NEW YORK (Reuters) - U.S. public pension funds are cutting investment return assumptions because of years of zero interest rate policies and changing how they manage risk to avoid a repeat of the damage caused by the financial crisis.
The growing recognition that short-term volatility can have a devastating impact on mature pension plans in the $4 trillion sector could herald a sea change in the way public funds invest in the future.
Since the 2008 financial crisis about two-thirds of the 126 funds tracked by the National Association of State Retirement Administrators have lowered their expected return targets. The average expected return now stands at 7.68 percent versus 8 percent in 2008.
The financial crisis left a hole in public pension funds. The average state pension fund has only around 80 percent of the assets it needs to meet its liabilities, according to a 2015 survey by Wilshire Consulting, down from 95 percent in 2007.
Perhaps the biggest confirmation of the move to cut back on risk within U.S. public pension sector may come from the California Public Employees’ Retirement System, the largest public pension fund with $300 billion in assets under management.
Calpers is considering cutting its expected rate of return in years following strong investment gains and adjusting its portfolio to reflect those lower return assumptions. The move would essentially cut back on exposure to higher-yielding but riskier assets as the plan improves its funding levels. It is similar to the liability-driven investing glide path models used by corporate plans. Its use is all but unheard of in the U.S. public pension sector. Such a move, which has yet to be adopted by the Calpers board, would follow recent announcements that the pension fund is cutting back its public equity exposure and raising its fixed-income holdings in addition to eliminating investments in hedge funds. “There is this shift to recognizing risk is a relevant piece of the discussion, it’s not just about how you get the highest returns over a long period of time but that short-term fluctuations in asset levels can be incredibly detrimental,” said Tamara Burden, an actuary at consulting firm Milliman. On aggregate about 70 percent of the sector’s assets are invested in equities and other so-called risk assets, according to CEM Benchmarking.
Others funds, such as California’s San Bernardino County Employees’ Retirement Association and the Teacher Retirement System of Texas, are using options and more active fund management to insulate portfolios from the kind of damaging volatility experienced in August.Burden is seeking to persuade public pension managers to use Milliman’s risk management strategy to reduce equity exposure in portfolios by shorting stock index futures. This means they don’t have to sell their fund’s equity holdings.
The strategy is being applied to about $70 billion in portfolios with variable annuities, retail mutual funds and collective investment trusts used by 401(k) plans, but so far not in the public pension sector.
Interest, Burden says, has increased this year with about 15 public pension administrators considering a shift versus five during the same period last year. That could also be due to Milliman’s more active marketing campaign.
Burden said pension managers are growing more concerned that “short-term fluctuations can be super powerful.” U.S. public pensions traditionally focus on equities and play down market volatility by pointing out long-run out-performances to justify targeting a 7-8 percent yearly return over a 20- to 30-year investment horizon. Their model was challenged by the financial crisis, which left them seriously underfunded. “The trend among pension funds is toward ‘de-risking,’” said Tom Aaron, an analyst at Moody’s. “This is a recognition of the maturing of plans. There may not be as much tolerance for risk.”
A handful of public pension funds have now developed their own hedging strategies and active style of fund management. San Bernardino County Employees’ Retirement Association uses option strategies, which protected the fund from the worst of the August selloff, and represents a more actively managed approach, the fund’s chief investments officer, Donald Pierce, said. San Bernardino allocates 28 percent to equities, lower than most funds. However, its risk profile is similar to the sector’s if investments in other so-called risk-assets are taken into account.
Pierce hedges about 40 percent of the fund’s equity portfolio and 30 percent of its credit portfolio using options and other derivatives. His more active strategy paid off on Aug. 24 when the S&P 500 fell nearly 4 percent. Pierce took an $80 million position in equities, split evenly between emerging markets and U.S. stocks. He sold out of half of it the next day for a 4 percent gain in a single day. “That’s a great month or quarter so naturally we decided to take some profits,” Pierce said.
Additional reporting by Rory Carroll; Editing by Leslie Adler