Underfunding Drives Investment Strategies of U.S. Corporate and Public Funds
March 13, 2013
U.S. Endowments and Foundations Increase Exposure to Alternative Investments
Greenwich Associates today announced the results of its most recent U.S. Investment Management Study. Among the key findings of that research are the following:
• Companies’ decisions about their defined benefit pension plans are being driven by the tension between desires to shed pension risk and the increasingly pressing need to generate enough investment returns to fund long-term liabilities.
• Underfunded U.S. public pension funds are adding risk to their portfolios as part of a quest for much-needed returns.
• Endowments and foundations appear to be doubling down on the so-called “Yale Model” by planning significant new investments in alternative asset classes and reductions in allocations to traditional equities and fixed income.
Corporate Pension Funds: In De-Risking, Actions Speak Louder than Words
Average funding ratios for U.S. corporate pension funds fell to 81% in 2012 from 89% in 2011, driven mainly by declining interest rates. More than 60% of all corporate DB pension plans are now funded at 85% or less, and only 10% of plans are fully funded.
Greenwich Associates research shows striking differences in portfolio allocations between well-funded and underfunded plans. Among the 12% of U.S. corporate funds with funding ratios of 105% or higher, fixed income currently makes up approximately 61% of their investment portfolios. Meanwhile, funds with ratios of 75% or less allocate only 31% to fixed income. The difference in equity allocations is equally stark.
“While plan sponsors with weaker funding ratios have found their intentions to move in a similar direction stymied, many have used the past two years to put in place dynamic allocation plan and glide paths for de-risking as interest rates rise and/or funding levels improve,” says Greenwich Associates consultant Goran Hagegard.
Public Pension funds Embark on Quest for Alpha
Public pension funds are attempting to improve investment returns by shifting assets into riskier asset classes. They are moving in this direction for a few simple reasons: They are underfunded, they face an environment of declining investment returns and they see little hope of cash infusions from struggling municipal and state plan sponsors.
“Results from our study show that from 2011–2012 public funds generally made no progress in closing funding gaps,” says Greenwich Associates consultant Andrew McCollum. Average solvency ratios of U.S. public defined benefit pension plans held steady at 77%, and Greenwich Associates estimates show that nearly three quarters of plans are significantly underfunded. Over that same period, public funds decreased their average actuarial earnings returns on plan assets to 7.5% from 7.9%.
“Particularly striking are funds’ stated intentions for their portfolios for the next three years,” says Greenwich Associates consultant John Webster. Nearly a quarter of public funds say they plan to significantly reduce allocations to current active U.S. equity allocations in that period, with only 6% planning to increase them. More funds are also planning to cut allocations to passive domestic equities and fixed income compared to those planning increases. Meanwhile, public funds are planning to significantly increase allocations to private equity, equity real estate, hedge funds, and commodities.
Endowments and Foundations Plan New Investments in Alternatives
Endowments and foundations appear to be doubling down on the so-called “Yale Model” by planning significant new investments in alternative asset classes and reductions in allocations to traditional equities and fixed income.
The mix of traditional securities versus alternative asset classes went largely unchanged by endowments and foundations from June 2011-2012. However, an impressive 27% of endowments and foundations say they expect to significantly increase allocations to private equity in the next three years, and 24% plan to make meaningful additions to hedge fund allocations In addition, more endowments and foundations plan to increase allocations to commodities and equity real estate than decrease allocations to those asset classes. Meanwhile, the percentage of endowments and foundations planning to significantly reduce allocations to domestic equities is nearly double the percentage planning increases. In fixed income, the bias toward cuts is even greater.
Funds’ satisfaction with the performance of their alternative investments will likely hinge largely on the reasons for their allocations. “Endowments and foundations hoping to duplicate the investment returns of the Yale model’s early adopters might end up disappointed,” says Greenwich Associates consultant Kurt Schoknecht. In the 12-month period ending June 30, 2012, the alternatives-heavy portfolios of endowments and foundations generated average investment returns of only 1%, compared to the 4% average returns produced by public pension fund investment portfolios and the 6% generated by corporate pension funds.