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Dial It Down: Pension Fund Managers Cope With Lower EROAs

By December 17, 2020 No Comments

Key takeaways from a NeuGroup for Pension and Benefits meeting sponsored by Insight Investment and BNY Mellon.

Pension fund managers discussed best practices in selecting and evaluating investment managers, asset allocation and the impact of lower estimated return on assets (EROA) among other topics at a virtual meeting sponsored by Investment Insight and BNY Mellon. Here are takeaways from the gathering compiled by Roger Heine, senior executive advisor at NeuGroup.
 
EROA expectations. Two-thirds of members are facing the reality that low interest rates are pushing down EROA assumptions, which ultimately reduce pension earnings under standard accounting.  Overall, EROA has eroded about 50 to 100 basis points over the past three years, according to figures presented by one member.

  • However, those pensions which still have large equity and risky asset allocations with higher expected returns are feeling less pain. 
  • With US interest rates now below expected inflation, actuaries and auditors have become less complacent with fixed income return assumptions based purely on historical returns—it seems almost impossible for these returns to be repeated going forward. 
  • Several members indicated that EROA analysis has evolved to weigh historical returns with forward-looking long-term estimates provided by fund managers and even actual recent performance. But several members expressed frustration with how much supposedly stable, long-term expectations can change year-to-year.
  • Several members emphasized that the EROA estimating process is performed independently of corporate management and is not influenced by the impact on reported earnings.

Adjustments to overall pension strategy? Despite all the market volatility in 2020, it appears most pensions stayed the course and have not fundamentally changed asset allocations as long-term strategies such as liability-driven investment (LDI) trumped sentiment that fixed income markets in particular have become overvalued.

Manager selection criteria. One member explained her very systematic process for selecting and retaining portfolio managers that starts with a highly quantitative approach, similar to analyzing each manager like a security under modern portfolio theory, based on historical data and evaluated almost continuously thanks to available software. 

  • Following that, qualitative factors are layered in, such as the investment philosophy, risk management controls and whether there is an idiosyncratic edge to the manager’s strategy.
  • Another member made the point that it’s important to look at historical performance on a rolling basis; otherwise, one good year could impact three, five and even 10-year historical performance.
  • Regarding the number of managers, three seemed to be a minimum requirement for each asset class to get diversification benefits. Larger pensions can have many more, limiting each manager to 15% to 20% concentration.
  • Another member discussed how it is preferable to work with underperforming managers before firing them, as you don’t want to do that at the bottom of their performance.

Passive vs active managers. There seems to be a trend to shift more assets to passive funds, particularly in the most liquid markets where the opportunity for alpha in active funds is probably minimal anyway and management fees are a drain on performance.

  • But a key challenge with passive funds is concentration in the tech-heavy top six or seven largest companies, with the imminent addition of Tesla to the S&P 500 adding to the challenge.

Contributions. Several members discussed how increasing corporate contributions to the pension makes a lot of sense when they would reduce the high 4.5% variable PBGC fees. But PBGC fees are capped for lower funded pensions, which discourages contributions among high yield companies.

  • The low borrowing rates for strong companies compared to much higher EROAs are also encouraging contributions to pensions.
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Justin Jones

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