Rates, Inflation and Uncertainty All Rise in 2017

As 2016 scored a hectic 12 months in economic and market rates, (most notably for pension funding),  the question remains for 2017—what should defined benefit (DB) plan sponsors and defined contribution (DC) plan participants expect throughout the year’s course?

Well for starters, according to Milliman’s Pension Funding Index (PFI), released in January, under an optimistic forecast with rising interest rates (reaching 4.55% by the end of 2017 and 5.15% by the endof 2018) and asset gains (11.2% annual returns), the funded ratio would climb to 92% by the end of 2017 and 105% by the end of 2018. Under a pessimistic forecast with similar interest rate and asset movements (3.45% discount rate at the end of 2017 and 2.85% by the end of 2018 and 3.2% annual returns), the funded ratio would decline to 75% by the end of 2017 and 69% by the end of 2018. 

Jason Shoup, senior portfolio manager and fixed income strategist of Legal & General Investment Management America (LGIMA), believes sponsors should be wary of seeing both highs and lows, as he expects enhanced growth with fatter tails in the coming year.

“What we’re contending with is an expectation of modestly improved growth in the U.S.—but an outlook that has much, much fatter tails to it, and as a result, a rates outlook that has much fatter tails to it as well,” he says. “Through the lens of a pension administrator and pension plan, you really need to be ready to act here, and you need to be poised in thinking about these issues because on the one hand, we may be seeing the highs of the market in terms of rates, or we may be seeing the lows.”

While rates are anticipated to rise over the year, Shoup adds that uncertainty will continue to heighten, mainly because of the indeterminate nature specific qualities and transactions have in affecting rates. 

“When we think about the outlook in the rates market, it’s something of a wild card, because you talk to economists, you talk to interest rate strategists, and there really is no historical precedent to translate what that improvement and confidence might do to capital expenditure (CAPEX), hiring, the mergers and acquisitions (M&As), to animal spirit, and how that may ultimately translate to growth and higher rates,” he says.

Additionally, LGIMA’s 2016 Market Commentary reports that upcoming potential legislation in response to the new Trump administration adds worry to political risk. “The new administration may succeed in extending the current business cycle, but the possibility that politics fail to live up to expectations seems remarkably high and argues for some degree and caution,” the report reads.

Shoup adds, “There’s quite a bit of uncertainty with respect to how high rates can go, and on the other side, if you have a misstep from the administration on corporate tax reform, on trade, on immigration, it’s quite possible that you have significant downside risks as well.”

The LGIMA report finds that despite market volatility, establishing de-risking strategies are imperative for plan sponsors. Report findings see plan sponsors interested in customized liability-driven investments (LDI) strategies, such as raising their fixed income allocation, liability benchmarking, completion management and hedging strategies associated with glidepaths.

Shoup and Jodan Ledford, head of U.S. Solutions for LGIMA, believe LDI will play a significant role in de-risking strategies for 2017. “In a DB perspective, I would think that in 2017, LDI will be a very strong conversation, where you will see flows,” says Ledford.

A report from Northern Trust’s Investment Manager Fourth Quarter 2016, which surveyed 100 investment managers in Northern Trust’s multi-manager platforms—including outsourced chief investment (OCIO) services—found that 78% of those responded forecast inflation to increase throughout 2017, a large increase from last quarter’s 47%.

Still, Mark Meisel, senior investment product manager of the Multi-Manager Solutions group at Northern Trust, believes managers will not see inflation increase dramatically over the course of the year. Therefore, he suggests that retirement portfolios be strategically asset allocated with adequate money in stocks and bonds, and to also diversify among asset classes to the best ability.

“If I were a participant and I saw the results, I would be making sure that I have enough allocated to asset classes that do okay in a rising rate environment—not dramatically rising rate—but a slow rising rate environment, and one where inflation is beginning to take impact again,” he says.

Meisel recommends real asset classes, including real estate investment trusts (REITs), Treasury Inflation Protected Securities (TIPS), and the global listed infrastructure. However, he warns that while commodities hold paramount correlation to inflation, they also have high volatility.

“That may be something that depending on the risk tolerance of the client, they may not want to invest in,” Meisel says. “Some of these other real assets I think would be important to have, with consideration for an appropriate allocation for their risk tolerance in those type of classes.”

For DB plan sponsors, Meisel suggests similar advice in reviewing asset allocations. “They should, again, look at their asset allocation amongst the asset classes and make sure they have enough inflation hedges in there.”

A State Street Global Advisors Market Outlook of 2017 found that forward return expectations for equities are less than 5%, while expectations in fixed income came in between 1% and 2%.

Lori Heinel, deputy global chief investment officer for State Street Global Advisors, believes that because of this, most DB plan sponsors—especially in the public space—will have a tough time achieving a return on asset assumption.

In response to the expectations, Heinel encourages clients to consider volatility management, illiquid assets and additional asset sources.

“Think a lot about volatility management, because in an era of lower returns, higher volatility can be deadly,” she says. “Also, look at things like illiquid assets, so whether it be private equity and private real estate or infrastructure, other kinds of things are often asset classes that they can take advantage of.”