Managers of public sector pension funds are “largely convinced” that inflation as a major issue is fading away, but still wary of more economic turbulence, a new report from Ortec Finance has found.

The study said that recent economic stress, including rising inflation and interest rates, is leading managers to do more scenario modeling and stress testing to help manage their plans. The Ortec Finance report was based on a survey of 50 U.S. public sector pension fund managers during April of this year.

Funded ratios in decent shape, but managers consider changing risk profiles

According to Investopedia, the industry generally considers funds that are at least 80% funded to be healthy. The Ortec Finance analysis found that the average funded ratio for U.S. public pension plans was 77.89% in 2022. Public pension plans had total accrued liabilities of $6.369 trillion, and total unfunded liabilities of $1.445 trillion. The analysis noted that one in seven (14%) of plans had funded ratios of 60% or less.

The report said that one way pension plan managers are seeking to keep their funding ratios healthy in part is by reviewing their risk profiles. The survey found that 94% of managers said the risk profile of their plan increased last year; 16% said it increased significantly. In addition, more than four out of five (81%) of managers surveyed expected the increase in risk profiles to continue in the next 12 months, with nearly one in three (32%) expecting a dramatic increase.

“The biggest driver of pension fund risk identified by the study is interest rate movements, with managers questioned saying this is the biggest concern for their fund followed by cash flow requirements and liquidity,” the report said. “The volatility of investment markets was rated as the third-most concerning risk, ahead of inflation which was rated fourth. Cybersecurity was rated as the fifth-most concerning risk.”

Inflation concerns may be easing

One bit of good news in the report: pension plan managers see inflation as moderating. The analysis found that 90% of managers said they are confident that inflation is on the decline. About half (52%) of managers said they believed inflation could be 3.3% or lower within a year. Only 10% of managers in the survey said they expected the U.S. inflation rate will be over 6% within a year.

“Our research found commodities have been the asset class that the U.S. public sector pension plans interviewed have relied on the most to help hedge against inflation over the past 12 months,” the report said. “Some 70% of those interviewed said their plans had increased their allocation to commodities to help with hedging compared with 52% who had increased allocations to infrastructure and 40% who put more into gold. Just 42% said they had increased allocations to inflation-linked bonds.”

The report makes a note of pointing out that these more optimistic views of inflation are not creating complacency. In addition to adjusting asset allocations to hedge against inflation, managers have concerns about stagflation, the combination of low growth and high inflation. Nearly all managers (98%) said they were very concerned or quite concerned about that risk.

Report suggests more scenario modeling and stress testing

The Ortec Finance report said that managers reported they will spend more on scenario modeling and stress testing in the next two years to help them manage possible market shocks. Around 44% of managers said those tools, which help generate and analyze plausible risk-return scenarios, were very effective, and 56% said they were mostly effective with asset liability management.

Marnix Engels, managing director of pension strategy at Ortec Finance, said that the last year had been economically challenging, and managers are clearly preparing for future market shocks, including investing more tools to help them analyze market conditions.

“The degree of uncertainty is extremely high for U.S. public sector pension plan sponsors but there is genuine optimism that lower inflation will become well-established, with very few managers expecting it to be as high as it currently is within a year or two,” Engels said. “The major challenge, however, remains that funded ratios are under pressure. This stresses the

importance of asset-liability management to improve the long-term financial position of the plans.”

The study noted that strategic asset allocation decisions are becoming increasingly complex. Current modeling approaches are too simplistic, the Ortec Finance study said, and may not be able to fully foresee major economic and market shock events.

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