MEP push, tax reform, emergence of China round out top five
The top story of 2018 as chosen by Pensions & Investments' editors showed that the ripple effects of the global financial crisis were still being felt by institutional investors 10 years later, as the long-lasting bull market that followed the catastrophe thanks to record low interest rates might be approaching its end.
The return of volatility, the incremental escalation of interest rates by the Federal Reserve Open Market Committee four times during the year and a declining market and how they all affected pension funding and money manager revenues represented the top story of 2018.
The rest of the top five stories of the year reflected an era of great change, as money managers continued to feel the mounting pressure to lower fees, the prospect of expanding open multiple employer plans emerged, the impact of tax reform transformed the corporate pension plan funding landscape, and a timeline was set to introduce Chinese equities and bonds into global benchmark indexes.
1. Return of volatility/rising rates
On Dec. 31, the S&P 500 index closed at 2,506.85, down 6.24% from the previous year, completing a calendar year that provided institutional investors with an unsavory mix of high highs and low lows.
It didn't take long for the return of volatility to make itself known in 2018. In the first quarter alone, the CBOE Volatility index increased 80.9%, its largest upswing in the previous 20 quarters and third-largest in the previous 40 quarters.
Contributors to increased volatility included investor concern over U.S. political threats to impose tariffs on China and other countries, the tech sector being harmed by waning demands and security issues, and the prospect of rising interest rates.
Other asset classes reflected a volatile year as well. In a down year for stocks, bonds did not have anything approaching a stellar 2018, with the Bloomberg Barclays Aggregate index flat, with a return of 0.01%.
The Federal Reserve's Open Market Committee raised rates four times in 2018, the most it has done since the end of the financial crisis, eventually settling on 2.25% to 2.5% at its Dec. 18-19 meeting. In its first-ever financial stability report on Nov. 28, the Fed itself acknowledged how its raising rates could have negative effects on the economy.
"Markets and institutions that may have become accustomed to the very low interest-rate environment of the post-crisis period will also need to continue to adjust to monetary policy normalization by the Federal Reserve and other central banks," the report said.
2. Fee pressure
The No. 2 story was the continuing pressure on money manager fees, which might have hit its peak in 2018 when Fidelity Investments dealt a blow to the concept of fees altogether by introducing two index funds on Aug. 1 that featured zero fees.
The Fidelity Zero Total Market Index Fund and the Fidelity Zero International Index Fund gathered a respective $753.5 million and $234.2 million in their first month on the market.
The introductions of those index funds, while notable, were a symptom of investor zeal for lower or non-existent fees. The impact of fee compression on the broader institutional money management industry was also a main contributor of reduced gains or even some declines in overall revenue and net income despite the continuing growth of assets under management.
BlackRock (BLK) Inc. (BLK), for example, reported its net income rose to $1.22 billion in the third quarter, up 14% from the second quarter. But that positive metric was tempered by the firm's report that revenue was down 0.8% to $3.58 billion, and it saw $24.8 billion in institutional net outflows for the quarter.
A March report showed margins among money management firms have started to decline and will continue to do so.
From 2011 to 2016, the report — co-authored by Christian Edelmann, partner and global head, corporate and institutional banking and wealth and asset management at management consultant Oliver Wyman, London, with others at Oliver Wyman and New York-based Morgan Stanley (MS) — said managers' cumulative AUM grew an annualized 6% while revenue grew just 4%. In 2017, AUM rose 13% and revenue increased 9% — a 4-percentage-point spread compared to the 2-percentage-point spread in the previous years. By 2020, AUM is expected to increase a cumulative 10% while revenues are expected to be lower by 13%, the report said.
3. Expansion of open multiple employer plans
For industry observers, movement to expand open multiple employer plans after a significant period of silence in Washington on the topic of retirement security came as a welcome development.
The stage was set in March, when Senate Finance Committee Chairman Orrin Hatch, R-Utah, and ranking member Ron Wyden, D-Ore., reintroduced the Retirement Enhancement and Savings Act, which among other goals made it easier for smaller employers to join open multiple employer plans.
It was followed by an executive order from President Donald Trump on Aug. 31 directing the departments of Labor and Treasury to rework regulations to enable more small employers to participate in open MEPs. The order to expand the plans was the first significant order by Mr. Trump in his then-19 months in office to expand retirement security.
The Labor Department, which under Mr. Trump's aegis had vacated its well-publicized fiduciary rule earlier in the year, responded on Oct. 22 with its proposal that would allow small businesses under limited circumstances to band together to offer employees defined contribution plans.
Industry sources interviewed in October said the DOL proposal still has room to grow. Aron Szapiro, Morningstar Inc.'s director of policy research based in Washington, noted the proposal does not allow for two unrelated employers to join a plan together or empower any of the kinds of organizations that traditionally offer retirement plans, like financial services firms, to set up an MEP and start marketing it.
Mr. Trump's order came five months after the U.S. House introduced the proposed Retirement Enhancement and Savings Act of 2018, which would make it easier for smaller employers to join open multiple employer plans, and also reduce Pension Benefit Guaranty Corp. premiums paid by cooperatives and small charity plan sponsors.
How the DOL proposal and the RESA will affect MEPs and what plans will emerge is unknown, but the impact of these kinds of plans expanding likely will command a great deal of attention, making it the No. 3 story of 2018.
4. Tax reform impact – pension contributions and risk transfer
The fourth biggest story of 2018 was the significant impact of tax reform, which led to a flurry of multibillion-dollar pension contributions by U.S. corporations eager to take advantage of the expiring corporate tax rate.
The Tax Cuts and Jobs Act, signed into law in December 2017, reduced the corporate tax rate to 21% from 35%. As a result, U.S. corporations had until Sept. 15 to deduct a portion of their pension contributions based on the higher 2017 rate.
In 2018, at least 25 companies contributed or announced plans to contribute a total of $14.4 billion to U.S. pension plans, citing tax reform as a primary reason, according to prior P&I news stories. A further 35 companies announced $18 billion in total global contributions this year, without specifying how much was headed for U.S. plans. (P&I only reported on publicly traded companies intending to contribute at least $100 million to global plans.)
The accelerated contributions and subsequent improved funding also led to the largest pension risk transfer transaction since the monster deals completed by General Motors Co. and Verizon Communications Inc. in 2012. In May, Memphis, Tenn.-based FedEx Corp. purchased a group annuity contract with Metropolitan Life Insurance Co. to transfer about $6 billion in U.S. pension plan obligations. The transaction, which transferred the benefit obligations of about 41,000 FedEx retirees and beneficiaries in multiple U.S. pension plans, was enabled in part by billions of dollars in pension contributions to improve the plans' funded status.
Industry experts expect at least $20 billion in annuity purchases for 2018.
5. Chinese equities and bonds entering indexes
The fifth top story of 2018 was the emergence of Chinese equities and bonds in major indexes, beginning in May with an initial 5% inclusion of China A shares by index provider MSCI Inc. in its China indexes and related composite indexes, including the MSCI Emerging Markets index. In September, MSCI said it was proposing an increase of large-cap China A-share securities to 20% from 5% of their respective free float-adjusted market capitalizations, which would occur in two stages in May 2019 and August 2019.
And on March 23, Bloomberg Barclays Indices announced it will begin adding Chinese government bonds to its widely tracked Global Aggregate index in April 2019 and achieve a full target weighting of 5.5% by November 2020.
Also, in September, FTSE Russell announced it would grant secondary emerging market status to China A shares in June 2019, when the shares will account for about 5.5% of the total FTSE Emerging index, representing initial net passive inflows of $10 billion in assets under management and represent about 0.57% of the FTSE Global All Cap index. It was the first of a three-stage implementation, with the next stages to take place in September 2019 and March 2020. The final two stages are dependent on the success of the first stage of implementation, FTSE Russell said at the time.
Money managers and consultants report that investment in China is at the forefront of nearly every recent conversation they have had with asset owner investment officers. Man Numeric, Acadian Asset Management LLC, PanAgora Asset Management Inc. and Robeco Institutional Asset Management BV are among the active managers that offer or soon will offer stand-alone A-share strategies.
Rounding out top 10
Rounding out the top 10 stories of 2018 are:
6. Fears surrounding the threat of protectionism and a trade war between the U.S. and China formed a speed bump in an otherwise strong global economy, creating uncertainty among institutional investors and re-evaluations of risks in their portfolios.
7. The announcements in May of the departures of chief investment officers from three of the five largest U.S. public pension plans: Theodore "Ted" Eliopoulos, CIO of the $330.5 billion California Public Employees' Retirement System, Sacramento, announced his imminent departure, as did Vicki Fuller, CIO of the $209.2 billion New York State Common Retirement Fund, and Scott Evans of the $200 billion New York City Retirement Systems. Mr. Eliopoulos left CalPERS in November and is being replaced by Yu Ben Meng in January; Ms. Fuller retired during the summer and a search is still in progress for a permanent replacement; and Mr. Evans left on June 29, replaced by Alex Done, who was named permanent CIO in December after serving on an interim basis.
8. The January launch of the European Union's regulatory reform, the Markets in Financial Instruments Directive II, or MiFID II, which reinforced and replaced existing rules, improving transparency and oversight of derivatives and other financial markets, introducing rules on high-frequency trading and strengthening investor protections. Money managers had to scramble as well to meet the new requirements to pay for external research as well.
9. The seeming end of the Department of Labor's fiduciary rule, developed in 2015 and implemented in 2016, and the emergence of a similar rule perhaps from the Securities and Exchange Commission. The DOL rule broadened the definition of fiduciary advice but in March, the 5th U.S. Circuit Court of Appeals struck down the rule, saying it represented regulatory overreach by the Labor Department, which did not appeal. The SEC, meanwhile, has worked on a three-leg proposal, which includes a standard of conduct for investment advisers that states they have a duty to act and provide advice that is in the best interest of the client.
10. Investment consultant mergers, acquisitions and consolidations. In November, Goldman Sachs Asset Management announced it would acquire Rocaton Investment Advisors' more than $600 billion in assets under advisement in an effort to expand its advisory and discretionary services for institutional clients. Three months earlier, investment consultant Mercer announced it would acquire two firms: Pavilion Financial Group's investment consulting business, and Summit Strategies Group, while AndCo Consulting would acquire the latter firm's public pension fund business. Also, Brussels-based Sofina, a client of investment consultant Cambridge Associates, announced in May it would acquire 20% of that firm's business.n