Inflation, war, rising interest rates posed steep challenges for investors in 2022

An inflationary environment that is anything but transitory, the volatility arising from Russia's invasion of Ukraine and other geopolitical crises, and a bevy of controversies surrounding ESG investing dominated headlines this year, while the fall of Allianz Global Investors and an exceptionally busy regulatory year were also among Pensions & Investments' top 10 stories of 2022.

The top story this year — chosen by P&I's editors — was inflation and the Federal Reserve's aggressive actions to curb it through multiple interest rate hikes. After more than a decade of near-zero interest rates, the Federal Open Market Committee's moves sparked a web of economic chain reactions that hit institutional investors' portfolios hard — the full impact of which have yet to be seen. Other big stories of the year included the U.K. gilt crisis and the impact of a cryptocurrency meltdown, including efforts to regulate it.

When rising inflation emerged in 2021, spurred in part by supply chain issues, observers in the institutional investing industry questioned whether inflation was a long-term issue or a transitory effect of the gradual reopening of the economy during the second year of the COVID-19 pandemic. That question was decidedly answered by the Federal Reserve in 2022, whose fight against inflation that defined the year in investing reached its end point on Dec. 14 when the it raised the federal funds rate to a range of 4.25% to 4.5%. It was the Federal Open Market Committee's seventh time raising rates in as many meetings after 75-basis-point increases in June, July, September and November, a 50-basis-point increase in May and a 25-basis-point increase in March.

While Bureau of Labor Statistics data show the consumer price index rose 7.1% in November from a year earlier, the smallest 12-month increase since December 2021 and below expectations, Fed Chairman Jerome H. Powell in a Dec. 14 press conference cautioned that "it will take substantially more evidence to give confidence that inflation is on a sustained downward path."

The final CPI results, followed by a more moderate rate hike, may have provided investors with some solace to close out a challenging year. However, the double whammy of inflation in tandem with rate hikes to quell its impact proved during the year that there was nowhere to hide as both equity and fixed-income returns suffered.

The first half of 2022 was particularly brutal and negatively affected both public pension funds and university endowments, many of which recognize a fiscal year-end of June 30. For that period, the 85 public pension funds and 46 endowments tracked by P&I had median returns of -4.9% and -4.1%, respectively.

While the first half of the year was marked by the worst equity and bond markets in well over a decade, the remainder of the year saw significant market volatility reflected by multiple rebounds and declines. Many investors anticipate some level of recession in 2023.

The second top story of 2022 was geopolitical concerns, both from Russia's invasion of Ukraine and China's continuing faltering economy that has been significantly impacted by COVID-19 lockdowns. Both before and after Russia's Feb. 24 invasion of Ukraine, officials in the U.S., U.K. and Europe imposed sanctions, which included the White House's action against Sberbank — Russia's largest lender — and four other financial institutions that represented an estimated $1 trillion in assets, along with a bevy of Russian elites and their family members. The largest U.S. pension funds and other institutional investors just as quickly announced moves to divest from Russian investments. Institutions' allocations to Russian investments were already low. For example, at the time of the invasion, CalPERS and CalSTRS, the nation's two largest defined benefit plans with combined assets of well over $700 billion, had less than a combined $1 billion in Russian exposure. Still, the rapidity of the actions by dozens of asset owners was notable. Other actions included benchmark index providers MSCI Inc. and FTSE Russell dropping Russian stocks from their equity indexes early in March, and FTSE Russell cutting out Russian bonds shortly thereafter. And during a grim year in the markets, conventional oil and gas investments made somewhat of a temporary comeback due to supply constraints resulting from Russia's invasion of Ukraine and subsequent sanctions.

Also during 2022, China's zero-COVID-19 policies and property market woes weighed on consumer sentiment, clouding what could otherwise be a rosy outlook for Chinese equities as Beijing works to steady an economy hobbled by last year's broad regulatory reset. Beset by pressure both by internal strife and global pressure, China's easing of the COVID policies could position the nation for growth in 2023.

The third top story of the year was the growing politicization of environmental, social and governance investing, and the emergence of BlackRock as its public face, capped by several state Republican lawmakers touting terminations of the world's largest money manager from asset pools even as they retained full stables of other managers that had long-established policies of integrating ESG factors into their investment processes. Among the most visible anti-ESG figures that emerged in 2022 is Florida Gov. Ron DeSantis, seen by many as a potential presidential candidate in 2024 and one of three trustees of the $230.3 billion Florida State Board of Administration, Tallahassee. He and the other trustees, Chief Financial Officer Jimmy Patronis and Attorney General Ashley Moody, passed a resolution in August prohibiting the board from including ESG considerations in the investment management of the Florida Retirement System, which the board oversees.

His fellow trustee Mr. Patronis went even further on Dec. 1 when he announced the state's Treasury department was terminating BlackRock from the management of $2 billion in the state's long-duration portfolio and its short-term investment fund. Neither fixed-income portfolio includes ESG considerations.

However, Florida was far from alone in publicly decrying BlackRock and its CEO Laurence D. Fink for their ESG-related efforts. Elected Republican officials in Arizona, Kentucky, Missouri, North Carolina and Texas have either terminated BlackRock from asset pools they oversee or joined calls to terminate the manager from public pension funds.

Public pension fund trustees, however, have proved resistant to the officials' calls. David Adkins, trustee with the board of the Kentucky Retirement Systems, Frankfort, and executive director/CEO of the Council of State Governments, said at a Dec. 1 board meeting that "it is clear like critical race theory that ESG is now the flavor of the month for being a punching bag in the culture wars, and we don't have to accept that framing of the issue. ESG is not the enemy. It is not the devil waiting behind the corner. It is an attempt to say that investing decisions and bottom-line definitions of returns can consider something more than just dollars on a spreadsheet."

While some Republican leaders decried BlackRock's ESG efforts as too much, their Democratic counterparts criticized the manager for not doing enough. In a September letter to Mr. Fink, New York City Comptroller Brad Lander, the fiduciary for the $228.2 billion New York City Retirement Systems, said BlackRock was abdicating responsibility because it told the attorneys generals that it does not ask companies to set specific emissions targets, and it continues to invest in fossil fuels without specific net-zero targets or commitments.

For its part, BlackRock has maintained in statements throughout the year that it maintains over $200 billion globally in fossil-fuel companies and also remains committed to its net-zero pledge and decarbonizing goals.

Just over two years after its Structured Alpha strategies suffered catastrophic losses for its pension fund clients, Allianz Global Investors was forced to abandon the U.S. market after an SEC investigation discovered what the agency called a "massive fraudulent scheme" perpetuated by the strategy's three portfolio managers. The Allianz SE money management subsidiary pled guilty to the charges and agreed to sell most of its U.S. business to Voya Financial after its plea activated an automatic 10-year disqualification from providing investment advisory services for U.S.-registered funds.

AllianzGI also agreed to pay more than $1 billion to settle the SEC charges and over $5 billion in restitution to investors who lost a total of $7 billion due to the collapse of Structured Alpha.

Arthur G. Jakoby, New York-based partner and co-chairman, securities litigation and enforcement at law firm Herrick, Feinstein LLP and a former SEC prosecutor, said in a phone interview in May that the magnitude of the restitution was unprecedented. A 71.4% recovery, when investors usually get 50 cents on the dollar back in such cases, represented an "incredible result" for the SEC.

The primary object of the SEC's ire was Gregoire P. Tournant, AllianzGI's lead portfolio manager for its Structured Alpha strategies, who the agency said consistently misled investors about the strategies' downside risk by lying about the stress tests he conducted.

Mr. Tournant surrendered to authorities from his home in Colorado and now faces a federal trial. His two top portfolio managers, Stephen G. Bond-Nelson and Trevor L. Taylor, pleaded guilty and cooperated with authorities' investigations.

A package of bills known as SECURE 2.0 is the fifth top story of 2022. After years of negotiation, lawmakers unveiled a retirement security package on Dec. 20 as part of a $1.7 trillion omnibus spending bill. The ominbus bill passed both chambers a few days later, preventing a government shutdown.

The retirement package, referred to as SECURE 2.0, includes several provisions, such as expanding automatic enrollment in new 401(k) and 403(b) plans, enhancing the tax credit for small businesses launching a retirement plan and allowing employers to make matching contributions to a 401(k) plan, 403(b) plan or SIMPLE IRA based on qualified student loan payments.

The package combined three bipartisan bills from both the House and Senate, including the Retirement Improvement and Savings Enhancement to Supplement Healthy Investments for the Nest Egg Act, or RISE & SHINE Act, which advanced out of the Senate Health, Education, Labor and Pensions Committee in June.

SECURE 2.0 builds on the original SECURE Act, which Congress passed in 2019.

The sixth top story of 2022 was a series of contentious battles against investment-related regulation. After nearly a year in office, the Biden administration ramped up the aggressiveness with which his agencies made regulatory decisions in line with policy. In March, the SEC unveiled a proposal for a rule that would require public companies to disclose climate-related information, including the oversight and governance of climate-related risks by boards and management, and how any identified climate-related risks have affected or are likely to affect strategy, business model and outlook, among other requirements. The proposal seemed to be another salvo in the escalating war regarding ESG, reaching its peak in December when two House Republicans introduced a bill that would limit the SEC's ability to establish additional disclosure requirements on public companies.

Another potential blow to the SEC's authority may be pending as well. In November, the U.S. Supreme Court heard arguments in a case that could allow companies and people facing SEC charges to challenge the agency's constitutional authority in U.S. District Court before the SEC settles the matter in-house.

While the court has yet to make a decision on the administrative law judge case and the SEC's rule-making authority, a June 30 Supreme Court decision may also affect the Department of Labor's own rule-making authority. That decision in favor of West Virginia in the state's lawsuit against the Environmental Protection Agency regarding that agency's regulatory authority could affect the DOL, some ERISA attorneys agreed.

The court's 6-3 ruling appears to limit the EPA's ability to regulate the emissions of greenhouse gases to individual power plants rather than more ambitious efforts such as cap-and-trade systems, in which carbon emissions are given a price that would motivate them to invest in cleaner technologies.

The lawsuit had challenged the level of the EPA's authority to regulate carbon emissions from power plants under the Clean Air Act.

One attorney cited the DOL's issuance earlier this year of Compliance Assistance Release 2022-01, a document for 401(k) plan fiduciaries telling them to "exercise extreme care" before selecting cryptocurrency as an investment option in plan menus.

ForUsAll Inc., a 401(k) plan administrator that offers cryptocurrency to participants through a self-directed brokerage window, filed a lawsuit on June 2 against the DOL seeking to vacate that guidance.

"For example, one argument made in that complaint is that the DOL singled out one asset class for special negative treatment even though the Employee Retirement (Income) Security Act doesn't give the DOL authority to do that. That argument seems stronger today," said Carol Buckmann, a partner at law firm Cohen & Buckmann PC, in an email after the EPA ruling was announced.

Other regulatory actions during a busy year included the DOL in November finalizing a rule to explicitly permit retirement plan fiduciaries to consider climate change and other ESG factors when selecting investments and exercising shareholder rights, and also in November proposing a rule to expand its Voluntary Fiduciary Correction Program that allows ERISA-covered plan sponsors to self-correct errors they make after failing to send employee contributions or participant loan repayments to retirement plans in a timely manner. Also, in August, the SEC finalized a rule requiring companies to disclose information reflecting the relationship between executive compensation and financial performance, and in December, approved a host of trading and best execution rules.

The seventh top story was a rude awakening coming for investors in light of a quarter lag muddying the pictures of fiscal-year returns. While public pension funds and university endowments largely posted negative returns for the year ended June 30, their results fell well above the index returns for public equities and fixed income, thanks in large part to alternative investment returns. However, because most investors report those returns as of a quarter earlier than the rest of the portfolio, industry experts anticipate the actual June 30 data and beyond to reflect significant write-downs across private markets.

Allan Emkin, San Diego-based managing principal of Meketa Investment Group, told CalSTRS' investment committee on Aug. 31 that in the next nine to 12 months, there will be write-downs in private market assets to reflect what has happened in the public markets "because they are not immune to what happens in the general economy or to the capital markets at large, and that has not yet been reflected in the portfolio," he said.

The $297.6 billion California State Teachers' Retirement System, West Sacramento, had a combined allocation of 37.4% to private equity, real estate and inflation sensitive assets. CalSTRS earned a net -1.3% for the fiscal year ended June 30, outperforming its -2.2% benchmark, with the quarter lag numbers.

Other asset owners with similarly large allocations to alternatives are also waiting for the other shoe to drop.

For example, real estate investors expect total returns to plunge to 4.4% in 2023 from an estimated 8.8% in 2022, according to the Pension Real Estate Association's third-quarter consensus forecast survey of the U.S. commercial real estate market released in September. The appreciation return of the NCREIF Property Index, reflecting property values, is expected to drop to 0.1% in 2023 from 4.7% in 2022.

The eighth top story was the U.K. pension fund liquidity crisis triggered by a government budget proposal from former Prime Minister Liz Truss and her chancellor Kwasi Kwarteng on Sept. 23 that included unfunded tax cuts and an energy price cap. The proposal led to a nosedive of gilt prices and huge collateral calls on liability-driven investing programs using derivatives to hedge interest-rate exposures. That nosedive led to a Sept. 28 action by the Bank of England to introduce a £65 billion ($80 billion) long-dated gilts emergency purchase program to enable LDI funds to address risks to their resilience from volatility.

Between Sept. 28 and Oct. 14, the Bank of England bought government bonds worth £19.3 billion, including £12.1 billion of long-dated conventional gilts and £7.2 billion of index-linked gilts. The central bank unwound the purchase program at the end of November, but the ripple effects of the emergency continue to be felt.

Calum Mackenzie, Edinburgh-based investment partner at Aon PLC, said in an October interview that "for many pension funds, when they make it through this very volatile period, they're likely to see very significant increases in funding positions and won't need as much risk — albeit with a smaller asset pool and much smaller liability pool. Definite asset allocation changes are going to be needed, and the rebuilding of their portfolios."

In a December report, the Bank of England's financial policy committee urged domestic and international financial watchdogs to take regulatory action to strengthen the resilience of LDI arrangements.

U.S. pension funds use a corporate bond discount curve to discount liabilities, as opposed to interest rates, so the LDI strategies they utilize direct them toward corporate bonds rather than government bonds, leading observers to say a similar crisis in the U.S. is unlikely.

A growing call for cryptocurrency regulation coupled with the crashes of major crypto firms FTX and BlockFi marked 2022. Since the creation of bitcoin in 2009, institutional investors have been slow to embrace cryptocurrency as legislators and governmental regulatory bodies had yet to place any kind of regulations around the growing market. However, after thousands of other cryptocurrencies have entered the marketplace over the past decade, growing interest and scrutiny resulted in desires to create some kind of framework.

Throughout 2022, both Congress and the SEC took a series of steps to address what Sen. John Boozman, R-Ark., has termed a "Wild West" industry. Mr. Boozman, ranking member of the Senate Agriculture Committee, introduced the bipartisan Digital Commodities Consumer Protection Act of 2022 in August with three fellow committee members, which gives the Commodity Futures Trading Commission the authority to regulate digital assets that act as commodities. While CFTC Chairman Rostin Behnam expressed support for the bill on Sept. 15, SEC Chairman Gary Gensler told the Senate Banking Committee that same day that crypto should fall under his agency's jurisdiction.

The SEC, for its part, announced in May it would nearly double the size of its newly renamed crypto assets and cyber unit to 50 dedicated positions from 30 roles. The unit is tasked with protecting crypto investors from cyber-related threats. That was followed in September by the creation of the new Office of Crypto Assets to review filings that involved the assets.

The cries for regulation only increased following the November filings for bankruptcy by crypto exchange FTX and crypto lender BlockFi. Sen. Sherrod Brown, D-Ohio, chairman of the Senate Banking Committee and a member of Senate Agriculture Committee, said in an emailed statement in November that his focus "has always been on the fraud, scams, volatility and outright theft in the crypto industry."

The 10th top story of the year were high-profile changes at major asset owners. In March, Nicole Musicco, a partner at New York-based private equity shop RedBird Capital Partners, became CalPERS' newest CIO. Before joining RedBird, Ms. Musicco spent a year as senior managing director, head of private markets at the C$73.7 billion ($57.9 billion) Investment Management Corp. of Ontario and spent 16 years with the C$227.7 billion Ontario Teachers' Pension Plan, leading both the private equity and public equity investment teams.

Ms. Musicco said in a February interview she was hired by IMCO for her direct investing skills, spending "the vast majority of my time building teams in private equity, infrastructure and real estate."

Ms. Musicco's experience in those asset classes may be reflected in CalPERS' investment committee on Nov. 14 changing its investment policy regarding staff investing in private assets, including an increase in the amount certain staff members can invest without board approval.

While CalPERS has given more authority to investment staff, another asset owner has chosen to address its investment management needs by quickly dispensing with its staff entirely.

David J. Holmgren, chief investment officer of Hartford HealthCare's $4.3 billion in pension and endowment assets, and his entire investment staff were removed from their positions on Sept. 20 without warning when the health-care company's board of directors announced they had hired Morgan Stanley as an OCIO manager.

Observers saw the move as puzzling considering Mr. Holmgren's team had produced outsized returns over the years, including producing a 1.1% gain in the three months ended March 31 while the policy target was down 3.8%.

Five of the seven people serving on the corporation's investment committee resigned after the Sept. 20 board meeting. Among them was David M. Roth, chairman of the Hartford HealthCare investment committee.

Also departing the industry after a 32-year-long career was Mansco Perry III, who retired in October as executive director and CIO of the $124.7 billion Minnesota State Board of Investment, St. Paul. In an October interview, Mr. Perry said as the pension fund investment management industry moves forward, the way portfolios are managed "will become increasingly important because of the challenges CIOs and their investment staff face given predictions of turbulent markets and lower returns." Mr. Perry was succeeded by Jill E. Schurtz.