Sunday, September 20, 2009

U.S. Pensions Rethinking Asset Allocation?

The FT reports that crisis spurs US pensions to rethink asset allocation:

Old habits die hard. In spite of the damage inflicted by two once-in-a-century equity market crashes in just 10 years, and millions of consultant man-hours spent advocating the switch to liability driven investment (LDI) methodologies to reduce funding risk, most US pension funds still embrace investment policies built upon earning the equity risk premium.

However, a recent report* from consultants Watson Wyatt Worldwide suggests US pension funds finally may be shifting away from equities toward greater allocations in fixed income (click on image above).

The company surveyed 85 senior managers, representing $82bn (£50bn, €56bn) of corporate pension assets, and found that between 2008 and 2010, target allocations to equities are to be cut by 10 percentage points of assets.

“For 20 years, target allocations to equities have been 60 per cent, plus or minus a few points,” says Carl Hess, Watson Wyatt’s global head of investment consulting. “Now, in less than two years, you have a huge drop.”

Rather than seeing sponsors giving up on the return potential of equities, Mr Hess says the lower equity holdings are just a matter of portfolio arithmetic. “With a move to cash bonds something has to give, and because assets were so concentrated in equities, it’s not surprising they were first to go.

“Public equities also make a logical source of funds, given that they’re the most liquid asset in many portfolios,” Mr Hess adds.

But Watson Wyatt may be declaring the age of LDI too soon, says Karin Franceries, vice-president with JPMorgan’s Strategic Advisory Investment Group in New York. The company has its own fresh survey, taking the investment pulse of 324 plan sponsors.

“Every single client is running an [asset-liability management study] right now, or has in the last 12 months, so clearly they are rethinking and restructuring,” says Ms Franceries. “People really are interested in increasing the duration of their fixed income allocations. But on the equity side, even though our clients have become more risk-aware, a lot of them still have confidence in equities.”

In JPMorgan’s sample, target allocations to equities are slated to decrease just three percentage points, from 54 per cent of portfolio assets at the end of 2008 to 51 per cent at the end of 2009. “Only 20 per cent of sponsors wanted to make a big decrease in the equity allocation (of 10 per cent or more of assets), while 70 per cent shifted back to their 2008 targets,” she says. “Moving away from equities still seems to be a theoretical idea.”

Mr Hess is nonetheless convinced a big change is under way. “I came out of 2008 saying the experience could really change things, in the same way that the Great Depression turned the US into a nation of savers for years. I see a shift in investors’ utility for risk, and I don’t expect to see it shift back any time soon.”

A second significant inference to come from Watson Wyatt’s survey is the inclination of pension plan sponsors to change their investment managers.

Considering all asset classes, 52 per cent of funds in the survey had both hired and fired managers between June 2008 and June 2009. Apparently sponsors were not willing to consider the recent performance of the markets or their active managers an aberration, and they wasted no time in finding new talent.

Most of the manager replacements were in US equities and fixed income. About two-thirds of sponsors fired and hired equity managers, while 68 per cent of plans added a fixed income firm, and 47 per cent fired one.

“Some of the changes were pent up,” says Mr Hess. “Due to the limited liquidity and higher volatility, it was a challenge to replace a manager in the second half of last year.”

He also observes a change to the US custom of giving a plan’s entire fixed income allocation to one manager: “We’re seeing clients break down the portfolio into smaller bits, so that 30 per cent of the portfolio assets is no longer in the hands of one manager. And that’s understandable, given that some managers underperformed by 10 or 15 per cent in the last year.”

The reasons behind manager rotation are not limited to performance disappointment. Bill DeWalt, a senior investment consultant at Watson Wyatt, points out that with assets down 30 to 50 per cent at some firms, concerns over the financial health of managers, and in turn their ability to hire and retain investment staff, have taken on a greater importance.

“For many of the firms we like so well – the boutiques managing $12bn or so – these questions have never come up before,” says Mr DeWalt. “They have to cut costs, but they can’t get rid of too many people, or stop travelling for research, because that risks destroying their process and product.”

*The New Reality of Pension Investment Strategies, Watson Wyatt Worldwide survey, August 2009

Clearly pension plans are rethinking asset allocation in light of what transpired in 2008. The shift towards long duration assets that are inflation-sensitive like infrastructure is already taking place, but this carries its own set of issues, the least of which is that there is not an infinite supply of deals and they are getting bid up as pensions pile into this asset class.

The reality is that pensions are caught because they have to deliver actuarial rate of returns that are based on rosy investment assumptions, which is why they are so overweight public equities in their asset allocation. But this also exposes them to huge downside volatility when a financial crisis erupts.

As I have stated countless times, pension parrots worry too much about outperforming their peers instead of worrying on delivering the highest possible risk-adjusted returns. The compensation structure at the large Canadian public pension funds rewards excessive risk taking, especially in private markets and hedge fund strategies where performance benchmarks are woefully inadequate because they do not reflect the underlying risks of the investments.

When it comes to managing billions of pension assets, the chief objective shouldn't be to take as much risk as possible to obtain the highest returns and gloat in front of the national media, but it should be to deliver the highest possible risk-adjusted returns making sure you are careful to limit your downside risk in any given year. In other words, use some plain old common sense and stick to an asset allocation that focuses on delivering steady returns no matter what environment presents itself.

We are in uncharted territory, so now more than ever, pension fund managers, board of directors and plan sponsors need to review their asset allocation more frequently, making all necessary adjustments as the environment evolves. Complacency and following the herd is highly irresponsible, ensuring mediocre performance over the long-term.


An informed reader sent me this comment:

So let me get this straight. Poor credit underwriting and bad business models in securitzation and credit default swaps caused massive losses. These then bust the banks who are the worlds main derivitive counterparties. Financial equities then go down, as this sector was bankrupt technically. Stock markets go down as the implications of bank failures gets better understood.

So the consultant and pensions funds industry is to rotate assets into credit? Because the equity market was volatile? It was the credit crisis that caused the equity market to be volatile!!! At least equity has upside, no one can ever make up for fixed income losses in the fixed income markets.

It strikes me that the equity markets have functioned quite well. Maybe the solution is for credit and derivitives trading in particular to be regulated like equity markets?

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