How Managers of Pension Funds, OCIOs Are Approaching Risk

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As central banks around the world raise interest rates to combat inflation, and geopolitical tensions remain taut, pension fund managers and outsourced CIOs are grappling with economic realities that have not been a concern for years.

These new and continuing challenges mean investment managers must adjust how they approach building a resilient asset allocation for pension funds to meet their long-term assumed rates of return. The tactics investment managers take also depend on the individual funds themselves: How managers invest to meet the liabilities of a frozen or closed corporate plan is different than their strategies for an open plan which continues to add new members.

Reducing risk while still trying to outpace the market in 2023 means revisiting public equity positions, diversifying portfolios into alternatives and looking to fixed income and private as higher yields offer opportunities not seen in years.

Some Corporate Plans Transfer Risk

Last year was tough, as stock and bond markets fell. However, for some corporate funds on a de-risking path, their funding levels improved because rising interest rates meant their liabilities fell by a similar amount, says Mike Moran, a senior pension strategist at Goldman Sachs Asset Management.

Higher yields allowed some funds to match liabilities using investment-grade fixed income or longer-dated U.S. Treasurys, while others employed interest-rate swaps or futures to fine-tune these hedges, he adds. In aggregate for corporate plans at the end of 2022, slightly more than half of their portfolios were in fixed income. Some of that was liability-hedging, but some of that was reducing public equity to purchase fixed income and use the coupon payments to de-risk and to benefits, Moran says.

Some well-funded plans are dusting off an old strategy now that rates are higher, opting for pension risk transfers, in which plans buy a group annuity from an insurer to offload some of the liability, Moran says.

One example was AT&T’s $8.1 billion May deal with Athene Holding to purchase group annuity contracts. Moran says more of his clients are considering benefit structure changes such as moving to cash-balance plans, closing plans to new entrants or freezing plans to de-risk by shrinking obligations.

“Many clients are saying to me, ‘Can I get out of the pension business?’” he says.

Balancing Risk and Return

For less-well-funded corporate plans and for open public sector plans which continue to add participants, last year’s market routs reduced funding levels. Open plans need growth because many have a return target that can range between 6.5% to 7.5%, Moran says.

Martin Jaugietis, co-head of Americas pensions within the multi-asset strategies and solutions group at BlackRock, concurs.

“The need for investment return for a less-well-funded plan is arguably even more acute now than it was 18 months ago,” he says, citing the potentially slowing economy.

There are multiple ways these plans can balance the need for growth and reduce risk, he says. A primary way is to diversify portfolio allocations, particularly on the growth side.

Andrew Junkin, CIO for the $101 billion Virginia Retirement System, says diversification is key to VRS withstanding economic downturns to meet their 6.75% assumed rate of return. As of year-end 2022, public equity is 31.8% of the pension fund’s asset allocation, which Junkin says is at the low end of holdings compared to VRS’s peer group. Other top sectors include private equity at 18.3%, real assets comprising 15.5%, fixed income at 12.3% and credit strategies at 13.7%. At the end of the 2022 fiscal year VRS’s portfolio returned 0.6%, net of fees.

In addition to diversifying asset allocation, Mike Hunstad, CIO for global equities at Northern Trust Asset Management, says his pension-plan clients want to reduce equities’ inherent risk. He says lower volatility equity strategies have become “a very hot topic within our client base” to reduce some of public equities’ tail risk presented by stocks while still improving portfolio performance.

“If we are going into an economic contraction, then higher-quality, lower-volatility stocks tend to significantly outperform their benchmark, plus you get that risk mitigation,” he says.

Jim Link, head of the institutional OCIO practice at U.S. Bancorp Asset Management, concurs: Pension funds are not necessarily making material shifts from their long-term asset allocations into fixed income from equities, but they are searching for high-quality assets with very reliable cash flows.

That includes staying in large-cap stocks and shying away from small- and mid-cap stocks that are less likely to do well in weaker economic environments. Some are looking for selective opportunities in commercial mortgage-backed securities, focusing on single-tent opportunities rather than pooled real estate investments.

Private Credit Opportunities

The investment managers say private credit may offer both growth and income in a way it has not in a while.

Junkin says much of private credit is conducted floating-rate, and with interest rates rising, spreads between U.S. Treasurys and private credit vehicles have widened to become more attractive. He sees low double-digit expected returns within the next five to 10 years for some strategies.

“[It] depends on what happens to rates going forward, but … to be able to get that kind of return with credit risk rather than equity risk is pretty attractive,” Junkin says. “We’re seeing opportunities all across the credit spectrum.”

He declined to elaborate, noting that VRS is currently going through its triennial asset-liability review process and expects to have a decision from its board in June.

Jaugietis says there is growing interest in private credit, particularly for underfunded corporate plans seeking asset classes that offer strong positive returns but also high correlations to liabilities, thereby bolstering funded ratios. He cites BlackRock’s capital market assumptions that private credit has a 0.33 correlation to liabilities, as compared with hedge funds’ correlation of 0.28 and commodities’ of 0.13.

Considering the currently inverted yield curve from a total-return perspective, BlackRock notes that intermediate credit offers the same expected return as longer-dated credit, he says, and from a liability-driven return program, this phenomenon allows the firm to be more precise in its hedging.

“As [corporate] pension plans mature, the duration of the liability tends to decline,” he says.