Rising Interest Rates Top Institutional Investor Concerns

Rising interest rates, a potential economic recession and geopolitical tension are the top concerns impacting the portfolio construction of institutional investor organizations in the next six months, according to NEPC 2022 Governance Survey respondents.

Rising interest rates ranked first among five macroeconomic factors likely to impact portfolio construction in the next six months—other choices were economic recession, geopolitical tension, global pandemic and maturation of environmental, social and governance disclosures, the survey found.

One reason for the emphasis on rising interest rates is the effect rates have on corporate pension funds. Unlike for many investors, “inflation is beneficial for most corporate pension plans,” explained Brad Smith, partner at NEPC and a member of the firm’s corporate defined benefit team, in an email. “Since most U.S. pension plans don’t offer [cost of living adjustment] benefit increases, higher levels of inflation can be a benefit to plan sponsors. “The most immediate impact from higher expected inflation is higher interest and discount rates. As discount rates rise, the estimated value of pension liabilities fall.”

Smith added, “Provided the remaining diversifying assets don’t fall as much as the liability estimates, the plan’s funded status can actually rise. During this recent market environment, we have seen many of our clients’ funded status estimates hold steady despite the significant market selloff.”

NEPC scored the factors, in a range from one to five, with factors expected to have the greatest impact ranked lower, according to the survey.

Among remaining factors, economic recession scored an average rank of 2.1, geopolitical tension 3.0, global pandemic 4.1 and maturation of ESG disclosures 4.5.

Additional analysis showed 67% of institutional investor respondents agreed that rising interest rates will have the greatest impact on their organizations’ upcoming portfolio construction.

Corporate pension plan clients working with NEPC have not overreacted to the market environment, Smith explained. 

“We have seen many of our clients’ funded status estimates hold steady despite the significant market selloff,” Smith wrote. “We have been advising clients to monitor their target hedge ratios actively. Large movement in discount rates can impact both asset and liability durations.”

The NEPC survey also showed that 60% of respondents in corporate and public pensions say deterioration of funded status because of market declines in 2022 is their main concern for the pension fund in the next 12 months.

NEPC queried pensions on the investment changes that that group of investors may pursue. Whereas 49% say they are considering maintaining the current asset mix with no change, 28% are considering increasing the amount invested in alternative asset investments, 14% are considering increasing the amount invested in cash or fixed income and 8% are considering increasing the amount invested in public equities, according to the survey.

Smith explained pension plans are likely to consider increasing alternative investments that are typically less correlated to ‘traditional’ investments—meaning well-known assets such as stocks, bonds cash and cash equivalents, he said.

“This lack of strong correlation to other markets can help smooth a plan’s return over time,” Smith says.  “Oftentimes, alternative investments are less liquid, hold above-average complex assets and are valued using a combination of market value adjustments and appraisals.”

When considering real estate as an alternative, Smith illustrated an example. 

“If you asked the typical homeowner, ‘What’s the value of [your] house?’, most would say, ‘I paid $X [amount] three years ago, and another similar house just sold for $Y, so I think $Y is a good estimate,’” he explains. “Until the house is sold, the estimate is based upon a combination of past market sales and/or estimates of future expected rental income. Since real estate is valued using market appraisal, recent property sales and discounting future rental income estimates, market values won’t change daily. As a result, valuations will tend to lag over time, both in falling and rising markets. Most alternative investment strategies are valued either monthly or quarterly in arrears.”

For defined contribution plans, the NEPC survey finds more than 50% are likely to incorporate environmental, social and governance investing strategies: 22% said their organization is very likely to incorporate ESG into their defined contribution plan governance, 30% somewhat likely, 30% unlikely and 17% unsure.

While previous surveys have shown that participants claim to want ESG investment options in their plan lineups, other data counters the conclusion. For example, the Schroders 2022 U.S. Retirement Survey found 87% of defined contribution plan participants want their investments to be aligned with their personal values, however, data shows slow progress for including ESG options within defined contribution plans.   

A total of 247 respondents completed the NEPC survey: 26% held an investment staff position, 47% were senior executives and 28% held job titles on the board or investment committee. Among institutional investor survey respondents, 25% were from public pensions, 19% foundation, 10% corporate pension, 9% defined contribution, 9% health care, 6% private wealth, 6% endowment, 6% Taft-Hartley plans, 2% insurance and 8% other.

The survey was conducted by NEPC, with data gathered from July to August.