Institutional investors all over the world are grappling with the fact investment markets will not deliver what they once did, so their ability to reach their return targets is compromised. Rather than take on more investment risk, they are looking to reduce those targets. So what changes will that mean?
The chair of the $A127 billion ($97.6 billion) Future Fund and former Australian federal treasurer, Peter Costello, told a media briefing in January that the fund’s target investment return of 4.5 per cent to 5 per cent above inflation was likely to be unsustainable without taking on excessive investment risk. Costello said that even though the fund’s actual returns since inception have averaged 7.7 per cent a year, and it has met its return targets over the past decade, those goals should be adjusted for the next 10 years.
He did not suggest an appropriate revised target, nor did he suggest changes to the fund’s long-term asset allocation ranges were necessary. As of December 31, 2016, the Future Fund held more than 19 per cent of its assets in cash, reflecting what Costello described as “elevated risks [from] geopolitical factors”.
Lowering return targets often has a disproportionate effect on a fund’s liabilities, because investment earnings typically make up the lion’s share of funds’ revenue. A National Association of State Retirement Administrators (NASRA) issue brief, Public Pension Plan Investment Return Assumptions, states that about 63 per cent of public pension fund assets have been accumulated through investment earnings, with about 25 per cent from employer contributions and 12 per cent from employee contributions.
In February, the NOK7.7 trillion ($913.46 billion) Norway Government Pension Fund Global (GPFG) announced it was reducing its target real rate of return to 3 per cent. At the same time, the fund announced it was increasing its strategic benchmark allocation to equities from 62.5 per cent to 70 per cent. Full details and the reasoning behind both moves will be presented to the Norwegian Parliament at the end of this month.
In a statement, the Norwegian Ministry of Finance and the Office of the Prime Minister said the estimate for the expected real return on the GPFG has been 4 per cent since the introduction in 2001 of the so-called fiscal rule, or handlingsregelen. This law states that spending of revenues from the fund over time will be equal to the fund’s real rate of return.
“Returns are likely to be lower going forward, as assessed by two separate public commissions (the Thøgersen and Mork commissions) and Norges Bank. We must adapt to this fact. We, therefore, propose to adjust the return estimate downwards to 3 per cent,” the statement read.
It also explained the fund’s increased exposure to equities, stating that the expected return on equities “exceeds that of bonds, thus supporting the aim of increasing the fund’s purchasing power”.
“At the same time, equities carry higher risks,” it stated. “The proposal to increase the equity share is based on a comprehensive assessment of the recommendations received.
“All in all, the government considers an equity share of 70 per cent to carry acceptable risk. The downward revision of the return estimate underpins the long investment horizon of the fund, a prerequisite for holding a high share of equities.”
CalSTRS review recommends lower target
US public-sector pension funds grappling with the likelihood of lower investment returns over the next five to 10 years are preparing stakeholders, including fund members, governments – and ultimately, taxpayers – for the possibility of higher contributions to meet pension funding liabilities.
In February, the California State Teachers’ Retirement System (CalSTRS) revealed that it had a less than 50 per cent chance of reaching its 7.5 per cent return target, based on its current strategic asset allocation, capital market assumptions and inflation predicted at 2.75 per cent.
The prospect of the fund missing its target rate of return is included in a paper presented to the board that recommended a reduction in the target rate to 7.25 per cent, to be phased in over two years starting on July 1, 2017.
The recommendation followed CalSTRS’ regular four-year study of actuarial and demographic assumptions used to monitor the system’s funded status – including the returns and contribution rates necessary to ensure the system is fully funded.
The previous study was completed in 2012. The one planned for 2016 was delayed by 12 months to take into account additional data, including updated member mortality information, and stated that while the fund’s strategic asset allocation remains appropriate, it cannot reach the higher target with that allocation nor without taking on greater risk.
Long-term, short-term projections diverge
US-based NASRA’s brief, updated in February this year, states the lower-for-longer investment environment since the global financial crisis (GFC) has affected return assumptions, but funds have more recently faced another issue.
“One challenging facet of setting the investment return assumption that has emerged more recently is a divergence between expected returns over the near term, that is, the next five to 10 years, and over the longer term, that is, 20 to 30 years,” the brief states. “A growing number of investment return projections are concluding that near-term returns will be materially lower than both historical norms and projected returns over longer timeframes.
“Because many near-term projections calculated recently are well below the long-term assumption most plans are using, some plans face the difficult choice of either maintaining a return assumption that is higher than near-term expectations or lowering their return assumption to reflect near-term expectations.”
Targets dropping at public funds
NASRA analysed 127 public pension funds and found that at least 65 of them have reduced target rates of return since 2012. Each of the 65 reduced its targets after applying expected future returns to existing strategic asset allocations, NASRA’s report stated.
“The median return investment assumption was 8 per cent in 2011 and is now [in February, 2017] 7.5 per cent,” the report stated. “The number of plans with an investment return assumption below 7.5 per cent has been steadily increasing since 2009. In that year, only six of these plans had an assumption below 7.5 per cent. Today, 34 of these plans have an assumed investment return of 7.25 per cent or less. Of these 34 plans, 17 have adopted an assumption of 7 per cent or less.”
Just before Christmas last year, the $306 billion California Public Employees Retirement System (CalPERS) board of administration announced a reduction in the discount rate used to calculate future pension liabilities, from 7.5 per cent to 7 per cent, to be phased in over three years starting in 2018-19. It’s not the first time in recent years CalPERS has reduced its discount rate, having cut it from 7.75 per cent to 7.5 per cent in 2012.
The board said it would review the fund’s asset allocation during its next regular asset-liability management cycle, a process that ends in February 2018.