Data & Research March 12, 2014

Institutions Show Positive Outlook for 2014

The expectations of institutional investors are predicted to remain positive during 2014 and beyond, says a new survey.
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The Commonfund Investor Outlook Survey gauged the sentiments of more than 200 respondents, representing a broad range of nonprofit institutional investors and pension funds with combined assets of $163 billion.

Overall, investor expectations for 2014 are reasonably strong with an average forecast for the S&P 500 Index of 6.5% and a median forecast of 7%. This represents a slight decrease from last year’s average forecast of 7.9% and a median forecast of 8%.

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The dispersion of expected annual performance narrowed with 60% of respondents expecting a return of between 5% and 8%. Over a three-year period, performance expectations were slightly lower with an average annual forecast for the S&P 500 Index over the next three years of 6.25%, compared with last year’s 7.1%.

“The data indicates a level of realistic optimism that’s both refreshing and important,” says Verne Sedlacek, president and CEO of Commonfund in Wilton, Connecticut. “Additionally, despite recent discussions surrounding emerging markets, we were pleased to see that investors have a positive viewpoint towards it, in addition to other long-term strategies.”

Investors report overall expectations for annual performance of institutional portfolios as follows:

  • Average 7.3% and a median 7% returns for one year vs. an average 7.6% and a median 7% last year;
  • Average 7.5% and a median 7% returns over three years vs. 7.3% and a median 7% last year; and
  • Average 7.7% and a median 8% returns over five years vs. 7.4% and a median 7% last year.

Survey respondents were asked about tail risks over the next three years. Tail risks are a form of portfolio risk that arises when the possibility that an investment will move more than three standard deviations from the mean is greater than what is shown by a normal distribution. Forty-four percent of respondents say that tail risks are increasing vs. 38% reporting the same last year. On the other hand, 11% on institutional investors say tail risks are decreasing vs. 13% last year, and 45% say they are staying the same vs. 49% last year.

The most significant tail risks reported relative to portfolio performance over the next three years have shifted greatly from a national concern to predominantly international concern. Fifty-eight percent of respondents cited geopolitical crisis as the most significant tail risk. The gridlock in Washington, the number one concern last year, decreased from 62% to 37% this year. Turmoil in the Mideast increased to 55% vs. 46% last year, and a slowdown in China increased from 26% to 46%.

In terms of market and index performance, the survey finds that emerging markets show a tempered level of confidence among investors with 58% of respondents expecting the MSCI Emerging Markets Index to outperform the S&P 500 Index over the next three years, compared with 78% last year. In a big increase from last year, 42% expect the MSCI – ex US (developed equity markets) to outperform, vs. 23% last year.

Twenty-six percent of respondents expect commodities, as measured by the Dow Jones-UBS Commodities Index, to outperform the S&P 500 Index over the next three years, compared with 27% last year. And 29% of respondents expect hedge funds as measured by the HFRI Fund Weighted Composite to outperform, compared with 26% last year.

Sentiment towards bonds had a slight upward shift with 5% of respondents expecting the Barclay’s Aggregate Bond Index to outperform the S&P 500 Index over the next three years, compared with 3% last year. Eight percent of respondents expect high yield bonds as measured by the Merrill Lunch High Yield Bond Index to outperform vs. 7% last year.

With regard to U.S. Treasury yields, the survey finds that expectations for the yield on the 10-year U.S. Treasury note by year-end 2014 reflect a modest increase in interest rates from current levels. With the 10-year U.S. Treasury at 2.8% as of early March 2014, the average and medium expectation from survey respondents see the figure at 3% over the rest of the year.

Approximately 19% expect little change or a slight decline, while more than one-third expect yields to rise to the range of 3.25% to 3.50%. Last year respondents expected the average yield of the 10-year Treasury to be 2.1% by year-end 2013.

As for asset allocations, 13% of respondents indicated they expect to decrease allocations over the next 12 to 18 months in their emerging markets equities compared to only 3% last year. Forty-two percent of respondents expect to increase allocations compared to 55% last year. European equities realized the biggest jump in expected allocations with an increase from 18% in 2013 to 29% this year.

The survey finds that the two greatest areas of concern for institutional investors are market/investment volatility and shortfalls in meeting return objectives. Although down slightly from 56% last year, market volatility was acknowledged as a concern by 54% of respondents this year. Shortfalls in meeting investment return objectives ranked second again this year, but dipped slightly to 42% from 48% last year. Other areas of concern include portfolio liquidity (66% vs. 62% last year) and deflation (64% vs. 76% last year).

The survey also asked respondents whether or not clients are planning to increase their use of fund-of-funds vehicles in their investment strategies. One in four respondents expects to increase their use of private capital fund-of-funds. For both hedge funds and private capital, more than half do not expect a change.

Commonfund is an organization that works to enhance the financial resources of long-term investors including nonprofit institutions, corporate pension plans and family offices through fund management, investment advice and treasury operations.

More information about the survey results can be found here.

The Markets March 11, 2014

PRT Window of Opportunity Is Open

Defined benefit plan sponsors have a window of opportunity to take action on pension risk.
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Pension plans experienced an incredible recovery in 2013 making pension risk transfer more feasible and less costly for plan sponsors. In addition, potential future developments could increase the cost to maintain pension plans as well as the cost to transfer pension liability, meaning plan sponsors would do well to make risk transfer moves now.

There are steps plan sponsors can take to better prepare their plans for pension risk transfer, noted by Chip Conradi, treasurer and vice president of tax at Clorox, who spoke about risk management strategies executed by the company during a webcast sponsored by Mercer.

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A couple of years ago, the company did a total rewards review, and as part of that analysis, decided its pension plan would be frozen. Clorox wanted to reduce the effect of volatility of pension funding on its financial position, so it worked with Mercer on a liability-driven investing (LDI) strategy.

Conradi said Clorox implemented a glide path strategy guided by certain triggers. For example, at 70% funded, the company changed the plan’s asset allocation to hold 45% bonds, 80% funded triggered a move to 50% bonds, another even triggered a move to 55% bonds, and the next trigger is an 85% funded status.

One problem the company had was educating the pension committee, according to Conradi. He explained many committee members didn’t understand why they would move to more bonds in a high interest rate environment. But, the firm educated the committee to change members’ focus from asset performance to managing the gap between assets and liabilities.

“Committee members are familiar with investment success, but what about risk management success?” Conradi queried. By hedging against interest rate movement and removing some equity risk from the plan, the plan’s funded status volatility was reduced from 11% to 6%.

De-risking did not have a significant effect on plan expense, Conradi said. The company has not made any contributions to the plan since the introduction of the glidepath, yet volatility risk is reduced, and funded status has increased.

Gordon Fletcher and Richard McEvoy, Mercer pension risk experts, explained as plans progress down the risk management path, they change the composition of their plan’s hedge portfolio—portfolio of bonds to match liabilities. The hedge portfolio becomes richer as the plan moves along the glide path; it includes a mix of credit and treasuries, and uses duration-matched bonds.

But, LDI strategies are not set and forget, they warned webcast attendees. During market stress, the hedge starts to unravel, bonds can be downgraded and possibly default. The plan’s liability may be unchanged, but assets are hit and it reduces the plan’s funded status. The key is active management of the credit portfolio and active management of the split between credits and treasuries, they said.

Improved funding as a result of LDI strategies enables defined benefit plan sponsors to take a closer look at pension risk transfer. Fletcher and McEvoy explained that a pension buyout currently has a premium of 8% above the plan’s accounting liability, while offering a lump-sum window to certain participants will only cost employers the plan liability for those participants. A lump-sum window for terminated vested participants offers a financially attractive option. However, the cost of maintaining a plan’s liability on the company’s balance sheet has risen, while the cost of transferring to an annuity has decreased, so plan sponsors should consider what is best for their plans.

Plan sponsors should also consider what may be coming down the regulatory pipeline, Geoff Manville, from Mercer’s Washington Resource Group, told webcast attendees.

He said the issue of derisking has become an active discussion in the policy community in Washington, D.C. The Treasury and PBGC have made it clear they have concerns about offering lump sums to those who have already commenced annuity payments. Although they have not stated a public position yet, Manvilled said there’s a chance they will soon. He notes that it will not affect lump sum offers to terminated vested participants not currently taking an annuity; that law is settled.

In addition, Manville noted the Department of Labor is looking at recommendations from the ERISA Advisory Council made late last year (see “ABC Testifies on Pension De-Risking”). Those recommendations include: clarify the “safest available” annuity rule applies to any purchase by a defined benefit plan; more disclosure and a minimum 90-day decision time frame for lump sum windows; clarify consequences of fiduciary breach in selecting an annuity buy-out carrier; and provide education and outreach to plan sponsors.

Manville said no relevant bills have been introduced in Congress, but a coming Government Accountability Office (GAO) report could prompt a legislative response. Finally, he noted that state lawmakers are looking at model legislation that would place costly new requirements on state-regulated insurers providing annuities to qualified defined benefit plans.

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