Public funds see major gains after frustrating years

Large U.S. public pension funds posted double-digit returns for the year ended June 30, following two years of lackluster returns.

Those results didn't surprise consultants, who pointed to public equity markets' strong performance over the year, but they cautioned that the outlook for U.S. equities isn't robust.

For the 12 months ended June 30, the Russell 1000 returned 18.03%; the Russell 2000, 24.6%; and the MSCI Europe Australasia Far East index, 20.27%. Over the same periods in 2016 and 2015, the Russell 1000 returned 2.93% and 7.37%, respectively; Russell 2000, -6.73% and 6.49%; and MSCI EAFE, -10.16% and -4.22%, respectively.

The median one-year return as of June 30 of the 34 number of plans tracked by Pensions & Investments through Aug. 30 was 12.4%.

"How public markets (stocks and bonds) performed will dictate how many of these public funds also performed," said Gregory DeForrest, senior vice president and co-manager of Callan Associates Inc.'s San Francisco fund sponsor consulting office.

For the year ended June 30, Callan calculated a median return of 13.06% for 107 public plans with more than $1 billion in assets.

While public market beta returns are "the main levers moving these funds around," many of Callan's public pension clients also saw positive manager alpha over the last couple of quarters, particularly with international equity, domestic equity and fixed income, Mr. DeForrest added.

It paid to be diversified, said Robert Waid, managing director at Wilshire Associates Inc. in Santa Monica, Calif., pointing to the strong 12-month returns for international equities, domestic small-cap equity, emerging markets equities (21.18% for the MSCI Emerging Markets index), high-yield corporate bonds (12.7% for the Bloomberg Barclays U.S. Corporate Bond index) and international real estate (5.85% for the Wilshire Global ex-U.S. Real Estate Securities index).

"The places where a lot of the public plans and larger plans diversified paid off," Mr. Waid said. The Wilshire Trust Universe Comparison Service calculated a median return of 12.41% for public plans for the year ended June 30, the highest return for that period in three years. The largest plans with more than $5 billion in assets returned a median 12.92%.

Along with larger plans' tendency to be more geographically diversified, Brian McDonnell, Boston-based global head of pensions at Cambridge Associates LLC, pointed to large plans' tendency to hold more in diversifying hedge funds and less in fixed income. Intermediate bond returns, measured by the Bloomberg Barclays U.S. Intermediate Government/Credit index, were relatively flat for the year at -0.21%.

While returns on alternatives asset classes generally lag by a quarter, Mr. Waid said of the public funds in TUCS that broke out their private equity and hedge fund returns, the median returns for those allocations were 12.1% and 7.1%, respectively.

The largest public defined benefit plan in the U.S., the $330.2 billion California Public Employees' Retirement System, Sacramento, returned a net 11.2% for its fiscal year ended June 30, aided by a 19.7% return from its $152.2 billion public equity portfolio.

While CalPERS' return reversed two years of weak results (0.61% for fiscal year 2016 and 2.4% for fiscal year 2015), the pension fund still underperformed its custom policy benchmark by 15 basis points. Public equities underperformed by 18 basis points, which a CalPERS spokeswoman attributed to a "slight defensive positioning in a strongly rising market." She did not elaborate.

The second-largest pension plan in the nation, the $213.5 billion California State Teachers' Retirement System, West Sacramento, returned a net 13.4% for its fiscal year ended June 30, topping its custom benchmark of 12.6%. As with CalPERS, public equity, which accounts for 56.4% of CalSTRS' portfolio, was a major contributor to the teachers' fund performance, returning 19.6%. In fiscal years 2016 and 2015, CalSTRS returned a net 1.4% in fiscal year 2016 and a 4.8% gross return in FY 2015.

The best one-year net return, 15.5%, reported by P&I belonged to the $11 billion Louisiana State Employees' Retirement System, Baton Rouge.

The major driver was public equity, particularly international and emerging markets equity, said Bobby Beale, chief investment officer, in an email. Public equity, which accounts for 57% of LASERS' portfolio, returned 20.9%. Emerging markets equity, which accounts for 12% of LASERS' portfolio, returned 24.3%.

In fiscal years 2016 and 2015, LASERS' overall gross returns were -2.4% and 1.7%, respectively.

The second-highest net return came from the Minnesota State Board of Investment's $65 billion pension portfolio, which returned 15.1%, surpassing its custom benchmark of 14.4%.

Net returns were not available for the $15.3 billion Oklahoma Teachers' Retirement System, Oklahoma City, and Kentucky Teachers' Retirement System, Frankfort, which returned a gross 15.3% and 15.37%, respectively. Gary Harbin, executive secretary of the Kentucky teachers plan, estimated the net return would be close to 15.02%.

Public equity was also a major contributor to Minnesota's performance, returning 19.9%, 70 basis points above its benchmark, said Mansco Perry III, executive director and chief investment officer, in an interview. The pension portfolio had a 65% allocation to public equity as of June 30.

The St. Paul-based board returned an overall net -0.1% and 4.4%, respectively, for the pension portfolio in fiscal years 2016 and 2015.

Longer term, for the five and 10 years ended June 30, most plans' annualized returns ranged from 7% to 10% and 4% to 6%, respectively. Median returns for the respective periods were 8.9% and 5.4%.

The 10-year results, which lag most plans' assumed rates of return, were dragged down by the global financial crisis, Callan's Mr. DeForrest said. Fifteen-year numbers look "a little more normative, although they are below the five-year numbers," he added.

For the five, 10 and 15 years ended June 30, Callan's database showed median annualized returns of 9.17%, 5.29%, and 7.45%, respectively, for public plans with more than $1 billion in assets.

Mr. DeForrest said public pension fund clients grappled with several themes during the most recent fiscal year, including whether to reduce the assumed rate of return, risk-asset levels vs. defensive-asset levels, fees, the role of active vs. passive managers, and diversification in the event of an equity downdraft,

With lower returns predicted for U.S. equities in the coming years, many funds are showing interest in strategies like direct lending, Cambridge's Mr. McDonnell said.

While this year's returns might have exceeded plan's assumptions, he warned against using a single year's return to influence long-term assumption setting. "That is supposed to be a 25- to 30-year assumption," Mr. McDonnell said.

Mr. DeForrest said many public funds are on the glidepath to lower their expected rates of return, which he expects to continue.

"One year will not change that," Mr. DeForrest said.