Recently I visited a few pension plans and it amazes me how the policy views on risk differ to meet seemingly similar return goals. The National Association of State Retirement Administrators (NASRA) reported earlier this year that of 126 major state and municipal systems, 32 had set an assumed rate of return between 7.5% and 8%, 37 had set a rate between 7% and 7.5% and 45 had an 8% rate. However, the risks the plans are taking to make their return goals differ significantly and may be the result of an evolution of risk-awareness.
According to one of the pension executive directors, “1/2% [assumed rate of return] won’t change anything about how we invest… we take as little risk as possible to get to our 8% goal and would never invest in risky assets [like commodities, the way another pension would].” This particular pension manages risk mostly from a liquidity perspective with three main buckets being “liquid”, “illiquid” and “moderately liquid” – where about 60% of the assets are allocated. The “liquid” is mostly cash, the “illiquid” contains private assets and real estate, and the “moderately liquid” contains mostly equities and credit.
“Another pension” with the same return goal of a real rate of return (the rate by which the long-term total return exceeds the inflation rate) of at least 5.5% per year claimed, “their peers will follow in their footsteps but someone needs to go first.” Follow in their footsteps to do what? Manage risk. Their target allocation is based on risk parity, just like Texas Teachers announced today, and the asset allocation target looks much less like the traditional stocks, bonds, real estate and alternatives like in the “conservative plan” described above. Texas Teachers’ has five different buckets, which is one less than “another pension” but is comparable.
Some of the noticable capital allocation differences are in the inflation linked bonds, commodities and global equities. In the self-described “conservative” plan, there is a policy of about 45% equities, 5% TIPS and no commodities. In the “risk-based plan” that describes themselves as flexible to take advantage of changing market conditions, equities get a target of about 10%, 30% TIPS and 8% commodities that mirrors Texas Teachers’ much more closely.
According to Cerulli Associates, since the early 1970’s, Modern Portfolio Theory has influenced asset allocation. Institutions looked to increase diversification and reduce risk by allocating to a broad number of diverse asset classes typically defined by underlying security type and marketability. However, the severe market stress and extreme volatility experienced in the global financial crisis of 2007-2009, caused many correlations between asset classes to rise that not only increased risk but lowered returns.
Today, institutional investors are under pressure to increase returns, while keeping risk unchanged, forcing many institutions to rethink their approach to portfolio construction. Many institutions and investment consultants are giving a face-lift to their traditional asset allocation classification approach for a “role bucketing” or risk-based approach, identifying the risks of an investment rather than which asset class it falls in. With the objective of generating more consistent returns across different economic environments, a growing number of institutions are changing their framework for asset allocation using a risk-based lens, reclassifying assets by factors that explain their risk and return characteristics.
Eighty-five percent of consultants surveyed by Cerulli consider asset allocation and diversification of investment portfolios according to underlying risk factors, as opposed to using the traditional style boxes. Of those 85%, 75% of gatekeepers indicated that they currently use a risk-based approach for constructing portfolios, and have made changes to clients’ investment policy statements and asset allocation accordingly.
This is a big change from the 60% stock / 30% bond / 10% alternative average allocation of ten years ago.