Historic down year puts retirement plans on notice

U.S. retirement plans could not escape historically negative equity and fixed-income markets during the year ended Sept. 30 and posted the highest-percentage asset losses in nearly half a century of Pensions & Investments' annual surveys.

In the year ended Sept. 30, the 1,000 largest U.S. retirement funds saw their assets plummet to $12.16 trillion, a record-setting 13.9% loss from a year earlier when the universe had reached an all-time high of $14.13 trillion.

That previous high was the result of a banner year of spectacularly strong returns in public and private equity and other alternative investment strategies, along with higher contributions to defined benefit and defined contribution plans.

The most recent year, however, represented nearly a direct opposite of the prior year's euphoria, with every public equity and fixed- income asset class seeing significant losses. Perhaps most remarkably, defined contribution plan assets fell 14.5% to $4.73 trillion vs. the 13.6% decline of defined benefit plan assets to $7.43 trillion, a stark reversal of a decadeslong trend that has seen DC plans outpace DB growth in part due to 401(k)s emerging as the primary corporate retirement plan.

For the year ended Sept. 30, the Russell 3000 index and Bloomberg U.S. Aggregate Bond index returned -17.6% and -14.6%, respectively."We think a lot of returns were pulled forward in 2020 and 2021, just given the extraordinary stimulus that was put into the economy" as a result of the COVID-19 pandemic, said Jeffrey MacLean, CEO of Verus Advisory Inc., El Segundo, Calif.

"So, you know the fallout from that is that the returns had to come from some years, and obviously 2022 got hit pretty hard. At a higher level, our markets have been experiencing lower and lower interest rates gradually for decades, and that regime changed very abruptly in 2022 when the Fed had no choice but to respond to inflationary pressures throughout the economy," Mr. MacLean said.

"Certainly (there were) the supply chain disruptions of COVID, but also the sheer volume of money that was printed and is now circulating throughout the economy has caused inflation to be higher than it's been in really over 30 years," he said.

Among the defined benefit plans within the 200 largest U.S. plan sponsors, the change in average asset mix reflected the difficult market return environment, with average allocations to domestic fixed income falling to 21% as of Sept. 30 from 22.8% a year earlier, domestic equity to 20.3% from 21.9% and international equity falling to 12.2% from 14.5%.

"We saw a correlation between equity and fixed-income returns that we haven't seen in a very long time," said Jonathan Pliner, a New York-based senior director and U.S. head of delegated portfolio management at Willis Towers Watson PLC. "There were very few places for plan sponsors to hide purely from an asset perspective."

"We certainly still think there's a fair amount of uncertainty from where we sit today,'' he said. "There's a lot of different plausible scenarios that could play out from a market and economic standpoint, so we think there may be a lot of market participants that are anticipating a recession."

But Mr. Pliner said there's also a reasonable probability of a soft landing. From the company's perspective, diversification will continue to be key in looking for assets that are driven by different return drivers. Finding areas beyond traditional equities and fixed income where clients can get a different return stream is as important today as it's ever been, he added.

Public defined benefit funds in particular have moved more and more toward alternatives for years. While the average allocations to public markets dropped among the top 200 DB plans, the average asset allocation to private equity increased to 15.2% as of Sept. 30, up from 12.8% a year earlier, real estate equity rose to 11.8% from 8% and the general alternative investments category rose to 10.2% from 8.3%.

Christopher Ailman, chief investment officer of the California State Teachers' Retirement System, West Sacramento, said in a phone interview that any form of diversification beyond the core investment areas of public equities and public fixed income helped institutional investors.

CalSTRS once again ranked third among all U.S. retirement plans, reporting $290.4 billion in assets as of Sept. 30, down 7.5% from a year earlier. It is the second-largest defined benefit plan at $288.6 billion.

The plan benefited primarily from a defensive posture, particularly in the first half of the year, Mr. Ailman said.

"We've been very low in fixed income," Mr. Ailman said. "We've used other investments to help diversify away from the growth characteristics of stocks and that diversification paid off for us."

As of Sept. 30, CalSTRS' allocation to fixed income was only 14.3%, while allocations to equity real estate, private equity and other alternatives were 17.9%, 17.2% and 12.9%, respectively. That 48% in alternatives was up from 36.1% the year before.

Mr. Ailman said CalSTRS also benefited from the lag in alternative investment reporting, particularly in real estate, which produced double-digit returns for the pension fund.

"I think any time you have such an aberrant year compared to the past decades, you've got to look at the year in context to the time frame, and it's all about the pandemic," Mr. Ailman said.

"It's not as easy to restart the global economy apparently as it is to shut it down. It's sort of understandable in such an unusual environment, and we're technically not out of it. The pandemic changed so much globally."

Another public pension fund that benefited from exposure to alternatives was the Missouri Public School and Education Employee Retirement Systems, which reported $51.2 billion in assets — all defined benefit — as of Sept. 30, down 10.3% from $57 billion a year earlier.

Craig Husting, chief investment officer of the Jefferson City-based pension funds, said in an email that the systems' investment staff began building their alternative investment portfolios in 2003 in order to provide diversification from stocks and bonds and take advantage of market inefficiencies.

The pension funds, which share a common investment trust, returned a net -7.4% for the year ended Sept. 30, ahead of equity and fixed-income indexes primarily because of its relatively mature alternative portfolios, said Mr. Husting, who has overseen the investment management of PSRS/PEERS since January 1999.

"We did not necessarily anticipate the market downturn," Mr. Husting said. "However, we have maintained an investment belief that the best long-term risk-adjusted returns can be achieved by investing in the broadest opportunity set possible. As such, the PSRS/PEERS asset allocation is balanced with a significant distribution to return-seeking assets such as stocks and private equity but also a healthy allocation to more defensive investments such as Treasury securities, cash and hedged assets. Our goal is to maintain a structured portfolio that has an opportunity to participate if the markets move higher, but also has substantial downside protection in the event of a market correction (similar to the most recent year)."

The system's target allocation is 24% domestic equities, 18% each private equity and U.S. Treasuries, 16% international equities, 11% private real estate, 6% hedged assets, 4% private credit and 3% credit bonds.

Also among the top 200 U.S. retirement plans, the Arizona Public Safety Personnel Retirement System, Phoenix, was a notable outlier, reporting a 13.3% increase in assets in the year ended Sept. 30 to $18.3 billion. The pension fund vaulted to 134th from 175th among all U.S. retirement plans and was one of only six plans to see increases in asset size for the year, but it was the only plan to see an increase above 3%.

The system, which collects the assets of over 200 municipal, county and state police and fire pension funds, has seen outsize contributions from those employers.

"We were well-positioned for the volatility and kept our cash on the sidelines in order to consider opportunistic deployment of investments," said Michael Townsend, administrator, in an email.

However, the real story was a movement by state and local governments to increase their contributions to the system. "We spent years talking about how pension funding works to build trust in our management and the state and local governments responded by paying down billions of dollars of unfunded pension liabilities," he said.

When breaking down the average asset mix of the top 200 plans between public and corporate plans, public plans had an average allocation of 20.8% to total fixed income, while corporate plans had an average allocation of 44.7% to total fixed income.

Corporate DB plans have moved more and more toward fixed income in the past two decades as more companies have closed and then frozen their DB plans.

For the first time in the history of the Pensions & Investments survey, the list of the top 10 U.S. retirement plans does not include a single corporate plan. P&I's survey report originally included only corporate plans from 1974 to 1979, adding public retirement plans in 1979.

As recently as 10 years ago, the top 10 plans included three corporations: General Motors Co., Detroit, was ranked seventh with $117.8 billion in U.S. retirement plan assets; International Business Machines Corp., Armonk, N.Y., ranked ninth at $94 billion; and Boeing Co., Chicago, ranked 10th at $91.4 billion. As of Sept. 30, P&I data show the three companies had $76.7 billion, $75.7 billion and an estimated $117.6 billion, respectively. Boeing dropped to the 12th ranked plan this year.

For the most recent survey, GM and IBM are now ranked a respective 28th and 29th among the largest retirement plans. Not coincidentally, the two firms are ranked first and second, respectively, among the largest pension risk transfer transactions of the past decade, another trend among corporate plans that has lowered assets over the years.

In the fall of 2012, GM purchased a group annuity contract from Prudential Insurance Co. of America to transfer $29 billion in U.S. DB plan assets to the insurer, and in September of this past year, IBM purchased a similar contract from Prudential to transfer a total of $16 billion.

As a result of that transfer of assets during a single year of poor market returns, IBM's total retirement plan assets dropped 34.4% from $115.4 billion in assets as of Sept. 30, 2021.

Michael Moran, New York-based senior pension strategist for Goldman Sachs Asset Management, said that even though overall corporate retirement plan assets dropped during the year ended Sept. 30, the plans themselves are actually healthier than ever.

"From a corporate DB perspective, things have really never been this good since the financial crisis, and that comes down to higher interest rates," Mr. Moran said.

The Federal Open Market Committee has raised rates eight times since the beginning of 2022, most recently raising the federal funds rate by 25 basis points to a range of 4.5% to 4.75% on Feb. 1.

"Yes, we have seen the size of these plans shrink pretty dramatically because of those equity and fixed-income returns last year, but those liabilities have come down even more," Mr. Moran said.

Higher rates mean lower liabilities, and despite the challenging return environment, most estimates show corporate funding ratios stayed at or above 100%. One report from MetLife Investment Management said the estimated average funding ratio of companies in the Russell 3000 that sponsor defined benefit plans was 100.7% as of Sept. 30.

Another positive note among retirement plans was that the strong returns of past years helped ease the pain of this past year.

While the year ended Sept. 30 saw a steep decline in assets, it did not erase the gains of the past five years. The assets of the top 1,000 plans have still increased 17.5% over the five years ended Sept. 30, compared with a 50.6% increase over the five years ended Sept. 30, 2021.

The cutoff to make the largest 200 plans was $11.9 billion as of Sept. 30, more than $2 billion from the prior year.