Institutional Asset Allocation

My comments about institutional asset allocation, along with those made by Mr. Ron Ryan (CEO, Ryan ALM) and Lynn Connolly (Principal, Harbor Peak, LLC), were well received on January 8, 2014. Part of a joint program that was sponsored by the Quantitative Work Alliance for Applied Finance, Education and Wisdom ("QWAFAFEW") and the Professional Risk Managers' International Association ("PRMIA"), our audience of investment professionals added to the lively debate about topics such as strategic versus tactical asset allocation, fees, role of the pension consultant and the likely capital market impact due to the implementation of strategies such as liability-driven investing ("LDI") and/or pension risk transfers ("PRT"). 

With the size of the U.S. retirement market at $20 trillion and counting, big money is at stake. Bad asset allocation decisions can lead to a cascade of economic woes. It is no surprise that fiduciary breach allegations in the form of ERISA lawsuits are increasingly focused on questions about the appropriateness of a given asset allocation mix and whether an investment consultant or financial advisor has helped or hindered the way that pension monies are allocated. Noteworthy is that scrutiny about the efficacy of the asset allocation process and resulting money mix can, and has been, applied to both defined benefit and defined contribution plans. Keep in mind that asset allocation decisions are likewise central to assessing popular financially engineered products such as target date funds. Accounting issues and how changing rules influence asset allocation decisions are yet another topic that we will tackle in coming months.

Click to access Susan Mangiero's asset allocation slides, distributed to members of the January 8 audience, and meant to peturb a discussion about this always essential topic. Interested readers can check out "Frequently Asked Questions About Target Date or Lifecycle Funds" (Investment Company Institute) and "Annual Survey of Large Pension Funds and Public Pension Reserve Funds: Report on pension funds' long-term investments" (OECD, October 2013).

If you have a specific question about asset allocation and/or the procedural process associated with asset-liability management, send an email to me.

U.S. Infrastructure and Pension Fund Investment

The world is truly getting smaller. A recent Wall Street Journal article describes the continued interest on the part of Japanese pension funds to directly invest in U.S. infrastructure projects such as a Michigan power plant. See "Japan's Pension Fund Association Targets Infrastructure Abroad" by Kosaku Narioka (July 2, 2013). Last year, the Ontario Municipal Employees Retirement System ("OMERS") joined forces with Japan's Pension Fund Association and a group led by Mitsubishi to invest $7.5 billion in roads, airports and other types of infrastructure projects. The goals are to raise $20 billion in total, avoid the expense of using intermediaries and gain exposure to long-term assets that are arguably a natural match to a defined benefit plan's long-term liabilities. See "OMERS, Japanese partners launch infrastructure fund" by Greg Roumeliotis (The Globe and Mail, April 26, 2012).

In their 2011 publication entitled "Pension Funds Investment In Infrastructure: A Survey," authors Raffaele Della Croce, Pierre-Alain Schieb and Barrie Stevens estimate the global infrastructure market at U.S. $50 trillion by 2030. This includes climate control projects. They add that, given the strain on numerous municipal and sovereign budgets and regulations that have impaired some banks' abilities to lend, infrastructure financing must depend on private sector finance.

With these opinions in mind, infrastructure investing by pension funds seems like a good idea. There is both a demand for long-term capital and a supply in the form of interested money in search of returns over time. Like any investment and/or strategy however, one needs to weigh risks against expected returns.

Currency risk and project completion risk are two considerations. Being able to obtain and properly interpret adequate performance reports is another concern. In "Insurers call for more transparent infrastructure investments," contributor Louie Woodall (June 14, 2013) writes that opacity is a roadblock to having insurance company institutional investors allocate more money to this asset class. Regulations cannot be ignored either. Olav Jones, deputy director-general of Insurance Europe is quoted as saying that "...the Solvency II calibration for long-term investments does not account for the actual default of these assets, which is the primary risk insurers have to reserve for when using a buy-to-hold strategy." To the extent that pensions may be asked to comply with Solvency II mandates (or something similar for non-European funds), their trustees will no doubt want to ensure that capital is being pledged on the basis of "true" economic risks they deem to be associated with identifed investments.

Fiduciary liability is another factor that, in my view, is seldom discussed. Specifically, there are situations when a pension fund may feel that political pressure is being brought to bear to have trust money used to support a local project. When I recently spoke about pension governance before an audience that included public fund trustees, several persons complained about the exertion of uncomfortable "influence" to allocate assets in a way that could be said to fuel growth for a particular city or county or state but not necessarily fit with the pension fund's investment strategy. I served on a June 17, 2013 panel entitled "Fiduciary Responsibility for Management & Trustees." It was part of the Tri-State Institutional Investors Forum. The conference was produced by the U.S. Markets Center for Institutional Investor Education.

Published in 2008, interested readers may want to download "Pension Fund Investment in Infrastructure: A Resource Paper" by Larry W. Beeferman, JD. I have had the pleasure of speaking about governance and pension risk management at events put together by Mr. Beeferman, senior executive with the Labor and Worklife Program at Harvard Law School.

Another resource is "Trends in Large Pension Fund Investment in Infrastructure" by Raffaele Della Croce (OECD, November 2012). Based on his survey research of beneficial owners with control of more than $7 trillion of assets, he describes infrastructure investing as "attractive" because it can "assist with liability driven investments and provide duration hedging." Later in the report, he discusses the tradeoff between liquidity of these longer-term commitments with the chance to diversify a pension portfolio.

With planes, boats, trains, cars and fast technology, we can go from Peoria to Paris in hours. It is no surprise then that we see pension giants focused at home and abroad.

Global Pension Assets: Another Tough Year

Hot off the press, the OECD's September 2012 issue of "Pension Markets In Focus" includes some notable statistics about pension schemes around the world. While aggregate assets increased to over $20 trillion (as of December 2011), post-fee real rates of return were miniscule at best. With an average annual rate of return of -1.7%, few winners bested the market at large. The award for the highest performing pension system went to Denmark with an annual return of 12.1% in 2011, followed by the Netherlands (8.2%), Australia (4.1%) and Iceland and New Zealand, each turning in a modest 2.3%. Turkey, Italy, Spain, Japan, the United Kingdom and the United States realized negative returns.

The news is not all grim.

According to André Laboul, OECD Head of the Financial Affairs Division Directorate for Financial and Enterprise Affairs, assessments of performance that consider many years show that the traditional 60% equity and 40% long-term sovereign bond mix have generated positive returns that range from 2.8% in Japan to 5.8% in the United Kingdom. Of course, many factors are at play, not the least of which is how much latitude an investment committee or policy-making body has to allocate monies locally versus internationally, the rate at which assets grow (and can be put to work) and the fees that are paid to various service providers.

Regarding asset class exposure, OECD researchers note that pension funds' allocation to "public equities declined significantly compared to past years." This trend is likewise noted in the "Global Pension Assets Study 2012." Published by Towers Watson in January, this compilation of interesting data points shows that the Netherlands and Japan have a "higher than average" allocation to bonds. In contrast, "in 2011, Australia, the UK and the US retained above average equity allocations." Apportioning more monies to alternatives is an undeniable reality for retirement plans in multiple countries

Since more than a few people posit that asset allocation decisions dominate portfolio returns, it is critical to track who is investing in what. Pension de-risking activity will likely have an impact on defined benefit plan portfolio mix going forward if, as experts suggest, more companies decide to exit or modify their exposure to the "pension business" by freezing a plan, using derivatives, offering lump sum payouts, entering into group annuities and so on.

Pension restructuring and adding more alternatives are factors that are changing the governance landscape in numerous ways. For one thing, the need for investigative due diligence and independent valuation services arguably becomes more acute. Second, the regulatory focus on holdings disclosure and compensation paid to service providers could inhibit the use of private funds at the same time that yield-seekers are writing checks.

The "push-pull" dynamic is holding everyone's attention since so much money is at stake.

The View From The Other Side - Regulatory Insight

Sometimes seeing over the other side of the desk is difficult, if not impossible. That's too bad because regulators and those they oversee have a lot to learn from each other. This is especially true if you embrace a primary goal of ultimately allowing for complete self-governing as a way to ensure more efficient markets.

"Pension Funds' Risk-Management Framework: Regulation and Supervisory Oversight" by Fiona Stewart (Working Paper No. 11, International Organisation of Pension Supervisors, November 2009) gets us part of the way. This new compendium of rules and regulations categorizes pension risk rules for Australia, Brazil, Germany, Kenya, Mexico, Netherlands and the UK in four areas - "management oversight and culture, strategy and risk assessment, control systems and information, reporting and communication." An audit checklist that pension supervisors can use in their examination work is offered as an appendix as is a convenient summary table that lays out country-specific risk management regulations about things such as the role of the Chief Risk Officer.

The two sides of the fence may never shake hands but studies like this enhance the understanding as to what is expected of plan sponsors by regulators.