Asset Allocation, Defined Benefit, Governance, Institutional Investors, Pension Funds, Public Funds

Chief Investment Officers Fess Up on their Biggest Fears

At Markets Group’s 7th Annual Tri-State Institutional Forum, Antonio Rodriguez, director of investment strategy, NYC Board of Education Retirement System, posed the question:” What keeps you up at night, currently?” to the CIOs sitting on the Conversation with the Region’s Leading Chief Investment Officers panel.  We know there are a lot of sleep deprived CIOs out there. So, Institutional Allocator decided to turn the question back on Rodriguez and pose the question to him and a few other CIOs.  Here’s a sampling of their responses.

Antonio Rodriguez: director of investment strategy, NYC Board of Education Retirement System:

Antonio Rodriguez: director of investment strategy, NYC Board of Education Retirement System

The number one thing is not being able to effectively communicate what is going on to my board and getting them the correct information, in a timely fashion and in the correct format. We are long-term investors, and more importantly, we have a sponsor, New York City, that is better positioned than most municipal sponsors. It is committed to paying the actuarial determined contribution rate every year. With a sponsor like that, we can withstand a whole bunch of volatility, and that is usually what keeps people up at night. It’s what is going to happen in markets in the next month, quarter and year. So we have the ability to withstand a lot of it.

If you want more market analysis, it’s more market existential questions. It’s like: ‘What if our rate structure is low for a lot longer? What does it means for pension systems and prefunding as a whole if you have long structural rates being low, but more importantly the yield curve being flat?’  So that is something from a large pension fund perspective that I think about a lot.

And then, what about if there is nowhere to hide?  Or, if all correlations on the downside are going to one? Or all correlations being high from a structural perspective? We can only tilt around the margins, but we are pretty much set around our strategic asset allocation. We hold onto it. We have rebalancing bands that let you tilt a bit, but for the most part, if we get hit by a wave, we are using our long-term nature to buoy us.

And then more generally, regime change–the mix of monetary policy, inflation, growth, rates, and fiscal policy. So far, returns on equity and equity risk premium have held up.  But I think there is a lot of evidence that’s mostly because there has been a massive decline in the share [of profits] going to labor. How much longer can returns come from squeezing labor share instead of productivity growth?  Shareholders are taking it [profits] out of labor. And what happens, long term, when people get very angry about that?  There is only so much you can squeeze before you lose all or a lot of demand.  The same with buybacks. You have to reinvest at higher and higher prices that aren’t necessarily because of higher productivity and higher profit growth.

Marcia Peters, chief investment officer, Portfolio Evaluations Inc.

Marcia Peters, chief investment officer, Portfolio Evaluations Inc. 

For me, it’s always the same answer, and that’s the level of underfunded state pension plans. Look at the data. The average funded status is about 50% for states, but depending on how they discount their liabilities many expect it’s actually lower than 50%. But that is pretty worrisome when most corporate plans that are not fully funded are probably in the 70% to 80% level.

At bottom of the list are Kentucky and Illinois.  Kentucky has an underfunded status around 30%. New Jersey and Connecticut are not far behind at around 35%. So it raises the question: ‘What does the future hold for these states and the residents in these states, as the states are trying to meet their obligations to their plan participants?’

States got themselves into this problem because they underestimated longevity. In other words, how long participants would live and how long they would collect their benefits.  Certainly, participants have generally exceeded the expectations that were built into the calculations.  But they also underestimated the demographic population shift, where there are fewer younger workers contributing to the system to support the payments for those retirees.

Another issue is the expected returns for their assets were over estimated. Plans also experienced setbacks during the “ bubble” in 2000 and also in 2008. So, while since 2009 they have recouped some of those loses, they have not really kept pace with contributions, and in some cases states have shifted assets out of the pension plans to other needs that they have. A combination of all of these things really has worked against the funded status, and I get especially concerned, because I don’t really see anything that states are doing in terms of developing strategies to try to fix the problem.

As a resident of New Jersey, which is a state with a very low funded status, it means state taxes may have to be raised, and/or benefits to retirees could be cut. There will be less money to spend on the essential services. Also, [speaking] as an investment professional,  some of the things that got them into trouble were risky investments back in the early 2000s and in 2008, and I get concerned that investment boards are going to take on more risky investments going forward, which doesn’t always help the situation.

P. Wayne Moore, deputy chief investment officer, Municipal Employees’ Retirement Fund City of Hartford

P. Wayne Moore, deputy chief investment officer, Municipal Employees’ Retirement Fund City of Hartford

Each month, 3,400 retirees from the City of Hartford are owed a defined benefit payment of $10 million dollars, earned over decades of service to the City.  As more employees retire there are fewer active workers available to support the fund, putting more stress on the City to increase its contributions and also potentially requiring higher rates of return on investments.

The payment amount increases every year, given the accelerated pace of retirements by police, firemen and other City employees. The pool of funds available to make the payments is balanced between City monies, employee contributions and investment income. While employee contributions are relatively stable, the amount and timing of City contributions to the pension fund are at times uncertain. Investment income is also uncertain. Therefore, [coming from the point of view of] an investment professional, there is a monthly “solution set” of uncertain cash flows that must add up to $10 million dollars, which is a substantial amount of money for a City the size of Hartford, Connecticut.

For me, it’s always the same answer, and that’s the level of underfunded state pension plans.

Donald Walker, deputy chief investment officer, The Board of Pensions of the Presbyterian Church

Donald Walker, deputy chief investment officer, The Board of Pensions of the Presbyterian Church

“I worry about correlations, and I share [other’s] worry about:  Are we protected from the unknown unknowns, such as geopolitical events, or shocks to the financial system. But those are things that I can only estimate a little bit. The things I worry about are things that our team can influence or control like, are we managing liquidity appropriately? Do we have the right tools to do our work well and provide adequate benefits for our plan members? That is what keeps me up at night when it comes right down to it, because we can’t appropriately handicap all those big unknowns. We can only work to balance the risks and maintain liquidity to weather the unexpected.”

Scott Stone, senior vice president & chief investment officer, Pentegra:

If I had to think of anything, it would be correlations. You get the power of diversification from between either zero or negative correlation between various asset classes. It’s just fundamental modern portfolio management theory. It’s just math–to the extent that the two main investor asset classes, U.S. equites and U.S. fixed income, over the last 20 years, have either been zero correlation or negative correlation. 

Scott Stone, senior vice president & chief investment officer, Pentegra

When you get into a more inflationary environment, inflation generally means bond prices are going down and the inflationary environment tends to be good for equities, over time, but we are noticing that starting in about 2016, it wasn’t so good for equity prices, when we thought there was an inflationary problem. 

Now, we have an inverted yield curve; Trump’s latest appointee to the Federal Reserve Board of Governors is talking about how the Fed should be cutting interest rates by 50 full basis points immediately. Speaking as a recovering bond trader, I don’t care what the equity market says, what I care about is what the bond market says, in terms of interest rates, and right now, the bond markets say short term rates are too high relative to the market’s view of long-term rates, and that is why you have an inversion. 

That is also why, for half a dozen times now, over the last 50 or 60 years, every time we have had this inversion, in particular three months to ten years, we have had a recession. There have neither been type one or type two errors in predictions to value with this particular inversion filter. It’s been 100 % accurate and it just inverted.  So, if that is still a real relationship, we are looking at a recession in about year; in about 300 to 400 days the recession will officially start, if all things are equal and we continue on this path. So, in terms of allocations and what keeps me up at night, now my problem is changing asset correlations and a yield curve inversion.

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