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BlackRock Study Shows U.S. Public Pensions Would Benefit From Rethinking Asset Allocation to Meet Future Liabilities

BlackRock |Jun 29, 2021

Pressure on funding ratios persists, despite quick recovery of asset values following market drawdowns

NEW YORK, June 29, 2021 - U.S. public pension plans face increased challenges in meeting their future liabilities, and could benefit by reconsidering certain parts of their asset allocation strategy, according to a new study from BlackRock (NYSE: BLK)

The study, “Public pensions, post-pandemic”, which leveraged data from over 85 public pension plans, showed that public pensions have experienced sideways to downward movement in funded ratios, despite posting solid investment results well ahead of assumed investment returns.  The challenge: liability growth and increasing required benefit payments put additional pressures on investment portfolios to outperform following periods of market decline, such as during the first quarter of 2020. 

“Public pensions have seen their liabilities grow during COVID due to early retirements and sluggish payroll growth.  These plans now face increasing pressure to generate performance,” said Zach Buchwald, Head of the U.S. and Canada Institutional Business at BlackRock. “Our study reveals that in fact many public plans are likely to fall short of their return assumptions, but certain asset allocation shifts may position plans for better outcomes.”

The findings 

The study showed that over the past two decades, periods of market decline (such as the 2001 Tech Bubble and the 2008 Global Financial Crisis)  caused significant asset erosion and declines in funded ratios.  Looking forward many public pension plans will have to hit their return assumptions consistently, and may even need to increase performance targets, to meet growing liabilities. To help address these challenges, the study explores considerations for public fund investors around portfolio construction:

Rethinking Fixed Income: In a lower-for-longer environment, yields in traditional fixed income assets no longer have the ability to provide the same level of diversification as they have in the past – yet public plans on average hold 23% in traditional fixed income allocations, with 50% of those holdings classified as Core Fixed Income.  Increasing flexibility into unconstrained fixed income and incorporating the ability to spread exposures across the liquidity spectrum may enable investors to meet higher return expectations and diversify away certain existing risks, the study found. 

Seeking Opportunities for higher returns through private markets: The average allocation in public funds to illiquid assets is approximately 23%; the research indicates that many plans likely have greater ability to take on more private assets and offer the diversification benefits to mitigate risks. The study modeled the potential impact of reallocating 5% of each plan’s exposure from public equity to private equity, and found expected returns increased by more than 70 basis points, on average, bringing many plans within reach of their assumed return. Risk increased commensurately, but portfolio efficiency—return per unit of risk—increased by an average of 3 basis points. 

Sustainable strategies designed for more resilient portfolio construction:  The rollercoaster of 2020’s drawdown and bounce-back highlighted the need for resilient portfolio strategies, and adding ESG-focused investments may offer pensions risk reduction without sacrificing return potential. Reallocating to sustainable investments has been shown to preserve the expected return for the average pension portfolio, with slight reduction in risk, based on BlackRock’s forward-looking capital markets assumptions.  Investors that account for climate risk exposures in portfolio design can help mitigate risk likely caused by possible assets re-pricing, increased regulation, and costs, and changing consumer preferences.

“The transition to a low-carbon world may offer big investment opportunities. We expect U.S. equities to produce higher returns under a green transition where the economy embraces a post-carbon future.” said Buchwald. “Investing through a sustainable lens is one way public pensions can build more defensive and robust portfolios.”

No Silver Bullet

None of these individual strategies is a complete solution for the challenges faced by public pensions, the study stresses.  But the research shows reasons to be optimistic about the opportunities presented by the post pandemic recovery and possibilities of previously overlooked portions of the market. Public pension plans will need to consider each suggestion carefully in the context of their current allocations, return targets, assets, liabilities, stakeholders, and other characteristics. 

“Our public pension clients are central to BlackRock’s mission to secure financial well-being for more people. The public pension system works on behalf of nearly 26 million American households and funding shortfalls must be resolved to support the future financial security of our teachers, police, firefighters, and other public servants.” said Buchwald.  “One of BlackRock’s top priorities is to provide our pension partners with solutions to help them navigate this challenging environment.”

About the Public Pension Peer Risk Study

The annual Public Pension Peer Risk Study utilized data from Pensions and Investments to collect fund-level asset data for more than 85 U.S. public pensions. Using Aladdin® analytics, each fund was mapped to BlackRock’s Capital Market Assumptions to estimate risk and return characteristics.  The plans reviewed represent over $1.8tn in pensions assets under management. Plans ranged in size from $300mn to $246bn, with average and median assets under management of $20bn and $9.5bn, respectively (all amounts given in USD).

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