Pension investment management used to be simple. The funds more or less knew when people were going to die, and they could invest in a range of bonds to match assets to expected liabilities.
That equation has become more difficult to calculate. People are living longer, so they draw down more benefits, while cash and bond returns have fallen to historically low levels. Until bond spreads began widening as a consequence of coronavirus outbreak and central bank reactions, yields of a record $17 trillion of bonds were sitting in negative territory – a quarter of all fixed-income assets. Now that has shifted, and much of US Treasury assets sit in that territory.
Such poor returns were, at least until recently, causing pension funds to slowly pull back from fixed income. And as markets begin to calm down, they will eventually have to resume this shift.
According to OECD global research, average investments in bonds have slowly been falling, from 50% in 2008 to 45% in 2018. But the pension funds are still a long time to make their shifts; public sector bonds and listed equities accounted for more than half of investments in 32 out of 36 OECD countries, and 39 out of 46 other reporting jurisdictions at the end of 2018 (the latest data available).
Fixed-income allocations of 45% to more than 50% sit well above the classical 60-40 balanced equity-bond fund model – and even that is unlikely to ensure adequate return needs.
In 2019 fund manager AQR Capital estimated that a 60-40 equity-bond fund might return as little as 2.9% on average a year after inflation over the next decade, down from an average of 5% since 1900. That return is well under the 5%-7% annual return funds need to cover their outflows.
Pension funds need to improve their investment returns, and do so soon.
At the heart of the problem facing pension funds is the erosion of fixed income asset returns. That is largely a consequence of the lingering effects of quantitative easing and rate cuts – something that risks being compounded by the emergency rate cuts of the Federal Reserve, Bank of England and others during March.
Amin Rajan, founder of the UK-based research firm Create, noted that QE and rates cuts were used to gin up the global economy after the 2008 financial crisis, and have continued being deployed in the decade since, with the latest cuts being the latest example. As a result, pension plans are making less, and so are on track to run out of money earlier than planned.
“The numbers are all the more worrying against the backdrop of the longest bull market in history,” Rajan told AsianInvestor. Falling rates in particular lead to lower cashflows and inflate the present value of future liabilities.
The impact of QE has forced pension trustee boards to make big judgement calls without the normal navigational tools.
“The pressure on these boards to step up to the plate and effectively discharge their fiduciary role is mounting each day,” said Rajan.
In particular, pension funds have had to increasingly look at higher returning assets such as equities, illiquid assets and emerging markets.
Funds in Hong Kong and Australia are the most assertive when it comes to equities, typically making 50% allocations, alongside 30% to bonds and 20% in cash. The larger Aussie supers also have sizeable (roughly 10%-15%) allocations to alternatives.
The Mandatory Provident Fund Schemes Authority of Hong Kong said members prefer growth funds, which likely accounts for the relatively high proportion of assets invested in equities. This has helped to boost their returns in the QE world of artificially stimulated equity markets in recent years.
Malaysia’s largest pension fund, the Employees’ Provident Fund (EPF) has made a relatively high (around 40%) allocation to public equities, and chief executive officer Alizakri Alias has said EPF’s investing priority this year is to expand its 30% allocation to overseas assets; it’s an understandable target, given that this portion made up 41% of its investment income in 2019.
Pension funds in Japan and Korea have typically had larger fixed-income exposures – in the region of 80% to 90% – to the detriment of their returns and the jeopardy of their long-term payout profile.
While the painful drops of equity markets during March may cause pension funds that have relied on them to reconsider the level of their dependence, the fact remains the asset class has been a decent performer over long periods. And selling down now might well be the worst time to do so.
This article has been adapted from a feature on the need for asset owners to adapt their investments, which originally featured in AsianInvestor's Spring 2020 edition.