Asset Allocation Trends for Public Pension Plans: A Six-Month Outlook
Amid ongoing economic and political changes across the United States, the top public DB plans continue to search for ways to grow their assets relative to their liabilities.
Dane Smith, State Street Global Advisors’ managing director and head of investment strategy and research, shares his insights into how public pension plans are looking at asset allocation across their portfolios over the next six months.
Q: What is the outlook for growth assets as we move into the latter part of 2024 and then into 2025?
Dane Smith: Growth assets are a topic of conversation among public DB plans for a very good reason. Most public plans have had unfunded liabilities in the range of $1.2 to $1.6 trillion over the last decade, and they are roughly 80% funded, on average. That's not terrible, but there's still quite a bit of work to be done for those plans.
Growth assets are going to be a focus for these plans over the next six months. We're fairly constructive on equities at this point in time. We have falling interest rates, a fairly good economy, and a resilient labor market, and this has all been helpful to equity markets. On top of that, one of the big risks to equities over the better part of the last three years has been inflation, and inflation is normalizing. This is an environment that equities tend to perform well in.
We continue to be most constructive on US equities. It's a very profitable segment of the equity market with good ROE, good profitability, good growth, and good earnings estimates going into 2025. We're a little less constructive on European equities, where we see softening demand and not as much growth. We’re also more neutral to Japan now than we have been over the better part of the last year. They're digesting a rise in interest rates and the election of a new prime minister, and we think those factors are creating additional risks in that market.
Finally, we have questions about emerging markets and small caps. We see a broadening of those markets and some positive momentum and tailwinds happening there. We’d want to see that momentum continue before we get overly bullish, but we remain somewhat optimistic on those segments of the market over the next six months.
Q: Let’s shift now and look at the other part of the traditional 60/40 portfolio. What is your outlook for the fixed income market, and where do you see client interest?
Dane Smith: Fixed income is a big part of overall asset allocation for public plans, and given the uncertainty around rates over the better part of the last year it's no wonder that it's been on most of our clients' minds as well.
Given that we see the path of inflation normalizing from this point forward, we think this is an environment that is positive for those who want to add duration and are interested in taking on some rate exposure within their overall portfolio.
Credit remains a little rich, so we are a bit less constructive on it right now. But we've seen a noticeable uptick in overall client interest on the systematic side of investing within credit and fixed income this year, and that makes a lot of sense. Bond markets are starting to act a little bit more like equity markets in their use of ETFs and ETNs, creating transparency and efficiency that allow managers to capture alpha in a more effective way.
Q: You touched on inflation already, but can we talk about inflation as it relates to DB plans that offer cost of living adjustments (COLA)?
Dane Smith: Although we see inflation normalizing over the long term, it won’t come without some volatility in rates and some movement in the overall yield curve as the market digests a number of lingering uncertainties. For example, what overall impact will the US election results have on both tariffs and immigration? Do those policies ultimately end up being inflationary? What does that do to the long end of the curve?
We don't think the path of inflation is ultimately a uniform one, and this does have an impact on how most states offer COLA. Each public plan has differences in how they calculate it, but on average, most of those plans that offer some sort of COLA pay around 2%, on average. What that means to us—particularly coming out of a market environment that included inflation surprises to the upside — is that sometimes those adjustments don't quite pay at a level commensurate with actual inflation.
In our discussions with public DB plans, we tell them we believe it makes sense to have some sort of strategic allocation that allows them to help hedge some of that risk in addition to COLA. We're thinking about real assets, we're thinking about TIPS, and we're thinking about the potential inclusion of gold within their overall strategic asset allocation. We believe that's just prudent planning, given the ultimate risk of inflation to public DB plans.
Contact your relationship manager to learn more about State Street Global Advisors can help corporate plans pursue their investment objectives.