Top issues U.S. institutional investors should be thinking about in 2024
- Institutional investors may want to consider an allocation to Quality equities as well as a sufficient allocation to government bonds.
- DB plan sponsors may want to re-evaluate the use of their pension surplus in the wake of IBM’s groundbreaking decision to reopen its frozen DB plan.
- DC plan sponsors should consider exploring retirement income solutions.
- Non-profits, including hospitals and healthcare systems, should consider evaluating how they’re managing liquidity in their portfolios.
With inflation finally on the decline and rate cuts possible this year, markets at first glance appear to have more to cheer about as 2024 unfolds than a year ago. And such optimism has no doubt taken hold in recent weeks, with the S&P 500 Index nearing record highs while the Bloomberg U.S. Aggregate Bond Index has rallied nearly 7% from its October 2023 lows.
However, a deeper look into the current economic environment reveals there are still plenty of worries to keep investors awake at night. For starters, we believe recession risks remain higher than normal, with a chance that the Fed’s recently concluded aggressive rate tightening cycle could tip the economy into a recession due to the lagged impacts of monetary policy. In addition, uncertainty surrounding the U.S. elections in the fall may inject fresh volatility into markets.
All this to say, the outlook for 2024 is perhaps more nuanced than it might appear, and if the past few years have taught us anything, it’s to expect the unexpected. Below, we’ve compiled a list of some of the key issues that we think institutional investors should be considering as the year gets underway, categorized by market segment. So, without further ado, let’s cut to the chase.
1. All institutional investors: Consider an allocation to Quality equities
We think Quality—a style of factor investing which emphasizes profitable companies with strong balance sheets—is an attractive strategy for institutional investors to consider in 2024. We recently touched on how active equity manager outlooks are split between those expecting a soft landing and those expecting a recession for the U.S. economy in 2024. Quality equities offer useful defense and balance across these scenarios. For example, our research team recently canvassed 96 years of equity market data and concluded that Quality was among the most reliable factor strategies for recessions. But Quality isn’t just a pure risk-off play. In addition to its defensive attributes, Quality currently leans into longer duration growth sectors like technology and healthcare, which gives it the potential to keep pace and potentially even benefit in a soft-landing scenario where interest rates decline and economic growth is lackluster.
Valuations are often another important consideration for institutional investors. Quality equities underperformed sharply in 2022 and—as a result of that re-rating—our composite relative valuation indicator for the style sits close to its most attractive levels in the last 15 years.1 Ultimately, we believe this combination of defense, balance and reasonable valuation makes Quality an attractive opportunity for institutional investors to consider in the year ahead.
2. Corporate DB plan sponsors: Re-evaluate the uses of your pension surplus
The most noteworthy aspect of IBM’s retirement program change was that the company found tangible utility in its pension surplus, using it to effectively replace a 401(k) benefit. Likewise, sponsors of overfunded defined benefit (DB) plans ought to re-evaluate their endgame strategies and the potential uses of pension surplus. Many plans are in a hibernation state, where the investments are positioned to maintain funded status, but not much of the portfolio is intended for future growth. Others still maintain an aggressive asset allocation to either help fund ongoing benefits or to continue building up their surplus. Still others are set on plan termination in the near future.
IBM’s change opens up a possibility of using the surplus to financially benefit the sponsor. While this type of design change has always been available, IBM trailblazing this plan design shift may make it more palatable to some sponsors.
These changes might also lead sponsors of underfunded plans on de-risking glide paths to reconsider their intentions once the plan is overfunded.
3. DC plan sponsors: Explore retirement income solutions
Defined contribution (DC) plans are both popular and predominant. However, when measured by the defined benefit (DB) yardstick of providing consistent income in retirement, they haven’t yet proven to be successful. Funding retirement for the working population is a global challenge, and a significant body of research has delved deeply into the projected retirement savings gap in the United States. Yet for all this valuable effort, little has focused on the gap that matters most to individuals: the gap between the retirement income they want and what they are on track to achieve.
The primary focus for DC committees has historically been on helping participants accumulate assets during their working years, with little support provided in retirement. A common analogy is taking an airplane flight only to have the pilot parachute out of the plane just before reaching the destination, leaving passengers to maneuver the landing on their own. The landing gear of our DC system is the strategies designed to help participants convert their accumulated retirement balances into a reliable stream of income. Without this support, the vast majority of today’s retirees rely on Social Security as their primary retirement benefit, and only source of guaranteed income.
For most of the last decade, retirement income was described as being very much in the talk stage. That has changed in the past few years. While still in the early stages today, in 2024 we have moved beyond just talk and the setting for the discussions is different now. It’s happening at investment committee meetings, rather than just industry conferences, with some plans actively implementing solutions and many other committees expressing interest in evaluating options for their plans. We expect this trend to continue in 2024 and beyond and believe that all committees—regardless of plan size—would be well-served to explore adding such a solution to their plan.
Acknowledging the capacity of plan fiduciaries to select and monitor investment options is far from unlimited, we believe balancing participant choice with plan-menu simplicity is key to avoiding unnecessary complexity for the participant and investment committee alike. With so many options available in the marketplace, how will a committee choose? To assist our clients, Russell Investments models the retirement outcomes from different product types, based on company specific demographics and plan income replacement objectives, to complement a qualitative review of the products by our manager research analysts.
4. Non-profits, including non-profit hospital and healthcare systems: Examine how you’re managing your portfolio’s liquidityWe believe that an allocation to private assets and alternative investments can help non-profits achieve their long-term goals more efficiently. However, because these investments are typically illiquid in nature, it’s important for non-profits to carefully manage the liquidity risk in their portfolios and ensure the allocations are appropriate given their cashflow needs, capital calls and portfolio rebalancing requirements.
We believe that an optimal way for non-profits to manage their liquidity needs is to utilize an approach that merges top-down asset allocation and bottom-up cash flow modeling. Such an approach pairs the top-down asset allocation modeling with two essential tests: the maximum outflow coverage test and the expected outflow coverage test, both of which we detail extensively in our recently published whitepaper.
There are also factors and preferences specific to each non-profit that should be considered. These include an organization’s tolerance for straying from its strategic allocation weights, as well as how much flexibility it desires in order to be able to make tactical tilts when market conditions change.
Ultimately, having less liquidity than is required for organizational needs can be ruinous, especially in a stressed market—but letting liquidity concerns leave an investor with less illiquidity than could be managed can result in a foregone opportunity for diversification and return enhancement. We stand ready to assist.
5. All institutional investors: Consider government bonds, especially U.S. Treasuries
In our December article, we explained how our outlook for falling bond yields would make an investment in U.S. Treasuries worthwhile for organizations to consider. After the December 2023 Fed meeting, U.S. Treasury yields fell as the central bank signaled interest rate cuts may be in store for 2024.
The market’s expectations for Fed policy has evolved to become more in-line with our views. Nevertheless, the gap has not fully closed. Markets anticipate a year-end 2024 Fed funds rate of around 4%. We wouldn’t be surprised if that number were closer to 3%. Looking out further, markets anticipate that the cash rate will bottom out at 3% in 2026, which is still somewhat above the Fed’s estimate of the neutral rate of interest.
Although we have reduced our recession probability from 55% to 45%, recession risks are still well above-average. There is still a significant probability that the Fed will need to cut rates aggressively to respond to a potential economic slowdown. Because of this, we continue to see the possibility for government bond yields to fall further. U.S. Treasuries are still somewhat attractive, even though the investment opportunity set may have narrowed since December. In light of our outlook, we believe that a small tactical overweight to duration (favoring intermediate bonds over shorter term bonds) could enable institutional investors to best capitalize on our macro views.
In the near-term, we think investors might benefit from the defensiveness of government bonds over corporate bonds. Credit spreads, both for investment grade and high yield debt, are still well below levels typically associated with recessions. Given that the corporate debt market may be underappreciating recession risk, we believe investors may want to consider increasing their allocation to government bonds.
The bottom line
Investing is often rife with uncertainty, and today’s complicated macroeconomic backdrop makes it difficult for investors to ascertain how the year may unfold. But we believe that by giving ample consideration to the issues outlined above, institutional investors will be better positioned to weather whatever comes their way.
1 Based on a global portfolio of Quality companies constructed by Russell Investments. The four valuation measures are price-book, price-sales, a cyclically adjusted price-earnings ratio, and enterprise value-ebitda. Each valuation measure looks at the multiple of the Quality portfolio relative to the multiple of the benchmark MSCI All Country World Index portfolio. Source: Russell Investments. Data as of Jan. 5, 2024.