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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
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‌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