Public Retirement Systems and Capital Market Developments

Public Retirement Systems and Capital Market Developments

State and local government retirement systems play a leading role in allocating capital across global markets on behalf of their members and stakeholders.

In May 2019, Segal Marco presented a broad review of capital market trends impacting the nation’s public pension funds at the National Conference on Public Employee Retirement Systems (NCPERS) Annual Conference in Austin, TX.

These trends will affect the ways that public and private sector pension funds invest for the benefit of their members and beneficiaries. Below is a description of a few trends that are currently affecting funds, as well as how funds are responding to them.  

The State of the U.S. Retirement System

State/local and private sector defined benefit (DB) fund assets increased from a combined $4.4 trillion in December 2008 to $6.8 trillion as of December 2018, an increase of over 50%. State/local and private sector defined benefit assets currently account for 42% of employer sponsored retirement plan assets.

Lack of access to the plans for private sector employees continues to pose a social and fiscal challenge to policy makers--in fact, one survey showed that 59% of working age individuals have no retirement plan.

Segal Marco Advisors is working with a number of multiemployer and public plan stakeholders, industry groups, non-profits, and governments to help address the retirement savings crisis by advocating strengthening our defined benefit system and by advising on public sector efforts to provide access to uncovered employees of small companies.     

The Rise of Wealth Management

Wealth management, a segment of the investment industry that services high net worth individuals, reportedly grew by $19.7 trillion in assets under management (AUM) globally from 2007 to 2017.  

Global investable assets of high net worth individuals are projected to hit almost $70 trillion by 2021. Growth in wealth management has been influenced in part by the growing concentration of wealth in the U.S. among a small percentage of the overall population: today, the wealthiest 1% of Americans now own more than the bottom 90% combined.

The wealth management industry is one of the fastest growing and most profitable segments of the financial services industry. The impacts to pension fund investors are as yet unknown, but wealth management is an increasing focus for asset management firms who also manage institutional assets.                  

The Expanding Role of Alternative Investments

Average public pension fund allocations to alternative investments and real estate reportedly more than tripled over a period of 15 – 20 years.

This change to investor allocations comes as return expectations for traditional asset classes (i.e. stocks and bonds) are set to be lower in the future. Private sector and multiemployer allocations to alternative investments have increased significantly and are projected to continue to grow.

Among large funds, allocations to alternative investments are typically higher, with investors drawn to alternatives for the potential of a higher expected portfolio return, reduced volatility and better portfolio efficiency.

While return potential may be greater than that of public markets, an effective alternative investment program requires an enhanced risk management framework to manage market, liquidity, operational and credit risk exposures.

Financial System Impacts of Passive Management

Continued investor flows from active equity management strategies to passive (Indexed) strategies have increased passive management’s share of equity mutual funds from just 3% in 1995 to 37% in 2017.

While passive management helps investors gain exposure to the markets at low cost, the aggregate impact of flows from active to passive management may be having unintended impacts on the U.S. financial system, on corporate governance and on competition in the financial services industry.

While some private sector studies on the potential impacts of passive investing reflect the publisher's business interests, there is a growing body of independent research that demonstrate a potential effect.

For example, a 2018 Federal Reserve Bank of Boston study found that asset flows to passively managed strategies have increased industry concentration and may be facilitating the use of trading strategies that lead to heightened market volatility.

Due to high barriers of entry and price competition, three firms, BlackRock, State Street Global Advisors and Vanguard, reportedly account for 80% - 90% of indexed assets under management. These firms (the “big three”) are now collectively the largest owners at 40% of U.S. public companies.

Environmental, Social, Governance (ESG) Integration

ESG strategies are focused on investing in firms and assets that will enhance shareholder value and pension fund performance while contributing to environmental, social or governance goals.

The mainstreaming of ESG in pension fund investment programs is evidenced in part by a report, from the Forum for Sustainable and Responsible Investment, that assets allocated to sustainable investing reportedly increased by 38% in the U.S. between 2016 and 2018.

Pension funds may integrate ESG into their investment programs through a number of mechanisms including corporate governance and proxy voting, investment policy provisions and investment manager selection.

Mechanisms to integrate ESG also include investments in alternative assets that seek to generate attractive risk-adjusted returns, while improving air quality, creating affordable housing, creating jobs and promoting labor practices that serve the interests of unions and signatory employers.  

Capital Stewardship and Corporate Governance

By one estimate, public and private pension funds own a combined 17% of shares of U.S. publicly traded companies. As capital stewards for a large portion of corporate America, public funds employ proxy voting and corporate governance (e.g. shareholder proposals) to influence companies they own to adopt practices aimed at enhancing shareholder value.

Actions that some pension funds are focused on in 2019 include initiatives to better align CEO pay with share price performance, board diversity, and majority voting to improve accountability, among others. Segal Marco is also one of a group of investors who are focused on requiring companies in the opioid supply chain to improve controls, in order to stem the current opioid-related public health crisis and protect shareholder value.        

Looking Ahead

Public retirement systems continue to implement leading edge practices to position their funds for strong risk-adjusted performance.

They advocate for improved corporate governance for the benefit of members and beneficiaries as the capital markets, global economy and risk exposures evolve. Trends in the capital markets will continue to shape the outlook for public funds.     

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Maureen O’Brien

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Tim Barron, CAIA
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