Public pensions, post-pandemic

BlackRock's Client Insight Unit analyzed data of more than 85 U.S. public pensions to understand the impact of the pandemic downturn and other extreme market events. We find that funding ratios have been significantly impaired, despite strong investment performance pointing to the importance of downside risk mitigation and portfolio resilience.

Adjusting portfolios in seeking to meet return assumptions in an ever-changing world

We analyzed fund-level data for over 85 public pensions to understand the aftermath of the pandemic’s market volatility and how plans are positioned to meet return assumptions over the next decade.

Despite the quick market recovery, the pandemic’s long-lasting impact will need to be addressed by future asset allocation decisions.
Persistent liability growth places additional pressure on investment portfolios to outperform.
Illiquid assets’ return premiums may help portfolios deliver on expectations.
Regional diversification within public equities, has the potential to improve portfolio efficiency.
Climate-aware portfolio design shows potential to boost resilience without sacrificing returns.
A more expansive approach to fixed income can help support total returns in a low-yield world.

After a year of navigating uncharted terrain, public pensions entered 2021 looking ahead to a post-pandemic recovery, but the far-reaching implications of COVID-19 on governments has added additional pressures for plans to generate adequate investment performance.

State and local governments incurred large costs to manage the pandemic and keep communities safe, while some simultaneously experienced decreases in tax revenue.1 Although tax revenue shortfalls were not as extreme as many initially predicted, budgets could still be squeezed to a point that will impact future pension contributions. Meanwhile, there’s evidence that the pandemic caused sharp rises in retirements, potentially adding to the widening gap between benefit payments and contributions.2

The long-term impact of these trends continues to unfold against a backdrop of challenging funding conditions. Since the Great Financial Crisis, funded status has hovered around the low to mid 70s. Strong performance in public equities has helped, but funded ratios continue to struggle due to other factors, such as sluggish payroll growth and improved mortality of retirees.

We believe looking forward many public pension plans have to hit their return assumptions consistently, and may even need to increase performance targets, to meet growing liabilities. Most plans will need to rethink their asset allocations to make up ground. Our analysis estimates that over half the plans may fall short of current assumed returns, based on current asset exposures and BlackRock’s May 2021 Capital Market Assumptions (CMAs).

This year we considered these challenges as we completed our annual public peer study to provide a holistic overview of the public pension investment landscape, including asset allocation, expected returns, risk factor decomposition, and stress testing. BlackRock partnered with Pensions & Investments to collect fund-level asset data for more than 85 U.S. public pensions. Using Aladdin® analytics, we mapped each fund to our asset class CMAs to estimate its risk and return characteristics. (Please see Exhibit A)

The plans we reviewed represent close to $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. The plans have an average funded status of 75.6%.

Running in place

Over the past decade, public pensions surpassed their assumed return expectations, largely due to the strength in public equity markets. However, our research suggests higher than expected investment performance was not enough to recover from the market stresses of the early aughts and public plans are still experiencing sideways to downward movement in funded ratios.

Following the Global Financial Crisis, public pensions realized average annualized returns of more than 8% over the past 10 years, while the median assumed return targets are now around 7%, after steadily declining over the years. Despite this strong investment performance, actuarial funded status has continued to drop over the past two decades from fully funded in 2001 to about 85% just prior to 2008, then to the low to mid 70s in the aftermath of the Great Financial Crisis and generally remains in that range today.

Since the turn of the century; market stresses, such as the 2001 Tech Bubble and the 2008 Global Financial Crisis, caused significant asset erosion and declines in funded ratios, which require larger returns to make up. For example, to recover from a 25% market decline, a portfolio would need to earn over 33%. Our analysis found that despite outperforming assumed returns following these crises, the market declines had lasting impact on the cumulative performance of a theoretical portfolio that consistently met its assumed return expectation and the average realized return of public pensions over the same period.

10 years of strong returns

Market drawdowns’ influence on cumulative performance

Source: Public Plan Data, January 2021. Past performance is not indicative of future results.

During longer recoveries the liability would also continue to grow due to factors such as normal and interest costs, making it even more difficult to get back to full funding. Additionally, while benefit payments reduce both the asset and the liability by the same amount, the denominator effect of being underfunded results in a decline in funded status.

The combination of these factors has increased the pressures on the investment performance to make up shortfalls for underfunded plans. We believe building efficient portfolios to diversify risk and improve returns will prove critical for public plans in the post pandemic recovery. We see opportunities across the following themes to help portfolios reach return expectations, while helping to weather market downturns of the future.

Portfolio resilience demands climate resistance

The historical market declines of the 2000s, including last year’s pandemic drop, demonstrated the need for pensions to enhance their portfolio resilience and downside protection. We believe climate risk and the net zero transition represent some of the biggest future market events and a thorough environmental, social and governance (ESG) analysis can help build more defensive and robust portfolios. Avoiding climate-related damages will help prevent economic deterioration and improve risk-asset returns. Reallocating to sustainable exposures preserves the expected return for the average pension portfolio, with slight reduction in risk based on our forward-looking CMAs, which now incorporate the impacts of climate change, reflecting our view that climate risk is investment risk.

Incorporating ESG into portfolio construction also positions portfolios for the post-carbon transition. Our analysis found that swapping the average plan’s US equity exposure from the MSCI USA Index to the MSCI USA ESG Enhanced Index not only significantly improved ESG ratings and scores, but also reduced the portfolio’s carbon intensity by more than 30%. For every $1 million invested, that reduction is equivalent to eliminating the emissions of 10 passenger vehicles driven in a full year. Investors that account for carbon and 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 impact of incorporating ESG

Increasing exposure to the MSCI ESG benchmark reduces portfolio’s carbon intensity

Source: BlackRock, with data provided by MSCI ESG Research for individual companies as of May 2021. The Weighted Average Carbon Intensity measures a portfolio’s exposure to carbon intensive companies. The figure is the sum of security weight (normalized for corporate positions only) multiplied by the security Carbon Intensity. MSCI rates companies on a ‘AAA’ to ‘CCC’ scale according to their exposure to industry specific ESG risks and their ability to manage those risks relative to peers. The portfolio MSCI ESG Rating is based on the weighted average ESG Quality Scores of the underlying companies within the portfolio, and then adjusted based on portfolio exposure to issuers with positive trending ESG scores, issuers with negative trending ESG scores, and ESG Laggards (B and CCC rated issuers). The result is the ESG Quality Score, which can be mapped directly to the letter ESG Rating. The MSCI ESG Pillar Scores are the weighted average of the underlying companies' scores rated on a scale of 0-10. Pillar scores are comparable across all industries because they are not industry-weighted like the overall MSCI ESG Quality Score. ‘Coverage’ is defined as the percent of the portfolio’s underlying holdings that have an MSCI ESG Rating. This material represents an assessment of the market environment at a specific time and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the readers as research or investment advice regarding any security in particular. For a glossary of terms, see Exhibit B. 1. All figures based on US EPA's calculation for converting greenhouse gas emissions (tCO2e) numbers into different types of equivalent units. Hypothetical example is for illustrative purposes only. Results for actual accounts will vary.

Moreover, the transition to a low-carbon world offers tremendous opportunities3 for economies and risk assets.  Our CMAs reflect our view that the green transition to a low-carbon economy, consistent with the Paris Agreement goals, will deliver an improved outlook for growth and risk assets relative to doing nothing. Globally, we estimate a cumulative loss in economic output of nearly 25% over the next two decades if no climate change mitigation measures were taken. To give another illustration, our expected returns for U.S. equities are 2% higher under a green transition in which the economy embraces the post-carbon future.

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Diversification potential of China A-Shares

Shifting assets within public market exposures could also help public pensions increase portfolio efficiency. One area of interest is onshore China exposure, as our research4 shows the potential to boost returns while providing diversification that have some risk benefits. China has grown to represent almost 20% of global GDP, but it’s still not fully reflected in global benchmarks. For example, the MSCI All Country World Index (ACWI) holds a weight of just 4% in China equities. (As of April 2021)

China A-Shares, which trade on the mainland exchanges of Shanghai and Shenzhen, have especially compelling potential to enhance both absolute and risk-adjusted returns. A-Shares have become much more accessible to investors outside of China in recent years. The MSCI China A Index offers relatively high potential returns and low historical correlations to other equity assets, including a correlation of just 0.36 to the MSCI USA Index. In our analysis we decreased MSCI ACWI exposure by 5% and reallocated to MSCI China A Index, which resulted in an average increase in expected return of 23 bps, while decreasing risk by 14 bps. Outcome for specific portfolios will vary depending on the client’s constraints and risk appetite.

Expected return and risk

Average projected impact of a 5% reallocation to the MSCI China A Index of the plans in the peer risk study universe.

Source: BlackRock as of May 2021. Expected 10-year risk and return calculations based on BlackRock’s capital market assumptions (CMA), See section titled "Capital Market and Modeling Assumptions" in Exhibit C at the end of this analysis for additional details. Risk: 84% confidence interval, 246 constant weighted monthly observations; 1yr horizon. For illustrative purposes only. There are no assurances that the hypothetical portfolio's objectives will be met. Additionally, there are frequently sharp differences between a hypothetical performance record and the actual record subsequently achieved. Another inherent limitation of these results is that the allocation decisions reflected in the performance record were not made under actual market conditions and, therefore, cannot completely account for the impact of financial risk in actual portfolio management. The performance shown does not represent any existing portfolio, and as such, is not an investible product. There is no guarantee that the capital market assumptions will be achieved, and actual returns could be significantly higher or lower than those shown.

Fixing fixed income

The 2020s have ushered in a new era for persistent low yields across most fixed income markets. Many of our public pension partners are weighing the impact the low yield environment could have on their ability to meet return targets and the diversification advantages of fixed income allocations. We see opportunities for them to reevaluate both the role of fixed income in their portfolio and how they allocate within their income bucket.

On the fiscal side, the US government’s response dwarfed the steps it took during and after the Great Financial Crisis. Our analysis5 estimated that the pandemic had a quarter of the GFC’s overall economic impact but received four times the fiscal response. All that spending has important implications for inflation, economic growth, government debt that drive bond performance. Meanwhile, changes in monetary policy pulled down interest rates and bond yields. The rate on the 10-year Treasury note, only about 2% at the beginning of the pandemic, fell rapidly and sharply, dropping almost 1.5 percentage points in just three months.

Although yields creeped higher during the first quarter of 2021, we expect a low-yield environment to persist for some time and to pose several challenges to public pensions.  Low yields could diminish bonds’ ability to provide the degree of diversification from equities that they have in the past.

Yields have little room left to fall

Low yields could diminish bonds’ ability to provide the degree of diversification from equities that they have in the past.

Source: BlackRock, Bloomberg, as of May 2021. U.S. recession periods are defined by National Bureau of Economic Research. Graph displays U.S. 10-year Treasury yield rate changes during recession periods. 10-year Treasury change reflects the biggest move seen from as early as six months before the recession period. Past performance is not indicative of future results.

The chances of fixed income contributing much to total returns has, in our view, been greatly diminished. Our estimates project the Bloomberg Barclays US Aggregate Index to return up to 1.8% in our May 2021 CMAs, reflecting a first-quarter rise in interest rates. The average US public pension plan has a 23% allocation to fixed income, with approximately half those assets in domestic core.  Such meaningful exposure to an asset with a likely return of less than 2% makes it very difficult for plans to achieve their desired results. It also places considerable pressure on the growth portion of the portfolio to outperform.

For example, consider a hypothetical plan with a 7% assumed return. If the plan were to maintain a 20% allocation to an asset, such as core fixed income, with an expected return below 2%, then that portfolio exposure would generate only about one-twentieth of the target return. The remaining allocations would need to generate at least 8.25% to reach the performance targets. To reach this higher growth target the portfolio may need to take on greater risk in the growth portfolio.

Introducing judicious exposure to less-liquid assets within the fixed-income allocation could prove crucial to meeting performance targets and maximizing the return generated per unit of risk.  Private debt underwriting enables investors to offer lending on their own terms, potentially leading to stronger covenants and better downside mitigation than what is currently available in the public markets. These qualities can improve recoveries and loss ratios in the event of defaults, potentially producing better risk-adjusted yields.

Fixed income can also help provide critical liquidity for pensions to meet their liabilities and we’ve seen some clients utilize ETFs to balance exposure to less liquid asset classes.

Investors with the willingness and capacity to accept greater risk in their fixed income allocations can also benefit from considering opportunistic private credit investments. Opportunistic credit involves lending to issuers that need flexible, bespoke financing solutions. It offers elements of both income and capital appreciation, with the potential for upside participation that can help deliver equity-like returns with a debt-like risk profile. While public pensions have been steadily increasing their allocations to private credit, our data shows that they tend to under-allocate to opportunistic credit.

Opportunistic private credit looks underfunded

Public pensions' allocations to private credit

Source: BlackRock and P&I. Average Private Credit allocations of all plans is a simple average.

Gaining ground with illiquid assets

Illiquid assets may help pensions meet these aggressive demands. Public pensions currently have a 23% average allocation to illiquid assets, and our research indicates that many plans could assume greater illiquidity risk in pursuit of return premiums.

Specifically, plans could use private markets as a primary tool to help them meet assumed returns and diversify against risk factor concentration. Our current market assumptions expect 10-year annualized returns of 9.3% for private credit and 19.5% for private equity.

We 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 0.03.

Many public pension plans are on this track as allocations to private equity and real assets have increased since 2010 by 2% and more than 4%, respectively. Our research suggests that public pensions have the ability to continue this trend and would benefit from doing so.

Looking ahead

None of these strategies—increasing allocations to illiquid assets, shifting portfolios’ geographic weights, incorporate climate considerations, evolving fixed income allocations — are the silver bullet. But we are optimistic on the opportunities of the post-pandemic recovery and possibilities of previously overlooked portions of the market. Public pension plans will need to consider each carefully in the context of their current allocations, return targets, assets, liabilities, stakeholders, and other characteristics.

BlackRock has the tools and expertise to help our public pension partners perform this type of analysis for to help them reach their goals in an efficient manner.

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Jonathan Cogan, CFA, CAIA
Client Insights Unit
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Sarah Siwinski
Client Insights Unit
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Calvin Yu
Head of the Client Insights Unit
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