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Public pensions in the 2020s: Planning for a very different decade ahead

BlackRock’s Client Insights Unit analyzed fund-level data for nearly 70 public pensions to gauge how likely they are to meet their return assumptions over the next decade. We find that most are unlikely to make their return targets, but changes in asset allocation may help.

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It’s been an unprecedented year for public pension investors. The market shock from Covid-19, and the subsequent snapback in the price of many risk assets, has provided a real-time test of plans’ strategic asset allocations and their approach to rebalancing. 

To gauge how likely plans are to meet their return assumptions in the years following the crisis, BlackRock partnered with Pensions & Investments to collect fund-level asset data for 69 U.S. public pensions.  We then leveraged the Aladdin® platform to map each fund1 to our May 2020 capital market assumptions (CMAs) to estimate the risk and return characteristics of each plan.

A different decade

While nearly all plans we analyzed exceeded their assumed return targets over the last ten years, the next decade looks considerably more challenging. More than 70% of plans are expected to miss assumed returns over the next ten years, based on their current asset allocations and our CMAs1. See the Falling short chart.

Falling short

Assumed versus expected returns for 69 US public pension plans

Assumed versus expected returns for 69 US public pension plans

 

Source: BlackRock, Pensions & Investments. Assumed returns based on Pensions & Investments data as of March 2020. Expected returns based on BlackRock’s 10-year capital market assumptions as of May 2020. There is no guarantee that the capital market assumptions will be achieved, and actual returns could be significantly higher or lower than those shown. See table titled Benchmark Mapping & Capital Market Assumptions in the Appendix for details.

When we examine the difference between plans that look set to achieve their return assumptions and those that look set to fall short, we find that those that appear more likely to achieve their target returns have significantly higher allocations to alternative assets and lower allocations to fixed income. See the Alternative outcomes chart, which breaks down the asset allocations of plans with an assumed return of 7.25%, the median of the plans we surveyed. The projected return differential between the two groups is significant: Plans that are likely to miss their target are forecast to post annual returns of 6.77%, vs. 7.97% for those that are likely to achieve their target.

Alternative outcomes

Asset allocations of U.S. public pension plans with 7.25% assumed return targets

Asset allocations of U.S. public pension plans with 7.25% assumed return targets

 

Source: BlackRock, Pensions & Investments, March 2020.

The primacy of private markets

Our capital market assumptions strongly favor private markets, while projecting muted, and in some cases negative, returns for many fixed income assets. Given the extremely low level of benchmark interest rates, and policymakers willingness to keep them ultralow for years to come, we think that plans with relatively high exposures to fixed income should consider reallocating a portion of their portfolios to private markets.

Of course, closing the gap between expected and assumed returns is not simply a matter of decreasing allocations to fixed income and increasing allocations to private markets. When investing in private markets, sourcing the right assets, building a diversified portfolio, and paying an appropriate level of fees are all paramount to delivering on the promise of private assets.

Another consideration in private markets investing is illiquidity, but we believe many plans may be overestimating the liquidity risks. To quantify this risk, the BlackRock Investment Institute performed a simulation based on a historical period of extended market stress: the global financial crisis. The simulation assesses how much an investor can allocate to private markets before running into problems meeting total portfolio spending requirements and capital calls from funds. The implications are striking, as they suggest that the ceiling for private market allocations may be higher than is often assumed—and may be even higher if the private markets allocation tilts towards income-earning assets.

For pension plans, increasing allocations to private markets could be the deciding factor in meeting return objectives over the next decade.  But not all private market assets are created equal. If we break down the private markets allocation of plans with 7.25% assumed returns, we find that the plans that are forecast to achieve their return objectives have their largest overweights to private credit (+9.07%) and private equity (+6.32%).

Of course, private markets don’t offer a panacea for public pensions. But we do think they represent an important component of a strategic plan for the next decade, along with a host of other factors including a thoughtful and flexible approach to holistic asset allocation and a continuous understanding of portfolio risk exposures.

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Calvin Yu
Head of the Client Insight Unit
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Jonathan Cogan
Member of the Client Insight Unit
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Sarah Siwinski
Member of the Client Insight Unit
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