Reversal of turbocharged markets sinks pension returns

U.S. public pension funds had nowhere to hide from a volatile market environment and plummeting equity and fixed-income returns during the fiscal year ended June 30.

The population of 57 pension funds tracked by Pensions & Investments as of Sept. 2 reported a range of returns from 3.7% to -14.5% for the fiscal year — many the worse since the financial crisis — reflecting a hostile market environment that acted as a stark reversal from record-smashing high returns the previous year when returns ranged from 20.3% to 36% in P&I's pension fund returns tracker.

For the latest fiscal year, the median return of plans tracked by P&I was -5.2%, while the median return among the funds tracked for the fiscal year ended June 30, 2021, was 26.8%.

The sharp drop in fiscal-year results came as a result of the rare confluence of poor returns in both equity and fixed-income markets. For the year ended June 30, the Russell 3000 index and Bloomberg U.S. Aggregate Bond index returned -13.9% and -10.3%, respectively, compared to a respective 44.2% and 4.6% for the year ended June 30, 2021.

While all pension funds' returns for the most recent fiscal year fell well below last year's exceptional numbers, those who allocated more assets to alternatives and limited their exposure to public markets felt less of the sting of the market downturn.

Steven J. Foresti, chief investment officer, global asset allocation and research at Wilshire Advisors LLC in Santa Monica, Calif., said in a phone interview this fiscal year was payback in some sense for the extraordinary returns of the prior year.

Much of those returns had been driven by "a wall of liquidity from both fiscal stimulus and central bank monetary stimulus and as the calendar year 2021 progressed and we started to get near the end of the calendar year, it was very clear that the Fed was not only going to shift policy from ultra-accommodative to less accommodative and then restrictive." It was clear that wall of liquidity was going to come down, he said.

"The natural question," Mr. Foresti said, "and we raised this question with clients at the beginning of this calendar year (is): If part of what you've collected in your returns up to this point was fueled by that wall of money and support, is it reasonable to think we're going to be able to hang onto all of this?"

Among the pension funds that have released their fiscal-year return information, those with more diversification away from public equities and fixed income have performed less poorly.

Hawaii Public Employees' Retirement System, Honolulu, chalked up a gross return of 3.7% for the fiscal year ended June 30, the highest tracked thus far and one of only seven public pension funds that have reported a positive return for the period. The pension fund eschews traditional asset classes in favor of a risk-based approach that splits its total allocation into targets of 67.5% to broad growth and 32.5% to diversifying strategies. The broad growth asset class is broken down into public growth, private growth and real assets, and diversifying strategies is broken down into liquid defensive, liquid diversifying and illiquid diversifying portfolios.

The pension fund benefited from strong returns by private growth and real assets, which returned a gross 29.6% and 15.4%, respectively, for the most recent fiscal year. The combined allocation to those subasset classes was 33.4% of the total fund as of June 30.

Maine Public Employees Retirement System, Augusta, chalked up a preliminary net return of 3.3%, the second-highest return. As of June 30, about 53% of its total assets were allocated to alternative investments, and its public markets exposure in domestic and international equities and fixed income was limited to a total of just under 39% of the plan's assets. By asset class, the alternative allocations were 20.7% private equity, 11% infrastructure, 10.1% real estate, 7.2% risk diversifiers (including hedge funds), 6.8% alternative credit and 4.9% natural resources.

At the other end of the spectrum, the Oklahoma Public Employees' Retirement System, Oklahoma City, had the lowest reported return at a gross -14.5%.

As of June 30, the system's total allocation to domestic and international equities and fixed income was 99.6% of assets.

Uniquely, this past fiscal year was very much a tale of two halves. As Mr. Foresti put it, all the stimulus that had driven the exceptional returns of the past year had boosted valuations, and the plummeting returns during the first half of 2022 represented a return to a more reasonable view of valuations rather than being connected to a very pessimistic view on fundamentals, he said.

For the six months ended Dec. 31, the Russell 3000 index returned 9.2% and for the six months ended June 30, the index returned -21.1%, while the Bloomberg U.S. Aggregate Bond index returned 0.1% for the six months ended Dec. 31 and -10.3% for the six months ended June 30.

So much of the poor public market returns coming in the back half of the fiscal year has created a scenario in which lagging private equity and real estate returns may lead to a more altered fiscal-year return picture than usual.

Jay V. Kloepfer, executive vice president and director of the capital markets research group at Callan LLC, San Francisco, said in a phone interview that private equity data can lag anywhere from six to nine months from the current period.

"These are a bunch of private investments and they have to get valued," Mr. Kloepfer said. "There's definitely been some losses, but it depends on the strategy, and if it's a strategy that's closer to the market, if you will, if it's an IPO or something like that, if it's something that has some publicly traded securities, they're showing the losses first."

Among the pension funds that reported alternative returns for the fiscal year ended June 30, real estate and private equity generally chalked up over 20%, contributing significantly to any overall fund return data. For example, the $48.6 billion Arizona State Retirement System, Phoenix, which ranked second on the overall list with a net return of 1.1%, reported net returns of 32.4% and 20.9%, respectively, for real estate and private equity.

"It's a case of June 30 numbers for part of your portfolio may just not reflect yet what changes could come, but that's in the case of an up market too," Mr. Kloepfer said.

The fall in public equity and public fixed-income markets could pose a challenge in rebalancing, Thomas Garrett, Seattle-based director of strategic research at Verus Advisory Inc., said in a phone interview.

"It depends on what the markdown of private assets ends up being but I think it's pretty safe to say investors are overallocated to private assets at this time," Mr. Garrett said. "How you deal with that from a rebalancing perspective depends on a little bit on specific policies of specific clients that deal with that in different ways. It's expensive to divest and rebalance out of private assets. You don't want to take a big price hit and sell on the secondary market."