Pension funds finding the allure of fixed income again in high-rate environment

U.S. fixed-income assets among the largest defined benefit plans took a significant jump in the past year, thanks to a combination of strong returns and a number of the largest plans making strategic asset allocation changes, according to Pensions & Investments’ latest survey of the largest U.S. retirement plans.

As of Sept. 30, U.S. fixed-income assets totaled $1.22 trillion among pension plans in the 200 largest U.S. retirement plan sponsors. Among 86 DB plans that responded both this year and last year, fixed-income assets totaled $1.16 trillion, up 23% from a year earlier.

For plans that provided breakdowns between active and passive U.S. fixed income, active assets totaled $876.5 billion, up 21.4% from a year earlier, and passive assets totaled $302 billion, up 73% from a year earlier.

Returns were strong for the period. For the year ended Sept. 30, the Bloomberg U.S. Aggregate Bond index returned 11.6%. Contributing even further to the hike in fixed-income assets this year and last year were significant changes in asset allocation.

No plan had a more significant change than the $54.5 billion Western Conference of Teamsters Pension Trust, Seattle. The multiemployer pension fund reported a total of $34.3 billion in U.S. fixed-income assets as of Sept. 30, up 308.6% from $8.4 billion the year before.

Alan Biller, chair of Alan Biller & Associates, the pension fund’s outsourced CIO since 2013, said in an interview that by the end of 2023, the pension fund had no withdrawal liabilities and its board decided to set up a dedicated bond account totaling nearly $32 billion to cover scheduled benefits.

For a multiemployer pension fund, the withdrawal liability is vested benefits allocable to single employers contributing to the fund that remain unfunded, according to the PBGC’s website.

“It’s actually, as far as we know, the largest dedicated account ever put together for a U.S. plan,” Biller said. “What it basically does is it’s not an exact cash match, but an approximate, well-structured cash match to cover the scheduled benefits of retirees, people who had retired through year-end 2023 who weren’t covered by other (much older) bond dedications.”

Biller said during 2024 the account picked up another $1 billion in assets, “so it’s now roughly a $33 billion dedication.” The pension fund reported $32.6 billion in passive U.S. fixed income assets as of Sept. 30, up from zero the year before in P&I's survey.

An excellent funding ratio also has contributed to the pension fund’s ability to allocate a large portion of its assets to the cash-matched account. As of Jan. 1, 2023, the pension fund had a funding ratio of 99.2%, according to its most recent Form 5500 filing.

Serge Agres, senior investment consultant with Cambridge Associates, said in an interview that cash-flow matching has become popular with multiemployer plans.

While Western Conference has not needed the Pension Benefit Guaranty Corp.'s special financial assistance that has been available to poorly funded multiemployer plans, that assistance contains restrictions on how it can be invested and has led to plans employing cash-flow matching.

“So cash-flow matching has become really popular, and what we’re seeing is a lot of those pension funds and actually applying them to the legacy portfolio as well,” Agres said.

Asset allocation changes

Other pension funds have also seen significant increases in fixed-income assets because of changes in their asset allocations following reviews conducted because of the rise in interest rates in 2022 and 2023.

Florida State Board of Administration, Tallahassee, reported its $205.2 billion Florida Retirement System pension plan had $43 billion in domestic fixed-income assets as of Sept. 30, up 45.7% from a year earlier.

The change was attributable primarily to an asset allocation study conducted by the board’s investment staff and investment consultant Aon Investments USA in 2023. That study prompted the plan to raise the fixed-income target to 21% from 18% and extend the duration of the portfolio to "full aggregate" by changing the portfolio benchmark to the Bloomberg U.S. Aggregate Bond index from the Bloomberg U.S. Intermediate Aggregate Bond index.

Lamar Taylor, the board’s chief investment officer, said in an interview that a lot of what staff and the consultant looked at in the allocation study was the economic change following the COVID-19 pandemic, including inflation that resulted in higher interest rates. That meant expected higher returns from fixed income. Taylor noted that the link between higher inflation and higher fixed-income returns was a historic real fed funds rate with a positive term premium added on top.

“We could look at the world in terms of how we could generate higher expected returns at the current level of risk we were taking at the time, or we could look for keeping the current level of returns and reducing the risk that we were taking,” said Taylor, “and that was really where we settled out, keeping roughly the same targeted level of returns by reducing the expected forward-looking volatility of the portfolio.”

“When we used those as the predicates, then that shifted down through increasing fixed income,” Taylor said.

He said much of that stems from their expectation that the U.S. is likely to see higher inflation over the next 15 years compared to the last 15 years.

“Those building blocks of expected fixed-income returns look relatively attractive,” Taylor said.

The increase in fixed income was implemented throughout 2024, said Todd Ludgate, director of fixed income, in the same interview.

“We took a measured approach to it,” Ludgate said. “Especially given the size of Florida, you can well imagine we have to be cognizant of not unduly moving the market. We moved over the course of many months into both internal and external managers in the targeted configuration.”

External fixed-income manager hirings completed during the third quarter of 2024 included J.P. Morgan Asset Management and Allspring Global Investments, running $2 billion and $839 million, respectively, in active domestic core fixed income, and State Street Global Advisors running a total of just under $1.3 billion in passive emerging markets debt and high-yield portfolios.

Also during 2023, the New York City Retirement Systems completed an asset allocation review. Among the top 200 U.S. retirement plans with DB plan assets, New York had the most assets reported in domestic fixed income in the survey, at $93 billion as of Sept. 30, up 25.1% from a year earlier.

Dropping TIPS for quant strategies

Steven Meier, CIO of the five retirement systems with a total of $285.5 billion in assets as of Sept. 30, said in an interview that the systems initiated an asset allocation review in 2023 because of a new state law passed in late 2022 that allowed the systems to allocate up to 35% of the overall portfolio to alternatives from the previous statutory limit of 25%.

The five retirement systems each have unique asset allocations and their own distinct boards. One common theme between all the retirement systems is a holistic approach between public and private fixed income, Meier said. In the P&I survey, the retirement systems allocated private opportunistic fixed-income investments to the fixed-income category and not private credit.

One specific change from the asset allocation review was the total divestment from Treasury inflation-protection securities, because the systems' TIPS exposure didn't provide the level of inflation protection they expected, Meier said.

Meier said the staff is currently reevaluating its portfolio construction, partially through the development of a suite of analytics to provide “much better quantitative analysis associated with actual performance over time.”

One example, he said, is some of the systems’ pension funds have as many as 10 high-yield managers.

“There’s a lot of overlap there,” Meier said. “Sure, this is not necessarily as painful in fixed income as it is in equity in terms of active managers canceling each other out, but we do have a duplication we think is unnecessary. So I think two things as a general statement across our fixed-income platform is we’re looking at potentially increasing our exposure at the margin to more passive strategies and to a much larger extent systematic or quantitative strategies.”

Another public pension fund, the $117.2 billion Virginia Retirement System, Richmond, reported $16.1 billion in domestic fixed-income assets as of Sept. 30, up 29.1% from a year earlier.

Greg Oliff, VRS’ co-director, fixed-income, said in an interview that the increase in assets was primarily the result of capital reallocation in addition to strong returns.

“As the equity market appreciated, we have boundaries on our benchmarks that are deemed by the board, so it’s not an autopilot reallocation, but certainly we were out to reallocate,” Oliff said. “So that was the vast majority of the uptick, and … we increased our benchmark allocation by 1% to fixed income as well (to 16% from 15%),” focused on core and core-plus strategies.

“Then it also just so happens that from (Sept. 30), their absolute return was above 12%, which is wild. We had a pretty wild ride up in terms of rates, and then in that specific window we had pretty much most of the curve, so we had a substantial kind of absolute return there,” he said.

Investment consultants who work with both corporate and public pension plans are seeing increased allocations to fixed income as well.

Scott Whalen, managing director and senior consultant at Verus Advisory, which has a number of public pension funds as clients, said both the firm and its clients are showing greater interest in fixed income because of the increase in interest rates.

“Through the low remedial environment, we were kind of hanging on by the skin of our teeth to stay diversified because you just weren’t getting anything from fixed income, but it still had that diversification benefit,” Whalen said. “Now that you’re seeing higher rates, fixed income is taking back its traditional place in the strategic asset allocation. It’s offering up a little bit more return. You have concerns from a lot of folks about the valuations with respect to equities, and so fixed income just looks that much more attractive from both perspectives: In its own right, and then also relative to risk assets that may seem a little expensive.”

Matt McDaniel, U.S. pension strategy and solutions leader at Mercer, said on the corporate side, fixed-income allocations are also going up because of improving funding ratios that have been the result of strong investment returns coupled with rising interest rates that lower liabilities.

Many corporate DB plans have long frozen benefit accruals and employ liability-driven investing strategies.

“As corporate plan sponsors get better funded, they tend to derisk,” McDaniel said. “One of the biggest ways they tend to derisk is removing assets from the equity portfolio or other growth assets to the fixed-income portfolio, and predominately they’re buying long duration, high-quality fixed income (assets like) long corporate bonds and long Treasuries."

For the year ended Sept. 30, the Bloomberg U.S. Long Credit index returned 18.9%.