Plan sponsors brace for a rough ride

U.S. public pension fund executives and trustees are honing their portfolios to ride the lower-return environment predicted over the next decade.

Dire market projections are coming from numerous investment gurus such as Jeremy Grantham, co-founder and chief investment strategist at Grantham, Mayo, Van Otterloo & Co. LLC. In a Jan. 3 investment perspective, he said the odds of a market bubble over the next six month to two years is higher than 50% and added that should that happen, the chances of a market decline of about 50% are "very, very high ... over 90%."

In mathematical terms, the return dilemma for U.S. public plans is obvious. The average assumed rate of return of the 100 largest U.S. public pension plans at fiscal year-end 2016 (the most recent data available) was 7.5%, according to Pensions & Investments data. But a composite forecast of the weighted annualized 10-year return of a diversified public plan portfolio was just 5.5%, based on P&I's analysis of asset class return assumptions from five major investment consulting firms.

Predictions of doom notwithstanding, U.S. ​ public fund chief investment officers and their teams are for the most part maintaining existing investment approaches while tweaking portfolios to increase returns and efficiency, said observers.

"We're not seeing widespread panic, but we are hearing a lot of concern from (public) pension fund clients," said Jay V. Kloepfer, executive vice president and head of capital markets research at investment consultant Callan LLC, San Francisco.

P&I focused analysis on large U.S. public pension funds — the majority of which are underfunded with an average funded status of June 30 of 68%, data from the Center for Retirement Research at Boston College showed. The impending decade of expected low returns could jeopardize these plans' ability to reach fully funded status based on multiyear funding schedules set by state or municipal laws or board guidelines.

Corporate pension funds, on the other hand, are required to maintain adequate defined benefit funding under the Employee Retirement Income Security Act, regardless of market returns. Many corporations also have transferred their pension risk to outside parties.

The no-win situation facing public plan executives is "the investor's challenge," said Steven J. Foresti, chief investment officer, Wilshire Consulting, Santa Monica, Calif. "For most institutional investors, there's a gap between their assumed rate of return and the returns they can expect from their investments."

Given market return forecasts, Mr. Foresti and other consultants stressed the probability of pension funds meeting assumed rate of return targets of more than 7% over a 10-year period is low, but improves significantly over 20- and 30-year horizons. That longer-term investment horizon synchronizes well with pension funding schedules.

Investment consultants at NEPC LLC, Boston, emphasize to their public fund clients that the "No. 1 goal is to improve the funded status of the plan" over the next 10 years, said Phillip R. Nelson, partner and director of asset allocation.

"If they can maintain their current funded status over the next 10 years, it's more likely that they will see improvement in that status over 20 years," Mr. Nelson added.

"If" is the operative word, said other sources, noting underfunded pension plans with low or negative cash flow are particularly vulnerable to market declines.

"Low expected returns are one of the two largest challenges facing U.S. pension funds in the years ahead. The other challenge is the potential for a recession. An average recession might cause a 15% or so drawdown to a typical U.S. pension fund," said Jase Auby, deputy chief investment officer of the $146 billion Teacher Retirement System of the State of Texas, Austin, in an email.

Faced with expectations for low returns, public fund investment teams can choose from three options for managing their portfolios over the next decade, according to Callan's Mr. Kloepfer:

• accept lower returns and maintain the existing asset allocation;
• be tactical and either move to cash and wait for opportunities to improve, or go further and hedge expected bad outcomes, both of which would require lowering equity exposures; and
• explore every possible nook and cranny in the capital markets to seek out sources of return not already exploited, including private market strategies such as private equity, infrastructure, real assets and private credit.

Public fund chief investment officers are finding creative ways to amp up returns, such as reducing the number of investment managers in an asset class and creating strategic partnerships with larger allocations to a single manager at a lower investment cost, said Michael Comstock, associate partner and head of public sector pension plans, Aon Hewitt Investment Consulting, Chicago.

Aggressive fee negotiations also are paying off, Mr. Comstock said. More money managers are capitulating and lowering fees or moving to new structures that only pay performance fees when managers exceed hurdle rates.

Sources pointed to the $361.6 billion California Public Employees' Retirement System, Sacramento, as an example of how trustees and investment staff are improving the odds of meeting assumed rates of return and protecting and improving funded status.

In December, CalPERS trustees approved a new asset allocation for the three years beginning July 1, that only tweaked the current allocation instead of a complete overhaul of the investment approach.

The target weighting to global equity was raised to 50% from 46%; fixed income was increased to 28% by eliminating a separate inflation-asset portfolio of 9% and folding 8 percentage points of those assets into the core bond portfolio; private equity stayed at 8% and real assets at 13%; and the liquid piece of the portfolio was reduced to 1% from 4%.

CalPERS investment staff said in a memo the new allocation would meet the 7% assumed rate of return over time without increasing the fund's interest-rate exposure or employer contributions.

The staff expects the annualized return to be 6.1% over the first 10 years and 8.3% over the following 11 to 60 years, board documents show.

CalPERS' funded status was 68% as of June 30, 2017.

In September, CIO Theodore Eliopoulos discussed creating a private equity direct investment program that would reduce the $800 million in fees the fund pays annually to private equity managers. Six managers have so far submitted bids for the contract.

To maintain CalPERS' 8% private equity target allocation, fund officials have decided to increase co-investments, separately managed accounts and secondary investments, CalPERS' request for information stated.

CalPERS trustees also approved the addition of a risk-mitigation plan aimed at reducing the vulnerability to a market downturn early last year. That plan goes into effect July 1, 2020.

In Texas, the staff of the teachers fund is scouring the globe to find investment strategies likely to outperform.

Mr. Auby said U.S. equities clearly are a challenge for investors because of relatively high current valuations. The TRS staff is looking for alternatives that would produce a higher expected return at a similar level of risk.

"Unfortunately, high valuations are a consistent theme across most asset classes. However, candidates expected to do at least better than U.S. public equity include public equity from areas of the world less further along in the economic cycle such as Europe, Japan and the emerging markets, as well as illiquid and/or levered debt strategies," Mr. Auby added.

"In an era of lower expected beta returns, we are refocusing on our ability to generate alpha. TRS efforts have included a restructuring of our public equity portfolio with a critical eye on what we can do well internally vs. those strategies we need have managed externally," he said.

Texas Teachers increased its proportion of internally managed global equity by 8 percentage points as part of the implementation of its alpha-generation program and incorporated alternative risk-premium investment strategies across the whole pension portfolio.

Texas Teachers' funded status was 80.5% as of Aug. 31.

A smaller Texas fund, the City of Austin Employees' Retirement System, is taking some steps consultants recommend to squeeze more return from the $2.7 billion fund to meet its 7.5% return target, said CIO David Veal.

The board approved the hire of BlackRock Inc. in December to manage the fund's first strategic partnership. Pending successful contract negotiations, BlackRock will be awarded $130 million, or about 5% of plan assets, for a multiasset portfolio, Mr. Veal said.

The idea behind the partnership with a large firm like BlackRock is to give the manager discretion to invest the portfolio in all of the categories currently included in the fund's asset allocation — equities, bonds, real estate, commodities, real estate and infrastructure — within target ranges set by pension fund investment staff.

"We want to let BlackRock manage the portfolio the way they see the best opportunities and hopefully, produce more alpha," Mr. Veal said.

The pension fund likely will expand its asset class lineup in the second half of 2018 based on the recommendations from an asset-liability study by investment consultant RVK. The fund's investment committee is to receive the report at its May 18 meeting; the full board is to consider allocation changes at a June 26 meeting.

High on the list of possible new allocations are private equity, private credit and timber, all strategies that can provide additional returns to improve the fund's funded status, now 67.5%, as well as to increase the chances of meeting the assumed rate of return over the long term, Mr. Veal said.

Any other asset classes the pension fund might add to its allocation mix will be added to BlackRock's portfolio options, he added.

Time is the key to the probability of the $49.9 billion Teachers' Retirement System of the State of Illinois, Springfield, reaching full funding. At 39.8% as of June 30, 2016, the fund has the worst funded status of the 25 largest U.S. public pension funds, according to P&I's analysis of data from pension fund comprehensive annual financial reports.

The fund's investment team is successfully negotiating lower fees with many managers and reducing the number of managers across the portfolio, said David Urbanek, director of communications. The fund also has significant — and growing — exposure to less liquid alternative investments such as private equity, real estate, real assets and private credit in an effort to stay on track to meet its 7% assumed rate of return over 30 years, he said.

But the fund's asset allocation and investment approach are not being drastically altered to cope with the low-return environment expected over the next 10 years.

"The portfolio is carefully managed within its risk parameters and stress tests are conducted to make sure that it's on track for the 30-year period," Mr. Urbanek said, stressing "the plan is never locked into meeting a 7% return on an annual basis."

The real problem for TRS is the lack of an actuarially adequate contribution from the state of Illinois for 78 years and that has "finally come home to roost," Mr. Urbanek said. He noted 25% of Illinois' general revenue now goes to meeting pension obligations, "vastly more than other states are paying."

"We should reach the goal of hitting a 90% funded status in 2045," Mr. Urbanek said, but "the key is the General Assembly making its promised payments."