Just as inflation, central bank pivots and a challenging investment environment monopolized conversations in 2022, it follows that those three dominant themes would wreak havoc on retirement plan returns across the globe.
Estimated investment returns for the seven largest retirement markets — Australia, Canada, Japan, the Netherlands, Switzerland, the U.K. and the U.S. — ranged from -4.8% in Australia to -22.3% in the Netherlands.
While retirement plans struggled with volatile asset class performances, inflation ate away at returns and interest-rate increases hit fixed-income markets in particular, funding ratios largely held out for defined benefit plans. U.K. pension funds also weathered their own gilts-related liquidity crisis, with leveraged liability-driven investment funds left scrambling for cash to post as collateral against derivatives positions.
However, another theme running through many retirement plans was the positive impact that rising interest rates have on pension plan funding — with liabilities largely falling at a greater rate than assets, resulting in improved funding ratios.
Pensions & Investments looked at the seven largest retirement markets and aggregate estimated investment returns across corporate pension funds, unless noted. Total assets by market and comparisons to Dec. 31, 2021, are in dollar terms, and are according to the Thinking Ahead Institute’s Global Pension Assets Study 2023.
U.S. corporate plans recorded an estimated -19% investment return, while public plan returns were an estimated -17%, said Steve Foresti, senior adviser, investments at Wilshire Advisors LLC in Santa Monica, Calif. That compares with an estimated 7% return for corporate plans and about 18% return for public funds in 2021.
“Whether corporate or public DB in the U.S., they both invested into the same market headwinds — but the balance sheet realization of the environment is completely different, just because of the accounting across the two plans,” he said.
For statewide systems, where liabilities are valued using a fixed assumed rate of return, funding ratios fell to about 70%, from about 86% in December 2021.
Corporate plans — where liabilities dropped as interest rates rose — ended 2022 at about 97% funded, vs. about 96% a year previous.
Similar to concerns for the U.K. outlook, Mr. Foresti said, “Markets seem to be pricing inflation as if this is a problem that’s been addressed (in the U.S.), and behind us, and that the inflation rate will very quickly come down to the Fed’s target rate or comfort level and then stay there.” But he’s not convinced the problem goes away in the next couple of quarters.
While fighting inflation of up to 9% probably won’t be the issue, getting it down to 4% or 5% “is probably the easier part” of the battle, he said. “Getting it down to the target rate is probably a bit more of a choppy pursuit,” leading to volatility.
Identifying portfolio vulnerabilities to inflation, for example, will be a theme for 2023, he added.
While Japanese pension funds were hit — just like other markets — by the Federal Reserve’s interest-rate hikes, the depreciation of the country’s currency “eased the damage” on asset returns a little, said Konosuke Kita, Tokyo-based director of consulting at Russell Investments.
But this currency impact also meant there was a “large gap” between plans that were hedged against interest-rate rises and those that were not.
“Many pension funds do not hedge currency in international equity, but some pension funds hedge 100% or 50%. So, the average return was much worse compared to the benchmark,” he said.
Based on a client universe of around 25 corporate plans, Japanese pension fund investment performance amounted to a -5.9% return in 2022, Mr. Kita said, compared with a 6.5% gain in 2021. That loss was largely driven by negative returns in hedged international fixed income, with an estimated 15.2% loss, and international equity returns of -10.3%, according to figures provided by Russell. Inflation of 4% in 2022 added to pension funds’ woes, compared to 0.8% inflation in 2021 — although still significantly lower than other developed markets.
The funding ratio of plans has also fallen because of the decline in asset values, at least on an actuarial liability basis, with fixed discount rates generally used for these calculations, Mr. Kita said. On a projected benefit obligation basis, however, the funding ratio did not worsen because of a rising discount rate leading to falling liabilities.
On an actuarial liability basis, funding ratios dropped to 116% from 123% in 2021. On a PBO basis, the funded status was relatively flat, at 111% vs. 113% a year earlier.
For this year, Japanese investors with a heavy allocation to currency-hedged international fixed income are facing a headwind from the current inverted yield curve situation, Mr. Kita said. “People are concerned (about) how they should manage currency risk,” he added. Another topic is the recovery of active alpha in global equity and/or hedge funds, he said.
“For 2022, the theme was volatility, stemming from surging inflation and interest rates, global supply chain disruption and geopolitical events,” said Steve Liu, Toronto-based associate director, client portfolio management at Russell Investments.
While most asset classes were down in 2022, DB plans that were relatively less hedged against interest-rate rises and had a significant portion of return-seeking assets in their investment portfolios saw “modestly improved” funding ratios, he said.
That improvement was largely the result of rising interest rates, plus relative outperformance of return-seeking assets over liability-hedging assets, he said.
A well-funded plan with a mix of 30% equities and 70% bonds had an estimated -17% return in 2022. A plan with a 60%/40% mix — and still looking to close a funding gap — achieved about -14%, while a significantly underfunded plan with an aggressive return-seeking portfolio at 80%/20% was looking at a -11% return in 2022.
Going forward, another gap may open up for Canadian plans: In November, Canada’s government decided to cease issuance of real-return bonds — an inflation-linked instrument.
“This decision is likely to leave a hole for some pension asset managers who are trying to hedge against a plan’s inflation risk, although some others have found comfort by turning to other types of assets such as U.S. TIPS and real assets,” Mr. Liu said.
Another risk to a plan’s financial health is a decline in interest rates. “With significantly increased odds of a recession striking Canada this year, we believe the central bank could respond by cutting rates later in 2023. This is a very real risk, as rates typically fall during most recessions,” Mr. Liu warned.
Russell executives believe it is an appropriate time for plan sponsors to consider raising their hedge ratios — by injecting cash into the portfolio to improve the funded status, by increasing physical LDI at the expense of return-seeking assets, or by increasing LDI duration.
U.K. pension funds had a lot to contend with in 2022, with all the problems that other markets faced in terms of economic impacts on returns, plus the added pressures of September and October’s liquidity crunch.
That being said, U.K. defined benefit plans weren’t the worst performers, with an estimated -20% return, according to consultant XPS Pensions Group. U.K. inflation was 10.5% at year-end, giving a real return of about -31%.
However, put in the context of pension funding and calculating the “comparable return” of liabilities over the year — at -35% — U.K. funds in aggregate ended the year about £400 billion ($488.7 billion) better off, said Simeon Willis, CIO at XPS in London.
The horrors of the fall’s liquidity crisis remain a theme for 2023, with two of his “things to watch” this year relating directly to that period.
One is potential new regulations around the management of LDI, to cover issues including the use of leverage and operational procedures. Based on findings by the House of Lords’ industry and regulators committee, published Feb. 7, “this is potentially far-reaching involving action from regulators, trustees, fund managers and consultants,” he said.
The second thing to watch is the selling of illiquid private markets assets at “distressed prices,” as pension funds continue work to increase the amount of liquid assets in their portfolios to support LDI hedging programs. However, “this has created an opportunity for schemes to buy at a cheap price where they have the ability to hold illiquid assets,” Mr. Willis added.
Pension risk transfer is also on the agenda, with many U.K. pension funds finding themselves in a better funding position than a year ago, said Charles Cowling, chief actuary at Mercer in Manchester, England.
Data from the Pension Protection Fund’s 7800 index show funding ratios at 136.5% as of Dec. 31, vs. 107.7% at the end of 2021. Funding ratios dipped slightly in January 2023, to 134.8%. The PPF is the lifeboat fund for pension plans of insolvent U.K. companies.
However, capacity at the insurers — both human and capital — will be a focus, and moving to buyout is “a huge amount of work — if you fully settle your liabilities, you have got to get your data absolutely agreed between you and an insurance company,” Mr. Cowling added. He said the value of liabilities transacted this year could be anywhere from £50 billion to £100 billion.
Another big question going forward is what happens to inflation and interest rates in the U.K. “If you look at what’s baked in, (market consensus expects) interest rates to peak, at about 4.5%, and projections suggesting inflation will come down to the magic 2% pretty quickly,” added James Brundrett, London-based partner and senior investment consultant at Mercer. “Is that going to happen, and how big a recession are we going to have? In the U.S., consensus is it’s going to be a soft landing — but the U.K. has got its own challenges and inflation is coming down more slowly,” Mr. Brundrett said.
A “turbulent 2022 with heightened inflation driving ongoing interest-rate rises and throwing international markets into periods of significant uncertainty” saw Australian superannuation funds return -4.8%, based on the median balanced growth option, said Kirby Rappell, Sydney-based executive director at SuperRatings Pty. Ltd. The investment return in 2021 was 13.4%.
The drivers of the negative return were declines in real estate and international shares — and were “further impacted by fixed interest failing to act as a safety net,” Mr. Rappell said. However, over the long term, super funds have gained an average 6.1% since 2000.
An ongoing topic of discussion for super funds is the impact of the COVID-19 pandemic on alternative allocations. With 20% to 30% of assets allocated to assets such as infrastructure, private equity and hedge funds, “the pandemic highlighted the need to revisit revaluation policies and processes as we saw the initial drawdown in markets” in 2020, Mr. Rappell said. The reason the discussion is ongoing is because traditional fixed income has not provided the diversification benefits traditionally expected of the exposure.
On the regulatory front, further super fund mergers are to be expected in 2023, as are developments related to the impact of the change in government mid-last year, Mr. Rappell said.
“There is a consultation on the expansion and nature of the performance test underway. There is also a consultation occurring to define the purpose of superannuation, with a focus on making it explicitly more focused on retirement income. The retirement income covenant came into effect last year, requiring funds to have a retirement strategy in place but this part of the market remains underdeveloped,” Mr. Rappell added.
In 2021, the government introduced its Your Future, Your Super reforms, which put in place an annual test of super fund performance against a benchmark return. Any fund failing the test is named, with a second consecutive failure meaning the super fund can no longer accept new members.
“For the funds who failed the first MySuper (default) test, they have largely merged with another fund or been sold. This has been a big shift for the industry,” Mr. Rappell added.
On average, solvency ratios of Dutch plans increased in 2022 to 118% from 114%.
“The increase in funding ratio seems limited, especially with the enormous rise in interest rates, but that is due to the fact that many pension funds made significant indexations during the year and at the end of the year,” said Thijs van Brenk, investment consultant, and Edward Krijgsman, principal and senior investment consultant, at Mercer LLC, both based in Amstelveen.
On the assets side, long-term yields increased, which was “advantageous” to funding ratios, but most risk assets performed poorly and detracted from the solvency ratio.
The estimated overall return for the Dutch pension funds in 2022 was -22.3%.
Messrs. van Brenk and Krijgsman said long-term yields increased, which was “advantageous to the solvency ratio,” although most risk assets — particularly equities — performed poorly and partially offset positive moves afforded by the rise in rates and subsequent drop in liabilities.
As with other markets, hedging rates were key in terms of overall performance. Pension funds with a relatively low interest-rate hedge performed better than those with a higher ratio. On the positive side, the average 50% currency hedge contributed positively due to a 6.6% appreciation of the U.S. dollar vs. the euro.
Outside markets, the story of Dutch plan consolidation continued — at the end of 2022 there were 182 pension funds in the Netherlands — a number that “will probably decline further,” Messrs. Van Brenk and Krijgsman said. In 2019, there were around 200 plans.
The focus for 2023 actually began late in 2022: On Dec. 22, the House of Representatives approved plans for a new pension contract in the Netherlands, known as pensioenakkoord, which will, in effect, make retirement plans more personal, according to the Dutch regulator De Nederlandsche Bank. It will be contribution-based, as opposed to the traditional promised benefits model, and providers will be able to better customize investments to different participant cohorts — taking more risk where appropriate.
The new law is set to come into force on July 1. Changes must be adopted by Jan. 1, 2027.
Plans in occupational pensions firm FCT’s sample achieved a median performance return of -10.1%, said Daniel Blatter, Zurich-based key account manager, head of Swiss-German branch.
While a negative return, that’s still better than the average according to the Pictet BVG 2005 indexes, Mr. Blatter said. The BVG-25 Plus index returned -14.1% in comparison, while the BVG-40 Plus index returned -14.9%.
The main drivers of the negative performance were Swiss equities (-17.2%), global equities (-17.1%) and Swiss bonds (-13.2%).
Looking ahead, the inflection point in bond returns will make an ongoing conversation over benefits more acute.
“For the first time in more than a decade, Swiss government bonds — which are considered (a) ‘risk-free return’ — are in positive territory. For years already it was difficult to generate positive return with safe investments,” Mr. Blatter said.
Due to that change, the conversion rate — used to calculate pension benefits — is potentially under pressure. “Lower conversion rates resulted directly in lower pensions for pensioners. If the technical interest rate is increased again, the redistribution from active members to pensioners will decrease for the first time in years. The untouchability of spoken pensions vs. the protection of the active members — which are clearly key risk-takers of the fund — is a challenge the industry is already aware of,” but things are changing and how the technical interest rate moves with the times is uncertain, Mr. Blatter added.