Large public retirement funds, particularly in the US, have unrealistically high investment return targets for the coming years, despite the likelihood of long-lasting ultra-low rates, finds a new study by the Official Monetary and Financial Institutions Forum (Omfif).
The overly high expectations threaten to leave the pension plans under-equipped to meet rising future retiree needs, and are underpinning the broader shift into alternative assets.
While the funds have reduced their target nominal rates of return, their target real investment returns are little changed (see graph below). Essentially, they are relying on assumptions of lower inflation to ensure they hit those targets, while expecting to achieve similar – or even higher – levels of investment income, according to Global Public Pensions 2020, published yesterday (November 19).
“While the available data predates the pandemic, it is difficult to imagine what might have prompted this optimism,” said the report, which analysed data from 100 public pension plans across the $17 trillion segment.
“Right now, the real long-term targets are still quite high,” Omfif economist Pierre Ortlieb noted during the launch event for the research. “It's not clear to me how public pensions aim to achieve those returns.
“And if the assumption is set too high and realised returns continuously fail to meet the target, then that will place a greater burden on contributors in the future,” he added.
The implication is that pension funds will continue to increase their allocations to alternative assets (which now stand at an average 13% in Omfif's sample), as they have been doing for some years, the report said. “Actuarial considerations add weight to the argument that this trend is set to continue.”
“The key question is whether these assumptions are credible considering the broader macrofinancial environment,” the paper added.
Epitomising the challenges faced is the biggest US state pension fund. California Public Employees’ Retirement System carried out an in-house survey of its capital market assumptions in 2019 and found it only stood a 40% chance of meeting its 7% return target. Hence Calpers plans to increase its exposure to private markets and away from public fixed income assets.
Thailand’s Government Pension Fund – like many other retirement plans – is on a similar path. Man Juttijudata, GPF’s chief investment strategy officer, said in the Omfif report: “Eight years ago we had only a 5% allocation to alternatives, and now we have 15% and plan to increase further.”
The fund is also trying to do away with the requirement, under Thai law, that it must have at least 60% of its portfolio in investment grade bonds.
“When we simulate removing this constraint, our performance always improves, but we’ve had no luck changing these rules,” Man said. GPF will try again next year when it next reviews its strategic asset allocation under its new chief executive, he added.
LOWER ... FOREVER?
The pension funds have little hope of any succour from fixed income assets, given that interest rates are widely expected to remain depressed for at least a decade.
In an online poll taken during the Omfif report launch, half of the audience said it would be 10 years before interest rates would return to ‘normal’, while a further 14% said they would never do so. One third (32%) chose four years, while 5% plumped for two years.
Similarly, Stefan Dunatov, executive vice president of investment strategy and risk at Canadian pension fund British Columbia Investment Management Corporation, wondered whether the label ‘lower for longer’ applied to rates would no longer be relevant.
“At some stage … it does sort of become permanent,” he said speaking on a panel discussion during the event.
“I think we have to get used to a world of zero or very low rates, possibly even negative rates,” Dunatov added. “I don't think we can discount the chance that we have entire yield curves below zero for a very long time.”
On the plus side as far as pension funds are concerned, he said he did not foresee inflation rebounding “any time soon”. He pointed to the “digitisation” of industries, “which keeps supply curves moving out”, and to the big drop in demand thanks to Covid-19.
“In general,” Dunatov said, “it's been hard to see what's going to be a real, substantial enough catalyst to create economy-wide inflation.”
Pension fund executives across the world will be fervently hoping he’s right.