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U.S. Pensions Rethinking Asset Allocation?
Submitted by Leo Kolivakis, publisher of Pension Pulse.
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.
***COMMENT FROM A READER***
An informed reader sent me this comment:
So let me get this straight. So It strikes me that the equity markets
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.
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.
have functioned quite well. Maybe the solution is for credit and
derivitives trading in particular to be regulated like equity markets?
»
I'd have to think the aging population will change that for a long time to come. (given no collapse...a collapse I'm certain will occur imo)
So even if things don't crash, we'll have a near generation of people leaving the workforce and thus a constant decrease year after year.
This was going to switch regardless of or if anything else happened. One could maybe say this alone would be enough or nearly enough to cause a recession. But it's coming now on top of everything else.
Missed the recovery? What recovery? Yeah paper recovery, for a limited time only, but of all this run up, only a few will get out just like last time. Yeah they missed the 'recovery', but they'll also miss alot of the coming 'crash'. Alot of this 'value' that is currently there won't be there very soon. You can sell now and realize those profits, or risk everything. But after it happens, everyone will be wanting out, and there will be people who sold at levels lower than march bottom who will be thanking their lucky stars they were even able to do that.
Anyone that has stayed out, imo, should stay out. Otherwise you're buying high right before.....
Let's just say I fully expect us to break the world sky diving record sometime soon, except it won't be people jumping out of planes - but buildings.
Managers that lost 40 percent, and now have missed the paper recovery, will be better off than those who got out last year, came in at the start of the paper recovery, made big paper profits that aren't yet realized, but are almost certainly going to be caught in the open for the next downturn....which should be much bigger, deeper, and longer lasting than the last. Coming this October, shock and awe.
The asset allocation should be retreating to safety or safer areas (which will still be slammed).
But you know how this will go. There are going to be TONS of people who lost 40 percent, got back in just recently around say the 8500 level, see some modest profits, so now they're down only 30 percent or so, maybe even bringing them in further by buying more. Then, soon, they'll lose 60-95 percent (if lucky) coming ahead. So these people are going to be screwed twice. Don't be one of these people. Only the really stupid people who deserve what will come will be these people. They didn't see the first one coming (because of blinders) and they won't see the second one coming (even bigger set of blinders on top of the current pair they're still wearing). These people will wonder what happened, and it's simple, they were too gullible for their wealth. Those people are walking around us, right now, and they are a plenty. Make sure YOU aren't one of them, because imo based on alot of the stuff I'm sure you've all read and more, there's about to be millions of these people...who are going to prove in the end, they weren't worth the wealth they thought they were, and by their own decision. That's the key to remember. That in the end, when it finally crashes, everyone left in the market will be too stupid for their own wealth, and will lose it. That's what happens when you hold onto a bunch of bankrupt companies, and companies who depend on the bankrupt companies continuing to operate in order for THEM to operate.
You need to be in/out or don't even bother going in imo. Our lows were still 'too high' technically, and things are even worse now. Of course the dollar devaluation throws everything into whack. Will we hit a dollar devastaed 100,000 on the stock market soon? Or will it crash to around 2000? Or will it go to 100,000 before going down to 2,000 or 10k..under a very devalued dollar (worth the equivalent of 500 Dow Jones, yes 0.5k)
This is the sort of volatility that is all but assured. Anybody with a brain knows it, or suspects it, or at the very least thinks there is a decent shot at it happening. When it comes to holding boomers' retirement funds, there should be asset reallocation. If anything I'm surprised it's not happening faster.
But in the end, greed gets them all. Greed isn't good, it clouds judgment. Take your profits while you can, or risk everything. That's when you know greed isn't good...because everyone that believes that who hasn't already been shocked, will soon see shock AND awe. A rude awakening, especially when they see how much it costs to live meagerly today. They didn't help protect the poor, blaming it on laziness, rather than pegging they weren't in on the scam. Now that a bunch of these people are about to be poor, they'll have to live through being poor, and the lowered state 'the poor' currently live (that THEY help make). It was a worse situation because of them, and now they're about to live through it. (and it could have been better for everyone, and them NOW-or SOON...because being poor is now going to be the new 'black'-and they are going to have to rely on the scant services that they themselves kept from expanding. In a sense it's going to be sweet justice, but also at the expense of a lot of innocent people.
But what else does one deserve when they KNOW everything is bankrupt, but they can't get themselves to pull out of the market because they might not 'catch' 5 percent gains. I'd be more concerned with preserving the wealth I DID have, rather than catching the next fiver percent gains. You have to be in and out, otherwise the capital you put in there to 'invest' WILL BE stolen by day traders. There is no buy and hold wealth anymore. You'd think that when a huge swath of people have been putting money in since the 90's and have less now than they put in total, they'd get the picture.
Why do people call this a "once in a century" issue? The market performance of the year past is a appx 1 in 80 chance of occurrence, meaning 2.5% yearly chance. It has happened 3 times in 40 years, a drop of 50%. So if you think this is "once in a century" you're probably one of these fools that thinks a "100 year flood" can only happen once in a hundred years.
FT -- IT'S STATISTICS. LEARN WHAT THE NUMBERS MEAN. If I want pop culture, I'll read Popular Mechanics.
What about this?
http://www.moneyandmarkets.com/pension-plan-shocker-dead-ahead-35427
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?
Defined Benefit Plans could well be in trouble. Guaranteed retirement checks funded by asset pools worth 50% leaves a large employer contribution. If the fund managers got chicken and jump into treasuries, then they missed the market recovery. The employer will be left with a large unfunded contribution and declining municipal revenues. Ouch!
Pensions (especially public sector) are the quickly ticking time-bombs we're sitting on. Everything else to date will have seemed minor. If you're an elected official (local, state or federal) you don't think beyond the next election and with everyone telling you 8% is the average return "why worry"..
The various promises that governments (of all stripes) have made will turn into a horror show and in the not to distant future. Leo, good to see you posting at ZH.