Macro Wrap – Pension Funds, the Ignored Behemoths

by Enis May 7, 2013 7:33 am • Commentary

Public and Private Pension Funds own about 16% of the publicly held companies in the U.S.  Compare that to 3% for hedge funds as a whole.  Here’s the chart from GS Research, courtesy of Sam Ro at Business Insider last month:

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Despite that large chunk of ownership, pension funds’ investment strategies and allocation shifts are rarely discussed.  The underfunded status of many public and private plans is well known.  (Sidenote:  the fact that such plans remain widely underfunded despite booming global equity markets is an illustration of how bonds are much more important than equities to the bulk of the institutional investment universe.)  So creative solutions to address such underfunding have become more popular, as tends to happen anywhere when there isn’t enough money to go around.

This week’s Buttonwood column in the Economist  discusses one such “creative” solution:

Failing to recognise the true cost of public pensions builds up all sorts of problems, as an academic paper last year made clear. As pension funds become more mature (ie, more of their members are retired) their asset allocation should, in theory, become more conservative. After all, the fund has to worry more about paying benefits immediately and has less scope to gamble that riskier assets will deliver long-term growth.

Sure enough, mature pension funds in Canada and Europe and in America’s private sector all follow this approach. But more mature American public plans have riskier portfolios than less mature equivalents. In its latest “Global Financial Stability Report” the IMF worried that American funds had increased the riskiness of their portfolios, “exposing them to greater volatility and liquidity risks”.

The explanation for such behaviour is not hard to find. American public-sector schemes discount their liabilities by the expected return on their assets. The riskier the asset mix, the higher the assumed return—and the lower the bill appears to be.

Part of the problem for much of the domestic world is demographics.  Aging problems are making such problems worse, and low interest rates globally can create perverse incentives.  When the fund’s mandate is to return 6-8% per year for decades, but the current manager’s job only depends on returns over a few years, the potential for desperate measures is quite high.

While demographics are a major long-term headwind to financial asset prices, one optimistic trend is the internationalization of investment markets.  International investors now own 14% of the U.S. stock market, almost equal to pension funds, and will likely exert growing influence in the years ahead.  They’re likely to be the most willing buyers to the oncoming horde of retiring sellers.