Bonds

Pension experts concerned about emerging valuation risk

Pension fund experts are worried about a rise in valuation risk, with recent reports showing many underfunded pension funds stabilizing even as asset allocation into riskier choices is getting a closer look. 

Valuation risk is defined as calculating what an asset is worth based on “fair-priced” or “fair-value,” estimates  as opposed to public market prices based on actual transactions. Fair-value comes into play on assets that are hard to pin a timely value on which includes private equity and real estate-based portfolios. 

“Over the past year, we’ve seen private equity and real estate valuations declining from an over-heated investment season,” said Anthony Randazzo, executive director, Equable Institute.

“All of the data is pointing to investor exuberance or an excess of cheap capital as key drivers of unrealistic valuations that underscores the drivers of valuation risk.” 

“Over the past year, we’ve seen private equity and real estate valuations declining from an over-heated investment season,” said Anthony Randazzo, executive director, Equable Institute. “All of the data is pointing to investor exuberance or an excess of cheap capital as key drivers of unrealistic valuations that underscores the drivers of valuation risk.” 

The comments coincide with the Wednesday release of an Equable Institute report, which signals mostly good news for public pension plans that are still labeled as “fragile.”

The health of public pensions remains an area of interest for bond holders who are sometimes second in line behind pension fund members for payback if a municipality goes bankrupt. Municipality credit ratings can also take a hit from a shaky pension fund.

Asset allocation in public pension plans remains an alchemical mix of low-risk, U.S. fixed income funds on one end of the spectrum combined with high-flying, alternative, real estate and private equity investments on the other.  

Part of the concern is based on the amount of assets that have shifted to higher risk, alternative investment categories. “Public funds have shifted from less than 10% of their investments in alts to more than a third in alternative asset classes,” said Randazzo. “There is a much higher share of public pension fund assets that are priced using fair-value methods as opposed to market-based prices.” 

According to 2022 research by actuarial firm Milliman, which serves as actuaries for pension fund sponsors, 3.6% of public pension fund assets are in cash, 20% are held in U.S. fixed income, while 28% of the aggregate funds are riding on private equity and real estate. 

“These are potentially hard to value assets,” said Becky Sielman, principal, consulting actuary, Milliman. “You might not get a private equity market valuation for three or four months after the close of your reporting period. Plan sponsors need to weigh whether that reporting lag is going to cause downstream issues for them.” 

In its report Equable  touts numbers correlated from PitchBook, showing a plunge in the one-year rolling rate of returns that have been tracked since 2017. Per the report, “private equity and real estate returns in 2021 were strong and that was reflected in 2022 fiscal year reporting. However, between 2022 and 2023 the returns have been falling and with them the valuation of these investments has declined.”  

The appeal of lower-risk bonds lies in the numbers while challenges in the real estate sector are well documented. “Allocations to real estate have not grown as quickly over the last decade as for other alternatives,” said Brian Whitworth, SVP, Hilltop Securities. ”The relative attractiveness of bonds depends on many factors including current yields.”   

Evaluating risk while investing for pension funds remains a high-wire act. “If you invest in a pension plan entirely in cash, you’re you are not appropriately spreading the cost of benefits across different generations of taxpayers,” said Sielman. “The trick is to get the right balance and that means having a very thoughtful consideration, about the appropriate level of risk.” 

In September, Standard & Poor’s reported a year-over-year drop in U.S. state pension funded ratios to 73.6% from 81.2%, while also predicting marginal improvement for fiscal 2023.  States with problematic fund levels include Missouri, Illinois, New Jersey, Connecticut, Kentucky, and South Carolina.  S&P also predicts a rise in contribution rates and sees trouble ahead for “other post employment benefits” which includes medical coverage.

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