Heavy drops in equity market valuations over the past two weeks are set to drastically impact the portfolio sizes of asset owners and pension savers across Asia, and will likely point to drastically lower returns this year.
Pension funds need to respond by preparing for tougher times to come, particularly through extensive asset diversification and reassessing their investment assumptions.
Hong Kong's Mandatory Provident Fund schemes offer an example of the coming pain. Research company MPF Ratings has warned that the MPFR Index of Equity Funds (Global) is set to record its worst three months ever.
“Global equity markets are on track to possibly fall 25% in March. If this occurs then global investments within MPF may record some of the worst quarterly performances on record," said Francis Chung, chairman of MPF Ratings.
Chart: Worst quarters of the MPFR Equity Index (Global)
Source: MPF Ratings
The bad performance of MPF funds will likely be representative of most pension funds, which typically use public bond and equity investments are a major component of their financial performance. According to OECD global research, 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).
Last year, fund manager AQR Capital estimated that the classical 60-40 balanced equity-bond fund model 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 prediction could end up proving optimistic, given the prospect of a prolonged global recession and much higher volatility in equity markets.
PENSION FUND PRIORITIES
In the face of a potential deterioration in pension funding ratios, what should funds and savers do to respond sensibly, minimise losses and avoid being drawn into riskier investments? Investment experts and asset owners advise three main points.
First: don’t panic amid falling public market valuations.
MPF Rating’s Chung urged investors not to grow too fearful upon seeing the poor results and risk incurring more losses to their pension savings by switching funds. He noted it would be very difficult for investors to try and call the bottom of the market, given the uncertainty regarding the severity of the Covid-19 pandemic and its long term effect on the global economy.
Second, diversification is key to ensuring better returns.
“The key driver of portfolio returns are asset allocation, whether equities or fixed income; it can cause over a 10% difference [in an asset owner’s annual returns],” said Janet Li, Asian wealth business leader for investment consultancy Mercer.
It’s a point supported by Richard Cooney, a senior investment consultant at Willis Towers Watson: “It is worth emphasising that the SAA [strategic asset allocation] decision is the most important decision facing an investor.”
Malaysia’s largest pension fund, the Employees’ Provident Fund (EPF), offers an example. It has around a 40%) allocation to public equities, which generated almost half of its total return in 2019. But chief EPF officer Alizakri Alias said in the fund’s recent annual report that domestic markets didn’t support EPF’s income-generating capabilities in 2019 so it will continue diversifying into overseas markets.
EPF’s overseas holdings across all asset classes make up 30% of its total assets and contributed 41% to its gross investment income in 2019.
Third, pension funds and other asset owners should use this period of global market dislocations to reassess their investment assumptions.
Leo Lee, director of the foreign investment division at Taiwan’s Bureau of Labor Funds, said pension funds need to conduct some thorough self-analysis about their investment assumptions. “All countries face the same challenges and it can only be resolved through a rigorous system review,” he told AsianInvestor.
In the BLF’s case, this involved looking at the experience of foreign pension reforms and gradually moving to a sustainable system through dynamic portfolio adjustments.
“The investment and use of labour insurance funds to invest in high-return investment products was a concern for the fund’s investment committee,” said Lee. “These investments are usually accompanied by high risks, and the portfolio is then more susceptible to factors such as economic growth and asset allocation. There are many variables.”
BLF has looked to foreign markets and alternative return strategies such as smart beta to boost returns. But Lee said its fundamental philosophy is still to be low risk. “I have always adhered to the principle of long-term stable layout,” he said.
Dong-Hun Jang, CIO at Korea’s Public Officials Benefit Association (Poba), said pension funds will likely have to pursue two tacks to secure their futures.
“Their target return needs to be increased and contributions from members will need to increase,” Jang told AsianInvestor. “I would suggest that taking advantage of the illiquidity premium is a good way for a pension fund to improve its funding ratio [over the longer term].”
Several Asia Pacific funds are investing more in illiquid alternative assets such as private equity, real estate and private debt for the promise of high single digit or double digit returns. Poba is a particular proponent, with infrastructure, private debt, mezzanine and real estate debt investments comprising around 50% of its W14.1 trillion ($11.85 billion) in assets.
Richard Morrow contributed to this article.