Poor Returns to Erase Years of US Public Pension Gains

Weak investment returns amid market volatility will likely undo the funding improvements US public pensions made in 2013 and 2014, according to Moody’s.

The ratings agency reported that unfunded pension liabilities increased by roughly 17% in fiscal year 2015 as public pensions failed to meet expected rates of return. With recent market volatility dampening the performance of US pension funds, Moody’s predicted a further decrease in funding levels in 2016.

“We project unfunded pension liabilities on a reported basis will grow by at least 10% in fiscal 2016 even under our most optimistic return scenario,” said Moody’s analyst Thomas Aaron.

Though expected returns for public pensions are typically around 7.5% annually, in the first half of fiscal 2016 several large public pensions reported negative returns, according to Moody’s. This, combined with stock market trends since 2015, suggests “investment returns will fall short of assumed targets.”

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“Should markets not recover sharply in the next several months, fiscal 2016 will mark the second consecutive year of investment performance below assumed rated for US public plans, following strong returns in 2013 and 2014,” Moody’s said.

2014 had been the “best year for state pensions since the recession,” according to Loop Capital Markets, with median funding levels increasing to 71.5%.

But in Moody’s most optimistic scenario for 2016, in which public pensions achieve average returns of 5%, net liabilities are projected to increase by 10%. In the rating agency’s most pessimistic scenario—where funds lose 10% on average—unfunded liabilities could jump by 59%.

These declines in funding levels are exacerbated by insufficient government contributions. Moody’s reported that less than half of the 56 plans in their sample received enough contributions to cover service and net liability interest costs in 2015—and no positive change is expected in 2016.

“Plans receiving weaker contributions will experience growing net liabilities even if investment performance meets assumptions,” Moody’s said.

Minimizing risk exposures during periods of market volatility can result in “substantial” alpha and doubled Sharpe ratios, according to Yale professors.

For “superior” risk-adjusted returns, investors should take less risk when markets are volatile, Yale academics have argued.

Volatility-managed portfolios—those that decrease risk exposure when returns are expected to be volatile, and vice versa—produce large, positive alphas and increase Sharpe ratios by “substantial” amounts, according to a study by Assistant Professors of Finance Alan Moreira and Tyler Muir.

“We find that short- and long-term investors alike can benefit from volatility timing, and that utility gains are substantial,” they wrote.

While the “common advice” is to increase or maintain risk levels following a downturn, a volatility-managed portfolio reduces risk during these volatile periods. For example, rather than buy equities following the 2008 market crash, the volatility-managed portfolio “cashed out almost completely and returned to the market only as the spike in volatility receded.”

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“An investor is better off paying attention to conditional volatility… suggesting that volatility is a key element of market timing.”“Since volatility movements are less persistent than movements in expected returns, our optimal portfolio strategy prescribes a gradual increase in the exposure as the initial volatility shock fades,” Moreira and Muir continued.

The pair concluded that it takes an average of 18 months for risk exposure to return to normal, beyond which they advised even further exposure to capture the persistent increase in expected returns.

“The difference in persistence allows investors to keep much of the expected return benefit, while at the same time reducing their overall risk exposure,” they argued.

For the study, Moreira and Muir constructed volatility-managed portfolios across market, value, momentum, profitability, return on equity, equity investment factor, and currency carry trade strategies, and plotted their returns from 1926 to 2015. They found that annualized alphas were “substantial,” with Sharpe ratios increasing by 50% to 100%.

The results were positive for both short-term investors, who are affected by all types of volatility, and long-term investors, who typically disregard more transient price movements, as they can afford to wait until the price recovers.

For both short- and long-term investors, the Yale professors recommended a combination of a buy-and-hold portfolio and a volatility-managed portfolio as the best method of achieving high risk-adjusted returns.

“Volatility-managed portfolios offer superior risk-adjusted returns and are easy to implement in real time,” Moreira and Muir concluded. “An investor is better off paying attention to conditional volatility… suggesting that volatility is a key element of market timing.”