Smart Beta Survey Highlights Opportunity, Need for Education

There is some lingering uncertainty about the role of smart beta institutional investing, as more than 50% of asset owners in the U.S. say they remain uncertain on the best approach for their particular purposes.

FTSE Russell published its 2018 Global Institutional Smart Beta Survey, marking the fifth annual installment of the smart beta survey.

Level-setting the conversation, FTSE Russell’s explains its use of “smart beta,” in the context of indexing, is simply meant as a “generic term for transparent, rules-based indexes that depart from the standard market capitalization weighting method in order to achieve particular objectives.” These objectives could include the generation of long-term excess index returns, the mitigation of volatility or enhanced diversification. FTSE Russell classifies these various approaches into two broad categories; alternatively-weighted (e.g. fundamental, equal or risk-weighted) and factor indexes (e.g. single or multi-factor).

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According to the 2018 smart beta survey, the vast majority (91%) of institutional asset owners globally have a smart beta investment allocation, have evaluated or are planning to evaluate smart beta in the next 18 months. The survey further shows a 16% increase in implementation or consideration over past five years.

Still, there is some lingering uncertainty about the role of smart beta investing, as more than 50% of asset owners in the U.S. and United Kingdom say they remain uncertain on the best approach for their particular purposes. Other survey highlights suggest the use of “multi-factor combination smart beta index-based investment strategies” by institutional investors has more than doubled since first measured in 2015, denoting how quickly this market segment is evolving.

According to FTSE Russell, nearly 40% of global institutional asset owners anticipate applying environmental, social and governance (ESG) investing themes to a smart beta strategy in the next 18 months—nearly half for performance reasons.

Commenting on these numbers, Rolf Agather, managing director of North America Research, FTSE Russell, predicts that strong growth will drive a greater need for education and sophistication on the topic of smart beta.

“The survey shows a 16% increase in smart beta implementation or consideration over the last five years,” Agather observes, “yet it also suggests that asset owners remain uncertain on how to best implement smart beta into their investment strategies.”

Among global asset owners surveyed in 2018, multi-factor combination smart beta strategies are used by 49%, a notable rise from 20% when first measured in 2015. Furthermore, 70% of asset owners are currently evaluating multi-factor combination smart beta strategies, far surpassing all other strategies. Important to note, related research shows there is a danger of institutional investors “diluting” their smart-beta portfolio convictions by attempting to implement multiple factors without adequate consideration of the way factors and peripheral risk exposures can interact in unanticipated ways. 

“Notably, asset owners in the U.S. are showing more interest in multi-factor smart beta index-based strategies yet, again lack of education was cited as a major barrier to implementation,” the survey report states. “However, amid the rapidly growing interest in multi-factor combination smart beta strategies, asset owner interest in fundamentally weighted strategies has declined. In 2018, 19% of global asset owners surveyed with an existing smart beta allocation are using these strategies, down from 41% usage when first measured in 2014.”

The full report is available for download here.

Think Multiemployer Pension Insolvencies Aren’t Your Problem?

Tens of thousands of employers in the U.S. contribute to multiemployer pension funds that are in critical and declining status, collectively facing an unfunded liability well above $100 billion; Society of Actuary researchers warn of potential ripple effects should many of their plans fail at once.

A new report published by the Society of Actuaries (SOA) throws into sharp detail the challenges faced by the U.S. multiemployer pension system.

Speaking about the report, Lisa Schilling, retirement research actuary for the SOA, quickly pointed out that there are many multiemployer pensions that are healthy and more or less entirely financially fit. In fact, there are more than 1,200 multiemployer pension plans in the United States today, covering about 10 million participants, including roughly 4 million retirees.

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However, while most multiemployer plans are financially stable, a growing number have been identified under federal law as “critical and declining.”

“Our study identifies more than 100 such plans that are meant to be representative of the larger problem, excluding plans receiving Pension Benefit Guaranty Corporation [PBGC] financial assistance or that have received approval for benefit suspensions under the Kline-Miller Multiemployer Pension Reform Act of 2014,” Schilling explains. “These plans cover roughly 1.4 million participants—about 719,000 of them retired and receiving annual benefits totaling more than $7.4 billion.”

As the SOA’s report shows, approximately 11,600 employers contribute to these financially stressed multiemployer pension plans. Broadly speaking, many of these plans are at risk of becoming insolvent within fewer than 10 years, the research warns. Such insolvencies will obviously be harmful to the participants and beneficiaries of the plans in question, but the loss of the significant economic momentum provided by retirees spending their pension plan assets could also harm the wider economy and, by extension, employers that otherwise have little affiliation with the troubled multiemployer pension industry.

“The estimated unfunded liability of these plans is $107.4 billion when measured at a 2.90% discount rate,” Schilling observes. “In our sample, there are 21 plans with approximately 95,000 participants that are projected to become insolvent by 2023, and 48 plans with approximately 545,000 participants are projected to become insolvent by 2028. On average, only about two-thirds of the pension benefits are estimated to be guaranteed by the Pension Benefit Guaranty Corporation.”

Overall, the authors anticipate that some 107 plans will run out of assets over the next 20 years, affecting over 11,000 contributing employers and roughly 875,000 participants.

“These projections assume future annual investment returns of 6%,” Schilling notes. This assumption was developed from several recently published capital market outlook reports and surveys of various investment advisers, and therefore differs from the long-term expected rates of return typically used for minimum funding purposes. Projections that use more detailed plan-specific data may render somewhat different results, although the general outcomes would likely be similar.

SOA’s data suggests the estimated 2018 unfunded liability for these 115 plans, as measured on a minimum funding basis, is $57 billion. (When measured at 2.90%, it is $108 billion. The discount rate of 2.90% represents a liability-weighted average of Treasury rates in April 2018.)

“When Treasury rates are used to discount only the plan’s unreduced benefit obligations after the point of projected plan insolvency, and the minimum funding basis discount rate is used otherwise, these plans’ total unfunded liability is $76 billion,” the report states. “Note that these liabilities reflect full plan benefits without regard to PBGC guarantee limits.”

Some of the conclusions in the report suggest many of these plans are not likely to be able to effect a course correction without outside influence: “Even with extraordinarily optimistic investment returns of 10% per year for 20 years, 68 of the 115 plans would be projected to become insolvent within 20 years.”

“Optimistic investment returns have limited impact on insolvency among these plans primarily because their net cash flow positions tend to be severely negative,” Schilling explains. “In 2018, 81 of the plans have annual negative net cash flow that is 10% or more of their assets. In other words, unless these plans’ assets earn at least 10% per year, the assets will decline. Twenty-seven of the plans have negative net cash flow that is 20% or more of their assets.”

Schilling further warns this set of plans includes a number that are large enough such that, if and when they run out of money, “they could individually end up sinking the PBGC’s multiemployer insurance program outright.”

“What that means is that the PBGC wound no longer be able to pay out even its very modest benefits to the sizable number of multiemployer pension plans that have already gone insolvent in the past,” Schilling explains. “That would represent an even greater economic blow for everyone involved. You could have folks retiring after 30 years of service literally getting a few thousand dollars a year from a pension that should have been worth far, far more. You have to ask, what will happen to food stamps and all the other social programs that are out there to help prop people up when their income falls short? It’s not encouraging.”

Thinking about where these issues may lead, Schilling says it seems clear that Congress must act soon and with gusto, or else no real solution will likely be possible. To this end, she is optimistic that U.S. Senators Orrin Hatch and Sherrod Brown are seeking public and industry input on ways to improve the solvency of multiemployer pension plans and the Pension Benefit Guarantee Corporation. However, like many others, she is skeptical that legislative action will be taken prior to the mid-term election. 

“This is a particular shame because many of these plans are already past the point of no return, and the sooner we can act, the better the outcome is going to be for everyone,” she concludes.

The SOA report was advised and reviewed by a team of researchers, including Christian Benjaminson, James Dexter, Cary Franklin, Eli Greenblum and Ellen Kleinstuber. The full text is available for download here.

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