Testing Public Pensions’ Sensitivity to Investment Returns

(September 27, 2013) — The inability to make investment returns above inflation has had the greatest impact on public pension funds’ serious underfunding.

“How Sensitive Is Public Pension Funding to Investment Returns?”, written by Alicia Munnell, Jean-Pierre Aubry, and Josh Hurwitz of the Center for Retirement Research at Boston College (CRR), projected dismal future returns for the next 30 years.

The study showed that real return, made over and above the rate of inflation, should be used for long-term targets because benefits are generally indexed for inflation before and after retirement. This was particularly critical for mature plans with large funding, negative cash flows, and lower contributions from pensioners.

This is because while the higher nominal returns would produce stronger revenues for pension funds, the returns were likely to be driven by higher inflation, which would also push the cost of living post-retirement and original benefits higher.

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The difference was clearly visible. State and local pension plans’ 2012 average nominal return was 7.75% while real return was 4.45%, according to the data.

When the assumed real return of 4.45% compared to historical returns, the researchers found that the average rolling 10- and 30-year real return for a hypothetical portfolio exceeded the assumption by at least 100 basis points.

This data raised the question of whether future returns will stay at similar levels using assumed real returns, especially considering the recent financial crisis.

Calculations revealed that even if the real return reaches the pensions’ expectations, the volatility in year-to-year returns could generate fluctuations that could adversely affect funding.

This means that returns must be higher than expected if pensions are to be fully funded in the next 30 years.

The brief named two reasons for such negative outcomes: employers are paying less than the full annual required contribution, and payments to amortize unfunded liability and an open 30-year amortization period yields to lower contributions.

With an average of 7% real returns, plans will be fully funded in 10 years. Plans will be fully funded in 20 years with an average of 5.79% real returns.

However, the likelihood of public pension funds reaching those yields looked uncertain: The CRR found that in the

50th percentile of generated returns over the 30-year projection, assets only accounted for 87% of liabilities.

Using this trajectory, the study concluded that the only way for public pensions to achieve a fully funded status is to gain higher returns.

Access the full paper here.

(September 27, 2013) — The largest foundations in the US have reduced their allocation to private equity over the past year and many have opted to outsource their investments, research has shown.

Foundations with more than $500 million reduced their allocation to funds offering access to leveraged buyouts, mezzanine debt, M&A, and international private equity from a 27% of their portfolios at the end of 2011 to 22% at the end of last year, Commonfund Institute data showed.

Smaller foundations—with between $101 million and $500 million—reduced their allocations slightly, from 20% to 19%, while the smallest investors retained an 11% stake of their alternative portfolios.

These investments gave foundations some of the worst returns over the year, contributing 7.7%, which lagged US equity returns of 17.5%.

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The overall allocation to alternatives by this group fell from 44% to 42%, but some hedge fund strategies gathered more assets, including market neutral and global macro approaches.

The core elements of these foundations’ portfolios were tweaked by single digits.

The number of foundations reporting that they had outsourced investment functions rose considerably, the Commonfund Institute found. From 30% saying they used a third party to make investment decisions in 2011, some 38% reported the same just 12 months later.

The use of consultants also rose from 76% employing a third party adviser in 2011, to 80% by the end of last year.

Of the largest funds, 72% reported having a CIO in position, but this number fell to 23% when taking the range of foundation sizes into account.

The Commonfund Institute surveyed 140 institutions across the US.