Investment Return Expectations and Wishful Thinking

When it comes to strategy games, count me in. Bridge and Scrabble are two of my favorites except when it looks like I have little chance for victory. It's one thing to lose a hand or two but feel confident in a possible win. It's altogether depressing to know that recovery is unlikely. This happened a few days ago when my husband added an E, U, A and L to create a cluster of words that scored him sixty-seven points. Ouch. Even with lots of high point letters, I knew that besting his bonanza move was improbable. Each time we play, I begin on an optimistic note and hope for a favorable outcome until that moment when I know it's time to recast my calculations.

It's good to wish upon a star yet just as important to distinguish fantasy from fiction. That's why I was surprised to learn the results of a recent study of 400 institutional investors about their performance predictions. Carried out by State Street Global Advisors ("SSGA"), in conjunction with the research arm of the Financial Times, main takeaways from the "Building Bridges" study include the following:

  • Traditional asset allocation models may be unable to generate a long-term average rate of return of eleven percent, certainly without forcing buyers to take on more risk.
  • Forty-one percent of survey-takers expressed a preference for "traditional" classifications of asset exposures versus factor or objective-driven identifiers.
  • Eleven percent of those in search of closing "performance gaps" rank smart beta strategies as most important and 38 percent of institutional investors will employ this approach alongside other activities. "Significantly, three-quarters of those respondents who have introduced smart beta approaches found moderate to significant improvement in portfolio performance."
  • Enlightened decision-makers are finding it hard to get board approval of "better ways to meet long-term performance goals" and peer groups are slow to follow suit.
  • Eighty-four percent of pension funds, sovereign wealth funds and other asset owners believe that underperformance is likely to continue for one year.

As Market Watch journalist Chuck Jaffe somewhat indelicately points out in "An overlooked investment risk: wishful thinking" (May 18, 2016), long-term investors are daydreaming if they believe they can regularly generate eleven percent per annum. He quotes Lori Heinel, chief portfolio strategist at SSGA, as acknowledging the difficulty of achieving this number, given "a really challenging growth outlook, inflation environment, and a really challenging investment return environment." Notably, it was only a few weeks ago when the special mediator for the U.S. Treasury Department sent a letter to Central States Pension Fund trustees, denying a rescue plan in part because its 7.5 percent annual investment return assumptions were not viewed as "reasonable."

As I described in an earlier blog post entitled "A Pension Rock and a Hard Place," public pension funds, union leaders, taxpayer groups and policy-makers are navigating choppy asset-liability management waters. They are not alone. Corporate plans, endowments, foundations and other types of institutional investors are likewise challenged with getting to their destination and not crashing on the rocks. My unrealistic expectations might lose me a game. For long-term investors, there is serious money at stake and model inputs are being scrutinized accordingly.

Foreign Corrupt Practices Act and Implications for Institutional Investors

For those who don't know, I am the lead contributor to an investment compliance blog known as Good Risk Governance Pays. I created this second blog as a way to showcase investment issues that had a wider reach than just the pension fund community. While I strive to publish different education-focused analyses on each blog, sometimes there are topics that I believe would be of interest to both sets of readers. A recent article that I co-wrote is one example. Entitled "Avoiding FCPA Liability by Tightening Internal Controls: Considerations for Institutional Investors and Corporate Counsel" (The Corporate Counselor, September 2014), Mr. H. David Kotz and Dr. Susan Mangiero explain the basics of the Foreign Corrupt Practice Act. Examples and links to reference materials are included, along with a discussion as to why this topic should be of critical importance to pension funds and other types of institutional investors. Click to download a text version of "Avoiding FCPA Liability by Tightening Internal Controls: Considerations for Institutional Investors and Corporate Counsel."

U.S. Infrastructure and Pension Fund Investment

The world is truly getting smaller. A recent Wall Street Journal article describes the continued interest on the part of Japanese pension funds to directly invest in U.S. infrastructure projects such as a Michigan power plant. See "Japan's Pension Fund Association Targets Infrastructure Abroad" by Kosaku Narioka (July 2, 2013). Last year, the Ontario Municipal Employees Retirement System ("OMERS") joined forces with Japan's Pension Fund Association and a group led by Mitsubishi to invest $7.5 billion in roads, airports and other types of infrastructure projects. The goals are to raise $20 billion in total, avoid the expense of using intermediaries and gain exposure to long-term assets that are arguably a natural match to a defined benefit plan's long-term liabilities. See "OMERS, Japanese partners launch infrastructure fund" by Greg Roumeliotis (The Globe and Mail, April 26, 2012).

In their 2011 publication entitled "Pension Funds Investment In Infrastructure: A Survey," authors Raffaele Della Croce, Pierre-Alain Schieb and Barrie Stevens estimate the global infrastructure market at U.S. $50 trillion by 2030. This includes climate control projects. They add that, given the strain on numerous municipal and sovereign budgets and regulations that have impaired some banks' abilities to lend, infrastructure financing must depend on private sector finance.

With these opinions in mind, infrastructure investing by pension funds seems like a good idea. There is both a demand for long-term capital and a supply in the form of interested money in search of returns over time. Like any investment and/or strategy however, one needs to weigh risks against expected returns.

Currency risk and project completion risk are two considerations. Being able to obtain and properly interpret adequate performance reports is another concern. In "Insurers call for more transparent infrastructure investments," contributor Louie Woodall (June 14, 2013) writes that opacity is a roadblock to having insurance company institutional investors allocate more money to this asset class. Regulations cannot be ignored either. Olav Jones, deputy director-general of Insurance Europe is quoted as saying that "...the Solvency II calibration for long-term investments does not account for the actual default of these assets, which is the primary risk insurers have to reserve for when using a buy-to-hold strategy." To the extent that pensions may be asked to comply with Solvency II mandates (or something similar for non-European funds), their trustees will no doubt want to ensure that capital is being pledged on the basis of "true" economic risks they deem to be associated with identifed investments.

Fiduciary liability is another factor that, in my view, is seldom discussed. Specifically, there are situations when a pension fund may feel that political pressure is being brought to bear to have trust money used to support a local project. When I recently spoke about pension governance before an audience that included public fund trustees, several persons complained about the exertion of uncomfortable "influence" to allocate assets in a way that could be said to fuel growth for a particular city or county or state but not necessarily fit with the pension fund's investment strategy. I served on a June 17, 2013 panel entitled "Fiduciary Responsibility for Management & Trustees." It was part of the Tri-State Institutional Investors Forum. The conference was produced by the U.S. Markets Center for Institutional Investor Education.

Published in 2008, interested readers may want to download "Pension Fund Investment in Infrastructure: A Resource Paper" by Larry W. Beeferman, JD. I have had the pleasure of speaking about governance and pension risk management at events put together by Mr. Beeferman, senior executive with the Labor and Worklife Program at Harvard Law School.

Another resource is "Trends in Large Pension Fund Investment in Infrastructure" by Raffaele Della Croce (OECD, November 2012). Based on his survey research of beneficial owners with control of more than $7 trillion of assets, he describes infrastructure investing as "attractive" because it can "assist with liability driven investments and provide duration hedging." Later in the report, he discusses the tradeoff between liquidity of these longer-term commitments with the chance to diversify a pension portfolio.

With planes, boats, trains, cars and fast technology, we can go from Peoria to Paris in hours. It is no surprise then that we see pension giants focused at home and abroad.