By: Christopher Rowlins, Partner, Senior Consultant
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After strong performance from the global capital markets, public pension and OPEB plans consequently generated outsized investment returns for the fiscal year ending June 30, 2021.
The median return for public plans within the Wilshire Trust Public Funds Universe was 26.97 percent for the one-year period ending June 30, 2021. These results offer a measure of relief for public plans whose investment returns over the previous three fiscal years ending June 30 have generally not met investment return expectations.
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Financial Markets Surge Higher
Global financial markets surged higher for the one-year period ending June 30, 2021, led by U.S. equities. The breadth of asset class returns ratified the pace of economic momentum with the highest returns sourced from areas of the markets closely aligned with the opening of global economies, particularly the U.S. Federal Reserve monetary policies and fiscal stimulus measures combined with vaccination efforts fostered a “risk on” sentiment during this period.
Most public plans benefited from sizeable allocations to U.S. equities, which continued to outperform international or foreign equities. Throughout this period, fixed income allocations benefited from corporate credit, particularly high-yield fixed income. Portfolios with exposure to real asset strategies also benefited from the rally as REITs and commodity prices advanced sharply on signs the global economy was staging a strong recovery fueled by both business and consumer confidence.
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Use of Indices and Benchmark Return Indices cannot be invested in directly. Index performance is reported gross of fees and expenses and
assumes the reinvest dividends and capital gains. Past performance does not indicate future performance and there is a possibility of a loss.
See disclosures for indices representing each asset class.
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Public Pension and OPEB Plans – What Next?
Following a strong fiscal year for public plans, the first thought for many Plan Sponsors will likely be to expect an increase in their plan’s funded ratio and a reduction in the Actuarially Determined Contribution. However, according to Becky Sielman and Jenn Castelhano, consulting actuaries at Milliman, actuaries are conservative by nature and are always waiting for the next bad thing to happen. Castelhano notes, “in this case, we don’t know if a market correction is right around the corner, so Plan Sponsors should not take it for granted that the current good news will continue indefinitely.”
Castelhano recommends that Plan Sponsors take this opportunity to shore up the actuarial assumptions being used to value plan liabilities, especially the investment return assumption. Many public pension plans are lowering their assumed rate of return even after posting record fiscal year investment returns as forward-looking expectations around economic growth and capital market assumptions are lower than previous years.
While public pension plans, actuaries and investment consultants have been looking to lower the rate of return assumption for the past several years, the recent market gains may provide Plan Sponsors with the opportunity to adjust the expected return assumption to more reasonable, lower levels without straining the municipality’s financial budget or required contributions.
“More holistically, Sielman adds, “if Plan Sponsors haven’t had an experience study performed recently, now would be an appropriate time to do so to ensure the actuarial assumptions are accurate and up-to-date.” Lastly, both Castelhano and Sielman suggest that if Plan Sponsors are not using an asset smoothing method for funding purposes, they should consider employing this method in the immediate future to help minimize the impact of future market fluctuations.
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Beyond the investment portfolio, governmental plans still face many challenges ahead in meeting their future liabilities. According to a recent report from Blackrock, state and local governments incurred large costs to manage the pandemic and keep communities safe, while some simultaneously experienced decreases in tax revenue. Blackrock noted that while “tax revenue shortfalls were not as extreme as many initially predicted, budgets could still be squeezed to a point that will impact future pension contributions.” Meanwhile, according to the Center for Retirement Research at Boston College, there is evidence that the pandemic caused a sharp increase in retirements, potentially increasing the widening gap between benefit payments and contributions. As liabilities continue to grow, it places more pressure on the investment portfolio to deliver.
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Investment Strategies – Flexible Fixed Income and Private Markets
While Federal Reserve policy served to restore liquidity and confidence to markets, a byproduct of its policy is a continued period of ultra-low interest rates. As we previously reported, in a lower-for-longer interest rate environment, yields across the curve for traditional fixed income assets simply cannot be expected to deliver the same level of returns they have in the past. In fact, our 20-year capital market return assumption for core fixed income showed a significant reduction in expected returns from now into the future. With many public pension and OPEB plans holding a meaningful allocation to traditional fixed income strategies, we believe the inclusion of more flexible fixed income strategies can serve to provide a more expansive approach across market sectors, diversifying away from interest rate risk.
Outside of public fixed income and global public equities, opportunities within illiquid private markets, such as private real estate or private equity, continue to be attractive areas to harvest return and provide diversification benefits. Given the long-term characteristics of plan liabilities, it is very likely that many plans will have an ability to allocate a sleeve of the portfolio to private markets.
While the most recent fiscal year investment returns for public plans were welcome news and served to strengthen funded statuses across the municipal landscape, public plans continue to face a host of challenges, including declining payrolls, growing liabilities and future asset allocation decisions. Due to this, it is critical that, in such a rapidly changing environment, Plan Sponsors’ retirement partners work in collaboration to ensure the municipalities’ pension plans are structured to meet the current and future needs of the pensions and their participants.
For more information, please contact any of the professionals at Fiducient Advisors.
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1Virus Did Not Bring Financial Rout That Many States Feared – New York Times, March 2021 2Center for Retirement Research at Boston College – 2021 Update: Public Plan Funding Improves as Workforce Declines
Comparisons to any indices referenced herein are for illustrative purposes only and are not meant to imply that actual returns or volatility will be similar to the indices. Indices cannot be invested in directly. Unmanaged index returns assume reinvestment of any and all distributions and do not reflect our fees or expenses.
High Yield: Bloomberg Barclays US Corporate High Yield Total Return Index Value Unhedged USD, U.S. Large Cap: S&P 500 Total Return Index, U.S. Small Cap: Russell 2000 Total Return Index, World: MSCI ACWI Net Total Return USD Index, International Developed: MSCI EAFE Net Total Return USD Index, Emerging Markets: MSCI Emerging Markets Net Total Return USD Index, U.S. Equity REITs: FTSE Nareit Equity REITs Total Return Index USD.
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This report is intended for the exclusive use of clients or prospective clients of Fiducient Advisors. The information contained herein is intended for the recipient, is confidential and may not be disseminated or distributed to any other person without the prior approval of Fiducient Advisors. Any dissemination or distribution is strictly prohibited. Information has been obtained from a variety of sources believed to be reliable though not independently verified. Any forecasts represent future expectations and actual returns, volatilities and correlations will differ from forecasts. This report does not represent a specific investment recommendation. Please consult with your advisor, attorney and accountant, as appropriate, regarding specific advice. Past performance does not indicate future performance and there is a possibility of a loss.
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