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Will Pension Funds Face More Volatility Ahead?

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By investing mostly in bonds, pension funds have been able to generate promising returns for a considerable period of time. But that isn’t happening now as investors are struggling with lower interest rates and lackluster economic growth. Hence, in order to achieve the level of returns raked up two decades back, such funds are increasing their exposure to riskier assets such as equities. This in turn is heightening the chances of volatility for such funds.

Pension Funds Shift Strategies

Pension funds are mostly designed to provide a steady stream of income at retirement. These funds have a larger exposure to less riskier assets such as bonds. By purchasing and holding investment-grade bonds for nearly two decades such funds have put up stellar performance. In 1995, a pension fund’s portfolio predominantly consisted of bonds and still yielded a return of 7.5%, according to the Callan Associates Inc.

But, things have started to change with pension funds piling up riskier assets to get a reasonable return. Callan figured out that pension funds have spread its money across riskier assets like equities, last year. These included U.S. large-cap firms, U.S. small-cap firms, non-U.S. equities and private equity. On the other hand, investments in bond shrunk to just 12%. Thanks to near-zero interest rates and lackluster economic growth, investors are taking on more and more risk for higher returns.

Reasons behind the Shift

Investors were convinced for a pretty long time that the Fed won’t raise rates further after the December lift-off. The Fed had hiked its rates to 0.25% in December for the first time in almost a decade.  A data-dependent central bank found it impossible to pursue a hawkish stance given the global turmoil in the stock market and a weak Chinese economy at the start of the year.

Meanwhile, the U.S. economy increased at an annual rate of 0.8% in the first quarter, below the consensus estimate of a 0.9% rise. This growth was way below the previous quarter’s growth rate of 1.4%. In response to weak global financial conditions and a slump in oil prices, companies tightened their belts, resulting in lackluster economic growth in the opening months of the year.

Courting Uncertainty

Historically, bonds have yielded safe returns and a steady stream of profits, which helped pension funds to give solid returns. However, such funds had to willy-nilly increase their exposure to equities to repeat such performances in a low-rate environment. But, Callan reported that such risky endeavor has exposed these funds to more volatility.

In fact, the standard deviation of pension funds increased considerably in the last two decades. In 1995, the standard deviation of such funds was about 6%, while it jumped to around 17.2% in 2015, according to Callan Associates.

Standard deviation is used to determine volatility in a portfolio. Investors regard standard deviation measurement on a fund’s annual returns as a way of finding out the degree of fluctuation that can happen from one year to the next.

Outlook

These developments have made investment in pension funds, hitherto regarded as stable, a big time gamble, with the nation’s largest public pension fund, the California Public Employees’ Retirement System, slipping 1.3% since Jul 1, 2015.

However, investors who are looking for pension funds may invest in the following three funds that boast a favorable Zacks Rank. While T. Rowe Price Retirement Balanced (TRRIX - Free Report) and Vanguard Target Retirement Income Investor (VTINX - Free Report) possess a Zacks Rank #1 (Strong Buy), JPMorgan SmartRetirement Income A (JSRAX - Free Report) has a Zacks Rank #2 (Buy).

About Zacks Mutual Fund Rank

By applying the Zacks Rank to mutual funds, investors can find funds that not only outpaced the market in the past but are also expected to outperform going forward. Pick the best mutual funds with the Zacks Rank.