U.S. public pensions posted their weakest performance in three years, falling a percentage point short of their investment targets, and the prospect of rock-bottom interest rates and a trade war-induced recession could put a greater strain on state and city retirement plans.
The median U.S. public pension returned 6.2% in the fiscal year that ended June 30 after paying fees to investment managers, according to InvestmentMetrics of Norwalk, Conn., which provides analytics to institutional investors. Pensions assume a median annual investment return of 7.3% to cover promised benefits.
“The market is challenged,” said Farouki Majeed, chief investment officer of the $14.7 billion School Employees Retirement System of Ohio, which returned 6.6%, short of its assumed 7.5% return. Over a 10-year period, the fund has returned an annualized 9.4%. “We certainly don’t expect that over the next 10 years.”
The Ohio pension plan, like other government retirement systems, has increased allocations to riskier investments in stocks and private equity as a decadeslong decline in interest rates and slow global economic growth made it harder for it to meet long-term targets.
This has exposed retirement systems to greater volatility even as they try to climb out of a hole that has left them with between $1.6 trillion and $4 trillion less than they need to cover all the benefits that have been promised, depending on the interest rate used to value liabilities.
That gap could get even bigger if U.S. Treasury yields, already close to all-time lows, fall further because of an escalating U.S.-Chinese trade war or the spread of economic stagnation from Japan to Europe.
“Global economic growth estimates have been steadily coming down for the next few years. That’s a concern,” Majeed said. “I would put trade and currency wars as more of a near-term risk.”
State and local pensions’ average allocations to stocks and alternative investments, like private equity and real estate, increased to 77% of their assets in 2017 from 67% in 2001, while fixed-income investments and cash declined to 23% from 33%, according to Boston College’s Center for Retirement Research. Ohio’s school pension has 75% of assets in stocks and alternatives.
The stepped-up investments in public and private equity have exposed pensions to market swings. Government retirement funds lost 7.5% in the fourth quarter of 2018, while stock markets swooned as higher interest rates weighed on investor sentiment. Stocks rebounded in the first quarter when Federal Reserve officials signaled they would not raise interest rates this year.
To be sure, last year’s below-target returns will not cause an unexpected spike in government pension contributions. Most retirement systems “smooth” the actuarial value of their assets, allowing pensions to recognize investment gains or losses over several years, dampening contribution volatility.
The median U.S. pension returned 7.7% after fees in fiscal 2018 and 11.9% in fiscal 2017, according to InvestmentMetrics. Over 20 years, the median public pension returned 5.7% annually after fees.
“There was some unexpectedly good performance that hasn’t yet fully been baked into contributions for the past couple years. That’s going to offset this a little bit,” said Tom Aaron, a Moody’s Investors Service analyst.
The sustained period of low interest rates since the financial crisis has led many public pensions to re-evaluate their long-term expected returns. State and local pensions have reduced their average investment returns to 7.3% from about 8% in 2010. Ohio’s school employee pension is considering lowering its 7.5% assumed rate, Majeed said.
Still, interest rates have fallen more, with rates on 10-year Treasuries declining to 1.7%.
“If you’ve got a funding strategy predicted on earning 7% per year, with very low market interest rates, that’s going to require moves into higher-return, but higher-risk, types of asset classes,” Aaron said.