year, significantly higher than the 10% they returned in 2012. Corporate funds have been derisking, said Konosuke Kita, Tokyo-based director, consulting at Russell Investments, although at a slower pace. On the other hand, he said, the ¥123.9 trillion ($1.2 trillion) Government Pension Investment Fund — the world's largest retirement fund — “has been increasing its equity allocation along with the market rise.”

For 2014 the theme globally is derisking.

Mr. Sweeting expects to see pension funds continuing to take risk off the table, particularly in the U.K.

“Deficits are still there, but they have been reducing — and schemes have been moving out of equities and into bonds. Within equity portfolios, they are moving more to global equities and are less domestically focused. I think this year we will see a move away from uninformed exposure to equity beta and a recognition that equities are not just a homogeneous group.”

Mr. Sweeting also sees a move into index-linked gilts, “because pension scheme liabilities are, to an extent, inflation-linked. This inflation linking becomes more important the further down the derisking curve a pension scheme is. In other words, the more a scheme has in bonds, the more of those bonds need to be inflation-linked, no matter how expensive they might seem,” he said.

In the Netherlands, Dutch funds are waiting to learn how they can invest in inflation-linked assets. “We may see a shift toward assets that both generate returns and are linked to inflation” when FTK2, the updated version of the country's financial assessment framework, is announced, said Mercer's Mr. van Ek. “Due to (be detailed) by the end of Q1, (it could include) how pension funds can use indexation. That is very important for the attractiveness of inflation-sensitive assets,” he said.

For Japan, Russell's Mr. Kita expects to see continued focus on preparation for a rise in bond yields.

Russell Investments' Mr. Curwood thinks funds in Canada, where the funded status of corporate plans averages 92%, will continue to look at dynamic asset allocation. “Some do not have the resources to do that, so are looking at outsourcing and/or using a consultant to help,” said Mr. Curwood. “I think with interest rates expected to rise, it is about (squeezing) out as much as they can in the fixed-income market, for those with the risk tolerance and the capability to do that.”

U.S. funds will focus on fixed income this year. As tapering starts to gather pace, money managers expect to see bond yields rise. The rise, combined with good equity returns, “could see more pension schemes starting to look at buying out,” said JPMAM's Mr. Sweeting. “However, buying out liabilities could still look expensive relative to just holding assets and running the liabilities off. There could well be more focus there on holding assets that can best meet liability cash flows, including more approximate matches such as infrastructure.”

In Switzerland, retrocessions — in which banks or investment managers that received payments for distributing or purchasing funds from distributors have to return those payments to pension plans — will be a big topic.

“There is a continuing discussion of how far back should repayments go,” said Eddie Stucki, senior investment consultant at Towers Watson in Zurich. “The amount depends on the case and fees — it is not that big an amount, but it is the notion of a conflict of interest here and (that) investment managers did not disclose that there was another payment happening — it hasn't helped to build trust between pension funds and their investment providers,” he said.