Strong returns nice, but aren't expected to​ last

Many institutional investors will be seeing returns in the low-double-digit range for the 12 months ended June 30, say investment consultants, a welcome reprieve from the 2014-'15 and 2015-'16 fiscal years, when returns were lackluster at best.

The difference in the latest fiscal year: equity markets cooperated. Strong equity markets in fiscal year 2017 helped many institutional investors "achieve a really nice year" with "overall low-double-digit returns," says Tim McCusker, chief investment officer for institutional investment consulting firm NEPC LLC, Boston.

The good news for this year followed fiscal 2016, during which most institutional investors saw flat or even negative investment returns. That was a double blow as it came on top of the 2015 fiscal year's single-digit investment returns.

The Russell 3000 index was up 18.51% while the MSCI All-Country World ex-U.S. index was up 20.45% in the year ended June 30. The MSCI Emerging Markets index did ​ even better with a 23.75% return.

In contrast, in the fiscal year ended June 30, 2016, the Russell 3000 had a 2.14% return while the MSCI All Country World index had a -10.24% return and the MSCI Emerging Markets index returned -12.05%.

Alan Glickstein, a senior retirement consultant at Willis Towers Watson PLC in New York, said markets have done well. "Whether you're looking at a one-year period ending in June 30 of this year, or the calendar year of 2016, or what have you, we're definitely seeing double-digit types of returns on the equities," he said. "So to the extent pension plans are significantly invested in equities, at least based on that short period of experience, they're going to get good news."

A June report by Wilshire Consulting showed that equities were still the largest asset class of state pension plans, 64.8% as of June 30, 2016, the latest numbers available.

But Mr. McCusker said the positive news about equity performance is also tempered with the fact that three year-annualized returns for many public pensions plans are below their assumed rates of return of 7.5% or so, given the low overall results for two of the last three fiscal years.

"It's nice to have the good year now, but the accumulation over three years is not where it needs to be," he said.

The more immediate future also looks cloudy. Investment consultants have lowered their investment return targets for as long as the next 10 years. They expect overall equity returns to be more muted and see fixed income remaining low, another factor that has helped diminish returns in two of the last three fiscal years.

The expected strong overall returns for asset owners for the 2016-2017 fiscal year may also not help pension plan funding ratios, which have been dropping.

In its June report, Wilshire Consulting calculated that the average aggregate market value funding ratio for state pension plans was 69% as of June 30, 2016. It was the second consecutive fiscal year that the funding ratio fell by 4 percentage points.

Increased investment returns could reverse that cycle but it all depends on what happens to liabilities.

Ned McGuire, a vice president and member of the pension risk solutions group of Wilshire Consulting, said as pension plans cut their assumed rate of rates in anticipation of potential lower investment returns, it could cancel out the effects of the most recent strong investment returns because it would result in liabilities rising.

Critics have long argued that public pension plans have set unrealistic return expectations that can't be met, which ends up passing along unfunded liabilities to future generations of taxpayers who are the ultimate backstop. They argue even a current trend for public plans to lower rates of return to 7% from 7.5% is still at least a percentage point above what is realistic investment-wise over the long term.

One possible sign of good news is that actuarial firm Milliman said in a report in May that the aggregate funded status of the 100 largest public pension funds rose to 72% as of March 31, up from 70.1% three months earlier, because asset growth outpaced liabilities.

Pension plans and other institutional investors don't usually start announcing investment returns until mid-July.

But in response to questions from Pensions & Investments, Christopher Ailman, chief investment officer of the $208.7 billion California State Teachers' Retirement System, West Sacramento, said in an email that CalSTRS expects to see double-digit investment returns for this most recent fiscal year.

But Mr. Ailman said, "As a long-term investor with a 30-year horizon, I try to impress on anyone I'm talking to, that just like one bad year does not break us, a good year does not make us."

CalSTRS had an overall 1.4% rate of return in the fiscal year ended June 30, 2016, significantly below its 7.5% expected rate of return.

William Coaker Jr., CIO of the $22.1 billion San Francisco City & County Employees' Retirement System, said in an interview with P&I in mid-June that the system was headed for an approximate 14% investment return due to strong equity returns in the fiscal year ending June 30.

But Mr. Coaker cautioned that future returns may not be as rosy.

"I expect beta returns going forward are going to be quite low in the range of, for equities, around 6, 6.5% and for bonds, 2.5%."