How Pensions Will Tackle the Next Crisis | Chief Investment Officer

What happens when the next market crash hits?

If one asked pensions across Europe—as the European Insurance and Occupational Pensions Authority (EIOPA) did last year—they would likely state their intention to rebalance in favor of the assets that have fallen in price.

But analysis of investor behavior during the financial crisis showed that the real track record was less sensible. Many pensions would likely join an immediate sell-off regardless of longer term perceived benefits of rebalancing.

“Further work needs to be done to analyze how prolonged adverse market conditions will affect the sponsors’ behavior and the possible consequences for financial stability and the real economy.”EIOPA surveyed 140 defined benefit (DB) or hybrid pension funds from 19 European countries as part of a “stress test” for the sector. Unlike similar initiatives for banks, the test was not designed for participants to pass or fail.

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The pensions were asked to layout their reactions to three scenarios, two of which involved market sell-offs, and one of which involved an unexpected spike in longevity.

Actuaries can relax: DB funds “demonstrated a relative resilience” when tackling a 20% fall in mortality rates.

In “Adverse Scenario 1”—the most similar to the 2008 market crash with falling asset prices, interest rates, and inflation—the majority of pensions said they would buy into equities, property, and alternatives or maintain their positions. More than a quarter of respondents said they would sell fixed-income assets.

EIOPA stress test How European DB funds would respond to a market sell-off. Weighted by assets. Source: EIOPA.Weighting respondents by asset size magnified the effect. Large Dutch investors were particularly adamant that they would rotate out of fixed income and into equities during a sell-off, in an effort to benefit from a market rebound, EIOPA said.

However, EIOPA’s analysis of behavior in 2008 indicated that many pensions did otherwise.

“The analysis of the 2008 data indicates that a full rebalancing of investment portfolios may not be realistic,” EIOPA’s full report said. “The sample of [pensions] moderately re-balanced investment portfolios by buying equities during the financial crisis. This means that investment behavior was on aggregate counter-cyclical, but to a lesser degree than indicated… through the stress test questionnaire.”

EIOPA admitted there were few firm conclusions to be drawn from the analysis: there were likely to be “a variety of responses” from investors, dependent on their individual funding concerns, the strength of corporate sponsors, and local economic conditions.

Andrew Vaughan, partner at consulting firm Barnett Waddingham, said UK pensions should have enough flexibility to address the risks identified by EIOPA’s report “without dangerous knee-jerk reactions.”

“Allowing appropriate recovery plans is key and we would hope EIOPA recognizes this in any future advice to the European Commission,” Vaughan said.

EIOPA Chairman Gabriel Bernardino said that the research had “deepened the supervisors’ understanding of the impact that different future stress scenarios can have on the pension plans’ resilience.”

US endowments recorded the lowest returns for the 2015 fiscal year since 2012 and reached a hiatus in outsourcing, according to NACUBO and Commonfund.

The joint study of 812 colleges representing a total of $529 billion in assets revealed endowments returned an average of 2.4% net of fees, a sharp drop from 2014’s 15.5%.

“FY 2015’s lower average one-year return is a great concern,” said John Walda, NACUBO’s president and CEO. “Lower returns may make it even tougher for colleges and universities to adequately fund financial aid, research, and other programs that are very reliant on endowment earnings and are vital to institutions’ missions.”

The dampened gains also contributed to a decline in endowments’ long-term return to 6.3% over a decade, from last year’s 7.1%.

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“The 7% target return could be a tall order over the next few years,” cautioned Catherine Keating, Commonfund’s president and CEO, on the conference call. “The endowment model can evolve and is still the best formula for long-term success… But a 6% or so range of returns—including alpha—is more likely going forward.”

Furthermore, NACUBO and Commonfund found endowments’ asset allocation remained stable despite turbulent market conditions in 2015, with small shifts away from equities to alternatives.

“Institutions are not panicking, not interested in twitchy things, and they have a steady-as-she-goes way of looking at the portfolio,” said Commonfund’s Executive Director Bill Jarvis.

The percentage of “substantially outsourced” endowments also remained the same at 43% over the last year, which may indicate a “pause in this trend.” The vast majority (84%) of respondents reported using a consultant for various services.

Endowments continued to focus on risk management in 2015, with 62% of funds using risk limits in their portfolios, up from 57% in 2014.

More than two-thirds of surveyed asset owners said they use measures such as alpha and beta—an increase from 61% in 2014—while more than half conducted stress testing or scenario analysis.

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