How Asset Balancing Has Gotten More Complex

Art by Nadja Zinnecker

The juggling act of public pension asset allocation seems to have one common element nowadays: seeking to move away from the usual stock/bond dependency, and into alternatives. But getting there is not easy, involving tons of planning and sometimes radical changes in mindset.

From 2005 through 2018, the equity share of public pension programs dropped to 48.7% from 61.3%, while fixed income slid to 21.5% from 27.8%, according to the Public Plans Database. During the same period, alts’ share increased almost four-fold, to 27.6% from 7.4%, beating out fixed income.

Pension funds need to think long-term—and stocks have a superior record of delivering good returns in the fullness of time, as Wharton School Professor Jeremy Siegel has demonstrated. But talk keeps bubbling about a pending recession, a discussion that serves as a new catalyst to decrease the dependency on equities. The long bull run in stocks surely must end at some point. That’s likely to occur sooner rather than later.

One virtue of alts is that, by their nature, they are very diverse, with different ones performing well in different economic conditions. Real estate usually does fine when interest rates are low because buying property is easier with cheap lending. Commodities tend to out-perform in inflationary times.

Amid recessions, one type of real estate usually perks up: rental apartments, since homebuying is tough and lots of people are booted out of their houses by foreclosures. Further, in slumps, precious metals, particularly gold and silver, historically have surged. Hedge funds, despite their uninspiring average returns lately, are meant to zig when the market zags, and a number do this very well

Pensions managers have been focusing on de-risking since the twin recessions that bracketed the last decade, with the downturn spawned by the 2008 financial crisis the most horrendous. This duo of debacles whittled away many plans’ asset valuations. For a while, a lot of them sought to regain their previous standing via heavy stock investing.

A sea change is under way nowadays. For many portfolios, the lessened dependence on the classic stock concentration has been dramatic, giving way to a more eclectic mix that promises less risk but still some handsome returns.

The situation at the $153 billion Teacher Retirement System of Texas illustrates the growing trend. Its board on Sept. 20 voted to slice the target allocation for stocks to 54% from 57%. Meanwhile, other alt categories are rising by a percentage point, with real estate moving to 15%, natural resources and infrastructure to 6%, cash to 2%, and stable value hedge funds to 5%.

Others are taking a similar path. The investment staff of the California State Teachers Retirement System (CalSTRS) is eyeing a new framework that would lower the stock allocation to 42% from 47%, while boosting real estate to 15% from 13%.  It keeps its goal for private equity to 13%, although it has been  at 9%, as it hasn’t found the right PE investments. As the staff explained in a document, “This is fine tuning focused on improving diversification, enhancing portfolio downside protection, and taking advantage of the risk-return profile of the private assets.”

Asset managers are always thinking about the degree of risk. The Los Angeles County Employee’s Retirement Association (assets: $57 billion) booked a decent 9.0% total return for fiscal 2018, in keeping with its solid numbers through the years. Over five years, LACERA’s annual return was 8.5%. The upshot: Its funded level sits at a solid 80%, as of 2018. That has happened amid a noticeable asset allocation shift.

A decade ago, public stocks were 50% of LACERA’s portfolio, and that has shrunk to a target of 35%, still sizable but less risky than previously. “It’s gone into real assets, credit,” and other non-traditional assets, said CIO Jonathan Grabel. Real estate now makes up around 10% of the portfolio.

LACERA, the largest US county pension fund, has 10.5% of its holdings in private equity. That allocation has served the program well. According to the American Investment Council, PE has returned 11.4% annually over the past 10 years for LACERA.

This doesn’t mean that pension funds have become risk averse, just more mindful of it. The stronger an organization is, the more it can risk. At Mercy Health in St. Louis (combined reserve and pension assets total: $3 billion), CIO Anthony Waskiewicz noted that “Mercy’s balance sheet has improved, so we are able to increase risk and take greater advantage of illiquid opportunities, such as private equity.” The plan has 35% in global equities and just 15% in fixed income.

Mercy has increased its target allocation to private investments to 30% (up from 21% recently).  Private investments include private equity, private debt, private real assets (energy and real estate).  These aren’t very liquid but are likely to generate good returns over the long-term. Separately, the organization has 20% in hedge funds. “We use hedge funds to dampen volatility,” Waskiewicz said.

As always with balance sheet and pension assets, prudence remains a watchword. The investment policy for the Mercy reserve portfolio is focused on risk tolerance, while the pension plan, which has been frozen since 2011, must account for significant liquidity needs.

Waskiewicz emphasized that, unlike universities with their avid alumni donors, hospitals typically do not have an avalanche of contributions. Every three years, Mercy’s investment committee adjusts its investment policy targets.   

Pension funds’ balancing act is a fraught one. Many plans employ outside managers, who may have disparate strategies that have to be melded into a coherent whole. The resulting hodgepodge can lead to multiple managers cancelling each other out, said Michael Hunstad, head of quantitative strategies at Northern Trust Asset Management.

An example, he said, would be a value and a growth manager offsetting one another, with the result “you’re doing no better than your benchmark.”

One aspect of asset allocation circa 2019 remains true: The mosaic of different asset classes will continue to grow more intricate.

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