The shift has left some pension plans vulnerable to future shortfalls in liquidity.
Chief Investment Officer
January 16, 2020
By Robert Stowe England
The easy monetary policies central banks have put in place over the last decade show no sign of abating anytime soon. Central bankers have bought bonds as a means of stimulating their economies, called quantitative easing (QE), and cut interest rates—and learned the hard way that any attempt to pull back risks sinking stock markets.
In this environment, pension plans have been compelled to channel more money into riskier and more illiquid assets, in search of higher returns. This shift has left some pension plans vulnerable to future shortfalls in liquidity. Plans may run out of cash and cash-generating assets just as they need it most, as a wave of baby boomers moves inexorably into retirement, claiming pension benefits.
Those are some of the chief concerns expressed by investors at 153 pension plans with €1.88 trillion ($2.1 trillion) in assets who responded to a survey sponsored by Paris-based Amundi Asset Management and CREATE-Research, a British boutique research firm specializing in investment management strategies.
“Central banks by injecting too much liquidity have, in effect, acted like sugar daddies for investors,” says Amin Rajan, chief executive officer of CREATE-Research and author of a report on the survey findings. CREATE is an acronym for Centre for Research and Technology in Europe and it is tied into a network of researchers who represent major asset management advisory firms and major employers.
A day of reckoning is coming, Rajan warned. “At some point, the party is finished. Someone is going to take the punch bowl away. Everything will revert back to the mean. Stock and bond prices cannot stay this high indefinitely.”
How soon will the party be over? “It may not happen for two or three years,” he said. In his opinion, the Federal Reserve, which reversed its rate-raising campaign and last fall lowered them 0.75 percentage points, can go on reducing interest rates. The Fed can reduce a full percentage point in 2020, Rajan indicated. “With the 2020 presidential election looming, they may be under pressure to do that,” he added.
“How soon will the party be over? “It may not happen for two or three years,” he said. In his opinion, the Federal Reserve, which reversed its rate-raising campaign and last fall lowered them 0.75 percentage points, can go on reducing interest rates. The Fed can reduce a full percentage point in 2020, Rajan indicated. “With the 2020 presidential election looming, they may be under pressure to do that,” he added.
For asset managers, the Amundi-CREATE monetary-easing report has struck an ominous chord. “I think it’s spot on,” said Terri Spath, chief investment officer and portfolio manager at Sierra Investment Management in Santa Monica, California. She highlighted the absurdity of keeping monetary policy at crisis levels since 2008 even though today “we’re not in a crisis.” Interest rates, once viewed as “lower for longer,” she said, are increasingly seen as “lower forever.”
Which asset classes will be most popular while QE and low interest rates last? Survey respondents’ top choice was global equities at 58%, with infrastructure at 51%, real estate at 46%, and alternative credit at 44%.
Pension plans remain heavily invested in equities because “there is no alternative,” noted Rajan, who called this approach “conviction-less trading.” Pension investors, he said, believe they must not miss out on the additional upside gains they think are yet to come.
There are worrisome trends that can produce a distorted market. “People borrow money to buy their own shares,” Rajan lamented, pointing to the corporate trend to reduce the number of shares outstanding by purchasing them. Why? “Liquidity is so cheap they can buy their own shares at a very low costs. The traditional signals in the equity markets are very difficult to ascertain. It is the reason equity is a buy.”
Another worry brought on by central bank easing: the high level of program trading with algorithms. “Algos are expected to trade if there is a sudden amount of movement in price. They will act without knowing what is driving the change,” Rajan said. This takes away investor discretion from the market and poses risks to investors.
A stark example of this was the May 2010 flash crash, when the Dow Jones Industrial Average plunged over 1,000 points in the short span of 36 minutes, before stop loss measures kicked in. “The market is disoriented so much [that] no one can make sense of it,” Rajan said.
The survey found that pensions want a degree of normality to return and for pricing of assets to better reflect underlying fundamentals. “They want to know where they stand. But, at the same time, they want the transition to be as pain free as possible,” Rajan observed.
The survey also asked pension plans which asset groups would see the valuations reconnect with their fundamentals over the next three years, after having been distorted by QE. Significant majorities identified equities (64%) and bonds (60%).
“The problem is that the downside risk at this point for many assets classes is greater than the upside risk,” Spath explained. Or to put it another way, “The problem is that you make money slowly but you can lose it quickly.”
Another worry is that future anticipated gains are likely to be lower than many expect, according to Chris Brightman, CIO at Research Affiliates in Newport Beach, California. “I think the very low level of interest rates, along with a low level of macroeconomic risk, has dramatically increased the prices of capital assets to the point that forward-looking returns from those capital assets will no longer meet the investment plans of institutional investors.”
Asset increases, due to central bank easing, can’t go on forever, and there’s a strong suspicion that the point of diminishing returns is at hand. That view is strongest at 75% of respondents who believe QE in Japan has reached that point, while 64% believe it is true for the Eurozone, 57% for the United States, and 52% for the United Kingdom.
One concern is that pension plans have shifted too far into passive investments, in part to improve returns by choosing the lowest cost index providers. “Let’s face it, whenever the market makes a swing away from active management toward passive management the way it has, the pendulum has swung too far and it is going to swing back. It’s not a question of ‘if’ but only ‘when’ it happens,” said Brian Singer, head of the Dynamic Allocation Strategies Team at William Blair.
What’s more, QE will be very hard to unravel without huge market volatility, the majority (52%) of pension plan respondents believes. Rajan points to the example of what happened in the US after the Fed raised interest rates in 2018—only to reverse course quickly when stocks took a nosedive.
Most of the respondents think that further monetary easing is inadvisable. “They can bring interest rates lower. However, academic studies find that when rates get much lower than they are now, it begins to damage the financial sector and have an adverse effect on the economy rather than a positive effect on the economy,” Singer said.
Obviously, all this unease is based upon many pension plans’ underfunded status. Current funding levels leave pension plans vulnerable to future financial unrest. Of those surveyed, only 29% are 100% funded. The remainder are below statutory funding requirements.
The survey found a significant minority (40%) of pension plans are already suffering from negative cash flows. Another 22% reported neutral cash flows and 33% revealed their cash flows are positive. Those with negative cash flow are likely seeing plan beneficiaries retiring at a faster rate than originally projected, according to Rajan. “They are actually burning their seed corn, paying benefits out of their capital base,” he said. The unease extends beyond the underfunded: Plans who are better funded also fret that they may face a similar fate, he added.
The survey also asked respondents how they are allocating their funds to manage the risks from low real yields and high equity prices. Broad asset diversification was chosen by 87% of the respondents, making it the top strategy. A significant majority (62%) say they have a strong focus on liquidity and 37% say they are coping with risk by managing asset duration.
When asked about the net impact of QE on pension finances, 75% of respondents in the survey said it has produced “a portfolio of risky assets.”
The flow of funds away from low-yielding bonds into riskier assets poses its own set of problems, in Singer’s view. “There’s a bubble today in illiquid assets,” he said, as pensions and other investors pour money into private equity, infrastructure, and real estate because they cannot get the sufficient returns from bonds.
One danger could come from unwinding exchange-traded funds (ETFs) that are invested in illiquid assets that will have be dumped on the market because investors are redeeming their shares in the ETF, Singer said. “When we see ETFs begin to unwind in some factor portfolio selling from a narrow factor, we will see a significant downturn in values.”
The flood into smart beta is one more source of anxiety. “It takes discretion away from investors,” Singer says. “If people sell a high-yield bond index, the underlying bonds probably do not have liquidity but they must be sold,” he said. Losses could be enormous. “It’s a risk of ruin strategy,” he said.
Some asset classes seem particularly vulnerable, such as US corporate bonds, Rajan cautioned. In pursuit of yields, investors have flooded into riskier segments of the corporate bond market and a number of small and mid-sized business have taken debt to dangerous levels. A number of them may not be able to maintain debt payments if the economy slows or grows too slowly, Rajan said.
Pension plans are taking steps to protect portfolios from the enduring impact of QE. A strong majority of 61% are diversifying by risk factors instead of asset class. The next most popular action, adopted by 55%, is to adopt secular themes. A majority of 53% allow longer periods of time for risk premia to materialize, meaning that they believe it will take longer than in the past to earn expected returns from some investments. Further, nearly half (49%) have delineated a clear separation of alpha and beta investing, in part to be sure they “are not paying alpha pricing for beta strategies,” the report states.
Some observers, however, do not believe that QE is the cause of low interest rates. “There are good underlying reasons to explain why yields are falling. The fall in yields is, in fact, has been going on for three decades, a long time,” said Tapan Datta, head of asset allocation at Aon Consulting in London.
“There are sound economic reasons for low interest rates, such as demographic maturity. Investment rates are down. And productive growth has slowed. All that pushes yields down,” Datta explained. He contended the findings of the survey have overstated the impact of QE, which he believes has had only a limited positive impact on economic growth.
Brightman at Research Affiliates thinks the assumptions behind the survey are based on a misunderstanding of cause and effect. “I think the choice of central banks to resort to quantitative easing is a reaction and acknowledgement of very low interest rates. I don’t think QE has caused the low interest rates but the other around. Low interest rates have caused QE,” Brightman said.
Whatever their cause, low rates are a headache for investors, especially those at pension plans, who must fund beneficiaries’ retirements with fewer resources than they once had.
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