Between a rock and a hard place
For many institutions, 2020 provided a disturbing echo of the 2008 financial crisis. Risk assets sold off across the board with a high degree of correlation that once again undermined the tenets of conventional diversification. In Canada, the median asset return for the first quarter was –6.6%, Canadian 10-year benchmark bond yields fell 91 basis points, and long bond yields dropped 38 basis points, increasing pension liabilities by 6.3%. The median funding ratio of Canadian pension plans fell below 90.0%, down from 102.5% at the start of the year.¹ In Japan, the world's largest pension fund lost 11% of its value, the most since 2008, and in the United States, where state pensions hold 75.0% of their assets in high beta stocks and alternative investments, many plans are on pace for their first fiscal year loss since 2009.² The appetite for risk assets has been driven over the years by a decades-long slide in bond yields and the need to repair funding ratios damaged by the Great Recession.
One of the most pressing issues for pension plans now is how to meet expected funding requirements given anticipated declines in tax or business revenue. Traditional sources of revenue—from sales and income tax to business revenues—are down sharply and will likely continue to erode until today’s record unemployment improves. Sponsors need to update their cash flow projections and review their risk management strategies.
Seemingly stuck between a rock and a hard place, some plans have responded to the crisis by continuing to add risk through the recent recovery or by adding leverage. Recently, we noted that a large pension trust added as much as $80 billion in leverage in the hopes that its investment gains will outstrip borrowing costs.³
A fundamental challenge to that approach is that projected returns are lower across many segments of the market. Unprecedented central bank intervention worldwide has pinned policy rates to zero or lower for the foreseeable future, while quantitative easing has helped push bond yields lower. Even high-yield bonds that sold off in the February/March timeframe are once again yielding below 5%, so investors aren’t being well compensated for the risk.⁴
One of the most pressing issues for pension plans now is how to meet expected funding requirements given anticipated declines in tax or business revenue.
Strategies for building resiliency
While these challenges are real, the choice investors face today isn’t a binary one between risk-on and risk-off. At Manulife Investment Management, we’ve been helping clients build more resilient portfolios for decades, leveraging a broad set of capabilities and a team of more than 475 investors around the world.⁵ Some of the solutions we’re discussing with clients today include the following:
- Private assets—Private investments span diverse asset classes across the credit spectrum, yet they all share a common feature—they’re not publicly traded. As a result, private assets can offer an opportunity to pursue an illiquidity premium over stocks, with lower day-to-day price volatility along the way. Research found that farmland was one of the best safe havens across a number of historic adverse market events spanning the prior 30 years.⁷ Investment managers affiliated with insurance companies can be well positioned since they’re able to offer clients the same private market strategies the insurer deploys on its balance sheet to meet its own financial obligations.
- ESG integration—At its core, environmental, social, and governance (ESG) integration is about resiliency and ensuring that investment portfolios are able to meet client needs in the long run. Sustainable strategies largely outperformed broad market indexes during the first quarter of 2020, according to research by Morningstar, with 70% of equity funds falling in the top half of their peer groups.⁶Just as sidestepping the traditional energy sector was a clear benefit early this year, it’s reasonable to expect that pandemic-related disruptions will be a focus of ESG research going forward. Today, 6 out of 10 institutions expect managers to integrate ESG more fully into their investment processes.⁸
- LDI—Stubbornly low or negative sovereign bond yields have compelled plan sponsors to take increasingly creative measures to maintain sufficiently high rates of return—a challenge insurers have faced for years. Liability-driven investment (LDI) pooled solutions can allow for a tailor-made approach in managing fixed-income assets against pension liabilities while also taking advantage of dynamic glide path management to help better frame asset allocation decisions. This year’s market drawdown provided yet another example of how LDI strategies can build resilience into portfolios. Asset management partners should have a heritage of risk management, deep actuarial expertise, and a wide range of derisking and return-enhancing tailored solutions at their disposal.
- OCIO—The challenges facing institutional investors this year have put the question of investment management front and center. As more organizations sharpen the focus on their core competencies, many are starting to question the cost effectiveness of maintaining large in-house investment departments, and many firms are seeking the help of outside expertise in navigating today’s turbulent markets. Outsourced chief investment officer (OCIO) providers can provide comprehensive fiduciary services that combine advice, portfolio management, and plan administration—all through a single point of contact.
While there is no silver bullet that will address the challenges facing investors today, there are strategies that can help insulate portfolios from market shocks, generate income in a low-yielding environment, and provide new sources of alpha. Reliance on these strategies may be increasingly important in the months and years ahead.
1 “Canadian plan funding drops dramatically in Q1,” Pensions & Investments, April 2020. 2 “How the Market Downturn Could Affect Public Pension Funds,” Pew Research, April 2020, Bloomberg, July 2020. 3 “CalPERS gambles on risky investment move,” CalMatters, June 2020. 4 U.S. Federal Reserve, June 2020. 5 Total number of investment professionals includes investment professionals of Manulife Investment Management and of Manulife-TEDA, as of March 31, 2020. 6 “Safe Haven Review: A Guide to Portfolio Protection In The 2020s,” BCA Research, October 2019. 7 “Sustainable Funds Weather the First Quarter Better Than Conventional Funds,” Morningstar, April 2020,Manulife Investment Management funds not included in this analysis. 8 “Trends in Manager Selection,” Greenwich Associates, 2020.
A widespread health crisis such as a global pandemic could cause substantial market volatility, exchange trading suspensions and closures, and affect portfolio performance. For example, the novel coronavirus disease (COVID-19) has resulted in significant disruptions to global business activity. The impact of a health crisis and other epidemics and pandemics that may arise in the future, could affect the global economy in ways that cannot necessarily be foreseen at the present time. A health crisis may exacerbate other pre-existing political, social and economic risks. Any such impact could adversely affect the portfolio’s performance, resulting in losses to your investment
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