CLIENT INSIGHTS

Assessing the impact of recent market volatility on U.S. public pensions

Recent market impact

As anxiety escalates regarding the outbreak of COVID-19 around the world, global equity markets have fallen sharply since mid-February. The impact of the outbreak is likely to be sharper and deeper than many anticipated. Yet we do not see this as a repeat of 2008 as the broader economic and market backdrop is on a firmer footing given the crisis was not precipitated by financial instability. Amid the volatility, we must be mindful of how market fluctuations create imbalances relative to a portfolio’s strategic asset allocation (SAA). Given the magnitude of the decline, investment decisions made during these times may be some of the most critical in shaping the portfolio’s path forward. Fortunately, portfolio and risk analytics can help investors think through portfolio construction as well as rebalancing and reallocation strategies in different economic scenarios.

In the fourth quarter of 2019, BlackRock collected data from approximately 70 U.S. public pension plans as part of our annual Public Pension Peer Risk Study. Based on this data, the average public pension plan was approximately 72% funded in 2019, with an average asset allocation of 45% equities, 22% fixed income, 31% alternatives and 2% cash.1

However, recent market volatility has severely impacted those figures. Our scenario analysis estimates that pension assets have declined by approximately 27% on average.2 This decline represents a 2.3 standard deviation movement based on expected portfolio volatility. As a result, the average funded status has declined by approximately 20% (See the A historic selloff chart). Dispersion of losses among pensions has been wide, ranging from -20% to -40% of assets, and from -9% to -32% of funded status. Better funded plans experienced greater funded status declines, as assets were impacted and liabilities were assumed constant in the analysis. Plans that were in the top quartile of losses had on average an 80% allocation to growth assets, while plans that were in the bottom quartile of losses had an average allocation of 73% to growth assets (See the Wide dispersion chart). 

Additionally, given the speed at which the recent market volatility transpired, asset allocations have likely drifted significantly for those plans that have not rebalanced. This has resulted in overweight positions to fixed income and cash, and underweight positions to equities and alternatives (See the Massive drift chart). As this simulated analysis is based on economic proxies of underlying investments, actual results may take several quarters to flow through to reported returns, and the impact to investors may differ.

A historic selloff

Estimated impact of market stresses on the average pension portfolio

Estimated impact of market stresses on the average pension portfolio

 

Source: BlackRock, March 2019. Risk: 84% confidence interval, 231 constant weighted monthly observations, 1yr horizon, as of 11/29/19; see the Appendix for additional    risk details. BlackRock mapped fund exposures to public index and private market proxies in performing the analysis; See the Appendix for details regarding the indexes used to represent each asset class. Historical scenarios simulate each plan’s current portfolio through historical time periods. Hypothetical scenarios simulate each plan’s current portfolio through hypothetical large market shocks and geopolitical stresses, with implied shocks. The performance shown is hypothetical and does not represent the performance of any existing portfolio. There is no guarantee that any portfolio will perform in this manner under similar scenarios going forward. The hypothetical performance does not reflect fees and expenses. If fees and expenses were included, the performance would be lower. It is not possible to invest directly in an unmanaged index. Please refer to the Appendix for additional information. Change in funded status assumes liabilities remain static while actuarial assets are shocked by amount of stress PnL.

Wide dispersion

Changes in asset value and funded status among all survey participants

Changes in asset value and funded status among all survey participants

 

Source: BlackRock, March 2019. Change in funded status assumes liabilities remain static while actuarial assets are shocked by amount of stress PnL; time period of recent market volatility is Feb 21 – Mar 19, 2020. Growth assets include all assets other than cash and fixed income.

Massive drift

Pre- and post-stress portfolio weights of the average pension portfolio

Pre- and post-stress portfolio weights of the average pension portfolio

Source: BlackRock, March 2019. Original allocation provided by survey participants. Time period of recent market volatility is Feb 21 – Mar 19, 2020. Private markets are based on proxies of underlying economic value, which may take several quarters to flow through to reported returns.

Shaping the recovery

Market drawdowns and recoveries have taken various shapes historically. To help plan the path forward, we have illustrated a few examples of potential recovery scenarios and analyzed the impact on pensions over time. 

Depending on the shape of the recovery, pension plans may regain their pre-stress funded status levels in about a year, or more gradually over time (see the Why rebalancing matters and Recovery shapes and sizes charts). 

Prudent portfolio construction and risk management is  of utmost importance, particularly during such volatile periods. With significant declines in funded status, pension plans may need to reassess their SAA in order to ensure they are taking the appropriate level of risk to achieve their assumed returns required for full funding.

Investment decisions made during these times are critical and can significantly drive future outcomes. What worked in the past may not necessarily work going forward, either due to the sheer size of market moves or due to changes in medium-term macroeconomic assumptions. Building portfolio resilience into an SAA is imperative, and it goes beyond diversification of asset classes. A well-constructed SAA analyzes portfolio risks from various factors and incorporates uncertainty around the future path of assets, including downside scenarios and scenarios beyond those observed historically.

Additionally, portfolios that drift with the market and are not rebalanced may result in concentrated positions that deviate from the SAA. We estimate that pensions that have not rebalanced their portfolios in response to recent market moves may be inadvertently taking approximately 1.5% of active risk relative to their original portfolios (see the Why rebalancing matters chart). Once the appropriate level of strategic risk is determined, taking further active risk inadvertently may have unintended consequences.

We favor rebalancing toward target weights. While we believe it may be too soon to overweight equities, it may be prudent to start leaning against market moves through rebalancing as well as posturing for potential opportunities. We caution investors from making changes without considering transaction costs, market liquidity and cash requirements, among other factors.

There is no silver bullet for investors, much less for public pensions in general. However, leveraging portfolio and risk management analytics to evaluate portfolios may help investors plan for different economic scenarios, with the goal of bringing plans closer to full funding over time.

Why rebalancing matters

Active risk of market drifted portfolio relative to original portfolio and effects under different scenarios

Active risk of market drifted portfolio relative to original portfolio and effects under different scenarios

 

Source: BlackRock, March 2019. Risk: 84% confidence interval, 231 constant weighted monthly observations, 1yr horizon, as of 11/29/19; see the Appendix for additional    risk details. BlackRock mapped fund exposures to public index and private market proxies in performing the analysis; See the Appendix for details regarding the indexes used to represent each asset class. Historical scenarios simulate each plan’s current portfolio through historical time periods. Hypothetical scenarios simulate each plan’s current portfolio through hypothetical large market shocks and geopolitical stresses, with implied shocks. The performance shown is hypothetical and does not represent the performance of any existing portfolio. There is no guarantee that any portfolio will perform in this manner under similar scenarios going forward. The hypothetical performance does not reflect fees and expenses. If fees and expenses were included, the performance would be lower. It is not possible to invest directly in an unmanaged index. Please refer to the Appendix for additional information. Change in funded status assumes liabilities remain static while actuarial assets are shocked by amount of stress PnL.

Recovery shapes and sizes

Illustrative recovery scenarios and potential impact on funded status

Illustrative recovery scenarios and potential impact on funded status
Potential recovery scenarios and potential impact on funded status

 

Source: BlackRock, March 2019. Recovery scenarios are for illustration purposes only; this information does not reflect any specific account or portfolio. Recovery scenarios are approximated by shocking ACWI by +/-20% for each incremental 15% market move; change in funded status assumes liabilities remain static while actuarial assets are shocked by amount of stress PnL. Active Risk reflects the risk of the rebalanced original allocation vs. the market drift allocation at each interval.

Calvin Yu
Head of the Client Insight Unit
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Jonathan Cogan
Vice President, Client Insight Unit
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Ben Ho
Vice President, Client Insight Unit
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Sarah Siwinski
Associate, Client Insight Unit
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Making sense of market turmoil
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Making sense of market turmoil