Session i bill clark

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“Investing in the Slow Lane” How Pension Funds Are Adapting to a Low Return, Low Growth World WILLIAM CLARK SENIOR VP AND CIO, FEDERAL RESERVE OFFICE OF EMPLOYEE BENEFITS JULY 18, 2016

Current Plan Funding Levels Have Barely Budged Since the Financial Crisis

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What Happened?

Strong equity returns were mostly offset by • A decline in the liability discount rate • Improvements in mortality rates

Pension Funds are Grudgingly Accepting We’re in a Low-return World

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My (Consensus) Views on the Current Investment Landscape

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Based on an objective view of valuation metrics, virtually all asset classes appear: 

Future returns on bonds and stocks will not match recent history (i.e., last 30 years)



Fully-valued to rich relative to history, but



Cheap to fairly-valued relative to sovereign debt

Consensus View: Future Returns Won’t Match the Past 30 Years

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6 US Equity Valuations Are Rich Relative to History, …

S&P 500 Valuation Metric

Current Index

Historical Percentile (Since 1976)

Median Stock

Historical Percentile (Since 1976)

EV/Sales

2.0

92

2,4

99

EV/EBITDA

10.9

86

11.2

99

Forward PE

16.8

86

17.6

96

Price/Book

2.8

66

2.9

83

PE/Growth

1.4x

88

1.8x

100

CAPE

22.3

73

NA

NA

Median Metric

86

99

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… but, Equity Risk Premia Look Attractive

Spread (bp) Yield to Worst (%) 1/1/2016

7/1/2015

Yield to Worst OAS

2/1/2016

9/1/2015

4/1/2015

11/1/2014

6/1/2014

1/1/2014

8/1/2013

3/1/2013

10/1/2012

5/1/2012

12/1/2011

7/1/2011

0 2/1/2011

1

9/1/2010

100

4/1/2010

3

6/1/2009

200

11/1/2009

4

1/1/2009

5

8/1/2008

300

3/1/2008

7

10/1/2007

YTW and OAS on Barclays Credit Index

5/1/2007

9

12/1/2006

400

%e

500

YTW (%)

600

7/1/2006

Axis Title 1/1/2015

7/1/2014

1/1/2014

7/1/2013

1/1/2013

7/1/2012

1/1/2012

7/1/2011

1/1/2011

7/1/2010

1/1/2010

7/1/2009

1/1/2009

7/1/2008

1/1/2008

7/1/2007

1/1/2007

7/1/2006

OAS (bp)

All-in Yields on Both IG and HY Debt Look Expensive Relative to History, But Spreads Seem Reasonable 8

YTW and OAS of Barclays High Yield Index

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8 20

6 15

10

2 5

0 0

Cap Rates for Commercial Real Estate Look Expensive Relative to History‌

9

10

‌but, Fairly Valued Relative to IG Debt

Implications: Pension Funds Must Dial Up Their Risk Level if They Wish to Meet Their Return Bogeys

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and/or…They Must Fund Their Pension Plans More Aggressively

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Percent of salary while active needed to fund a typical pension benefit for 35 year old* new hire for various realized investment returns ANNUAL INVESTMENT RETURN

% OF SALARY NEEDED TO FUND PROJECTED PENSION BENEFITS

10%

3.08%

9%

4.13%

8%

5.56%

7%

7.53%

6%

10.24%

5%

14.01%

0%

74.70%

*ASSUMES STARTING SALARY OF $75,000, 4% ANNUAL SALARY GROWTH, AND EMPLOYEE RETIRES AT AGE 60.

The same holds true for individuals in their 401(k) plans. Query: Are we living out the paradox of thrift?

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Pension Funds Are Responding to This Environment by Adopting a Range of Seemingly Contradictory Policies

Aggressive

Conservative



Increasing allocations to alternative asset classes (private equity, real estate, hedge funds)



Increased use of lower-cost passive (indexed) strategies for public markets exposures



Attempting to capture a perceived illiquidity premium



Focus on lower-risk equity strategies (i.e., “smart beta”) – primarily dividend and dividend growth strategies



Adopting policies



Development of transfer” market

“dynamic a

de-risking” “pension

risk

Pension Funds Are Pursuing the “Endowment Model” for Large Portions of Their Portfolios…

Although there is now some pushback against hedge funds allocations, primarily over misalignment of fee structures

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Private Equity in Particular Has Generated Significant Excess Returns Over Public Equity

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Question: Can it continue to deliver these returns given the tremendous growth in AUM?

Theory: Alternative Managers Can Utilize Multiple Factors to Generate Excess Returns

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Example: Excess Yield on DirectlyOriginated Loans Appears Attractive Illiquidity Premium on Direct Loans 14 12 10 8 6 4 2 0

2007

2008

2009

2010

2011

2012

Yield on Originated Senior Term Debt

2013

2014

Yield on Traded Loans

2015

Q1 2016

Supply-Demand at Work: Are Institutional Investors Filling a Void?

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We’re Seeing a Massive Shift From Active to Passive Management, Particularly In Public Equities

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While Vanguard Had Record Inflows in 2015, the Rest of the Industry Had Net Outflows of $85B!

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Pension Funds Are Seeking Higher Income From Their Public Equity Portfolios; Fund Flows Are Driving Relative Performance at the “Factor” Level YTD Returns Through June 30, 2016 Dividend Aristocrat/ Growth Index

Regular Index

S&P 500

11.6%

4.1%

S&P 400

18.7%

8.2%

Russell 2000

17.4%

2.7%

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Dichotomy of Views: Asset Allocators Want Income, While “Stockpickers” Want Higher Capex Companies Appear to be Responding to Investor Appetite

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Most Recent BAML Fund Manager Survey

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Many Corporate DB Plans Have Adopted “Dynamic Derisking� Policies An Illustration of a Dynamic De-Risking Deliverable

70% 60% 50% 40% 30%

Terminal Portfolio Consumption

Rebalancing boundaries

E

20% 50% 10%

Target risk allocation

D

70%

90%

110%

A Accounting Proxy Measure of Funded Status

B

Funded status target

0%

C 50%

Source: NISA Investment Advisors

70%

90%

110%

AA Accounting Proxy Measure of Funded Status

Implication: The back end of the yield curve will be well-bid for years.

Finally, a “Risk Transfer� Market for DB Plans is Developing in the US

Why?: To avoid rising PBGC premiums and balance sheet/income statement volatility

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Conclusions and Insights

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

If one accepts that we are in a low-return world, we all need to save more (“Paradox of Thrift”)



By being a liquidity provider, institutions are becoming more integral to the integrity of the financial system; systemic implications?



Flows into passive strategies make it even more difficult for active managers to outperform; is this a self-fulfilling prophecy?; are alternative investment managers now integral to ensure market efficiency?



Investors’ appetite for income may be driving companies to return greater levels of capital (dividends, buybacks) to shareholders at the expense of capex



De-risking activities by pensions (particularly corporates) will cause the yield curve to be flatter than would otherwise be the case for years to come