The $25.1 billion Iowa Public Employees' Retirement System rejected a proposal to move to a risk-parity whole-portfolio approach that would have leveraged government bonds by $15 billion because of fear that rising interest rates would pummel returns in the near future.
The proposal came from investment consultant Wilshire Associates Inc. as one of two ways the pension fund might boost returns to continue meeting its 7.5% return assumption while keeping a lid on risk.
The other proposal would use “moderate volatility absolute-return strategies as replacements for existing fixed-income and equity allocations,” Karl C. Koch, chief investment officer of the Des Monies-based system, said an e-mailed statement.
“ Wilshire Associates reviewed different types of risk-mitigating strategies, including risk parity, tail-risk hedging, low-volatility equity, active volatility management and tactical asset allocation,” Mr. Koch said.
IPERS would need to leverage its assets by $15 billion to achieve its 7.5% return objective over the next 10 years without exceeding its risk tolerance, Mr. Koch said.
Such a leveraged strategy would enable the system's fund “to gain more exposure to lower volatility bonds while reducing exposure to higher volatility stocks,” Mr. Koch said. But the leverage would expose the IPERS fund to “significantly more interest rate risk at a time when interest rates are expected to rise.”
The analysis was part of IPERS' annual review of its asset allocation and consideration of new strategies.
Eileen Neill, Santa Monica, Calif.-based managing director at Wilshire, presented modeling “with the objective of determining if some new strategies could help IPERS achieve its 7.5% return objective” over the next decade and stay within the IPERS board's tolerance for risk, Mr. Koch said.
The modeling “indicated that in the low-return environment currently forecasted by Wilshire, it is not possible to achieve the 7.5% return objective without employing a large amount of leverage in the portfolio,” Mr. Koch said.
On the absolute-return strategies, the analysis showed it would “provide a small increase in returns, but did not significantly improve Sharpe ratios,” a measure of risk-adjusted performance, he said.
“ Grosvenor Capital Management provided information on hedge fund investing and how the industry is addressing transparency, risk management and fees.”
IPERS has no hedge fund or absolute-return allocation now.
The pension fund has two existing portable alpha strategies, both “global tactical asset allocation mandates with volatility targets of 5% or less,” Mr. Koch said in an e-mailed response to questions. One is managed by Mellon Capital Management Corp. and the other by First Quadrant LP, each with about $390 million.
The Wilshire analysis concluded “a levered bond strategy achieved the 7.5% return, improved the Sharpe ratio, reduced the portfolio's exposure to equity risk, and reduced the portfolio's overall risk,” Mr. Koch said. “However, a levered bond strategy would require approximately $15 billion in leverage through a Treasury futures overlay, and would expose the fund to significantly more interest-rate risk.”
The IPERS board decided against adopting either strategy for now. “Based on the analysis, staff and Wilshire recommended that the current policy asset allocation be maintained, while continuing to periodically review levered bond and absolute-return strategies,” Mr. Koch said.
A challenge for all
Jay Love, Atlanta-based partner and senior consultant with Mercer Investment Consulting Inc., who isn't involved with the plan and spoke generally, said reaching such an assumed return will be a challenge for all pension funds over the next 10 years.
A 7.5% assumed return “is going to be difficult to achieve without using more complex investments and investment structures,” Mr. Love said. “A plain-vanilla approach cannot achieve 7.5% without taking a significant amount of equity risk.”
“Portable alpha would be a typical way to achieve that objective,” Mr. Love said. “But taking it does entail significant equity market volatility.”
In terms of other approaches, “illiquidity risk is generally rewarded, if they (pension funds) are willing to take it on,” Mr. Love said, citing private equity and real estate investments as examples. “Public plans do have that long-term horizon to permit that illiquidity,” he said.
IPERS' current allocation is U.S. equity, 23%; international equity, 15%; core fixed income, 28%; credit opportunities strategies, 5%; U.S. Treasury inflation-protected securities, 5%; private equity, 13%; real estate, 8%; other real assets, 2%; and cash, 1%.
“Based on current assumptions, IPERS' current asset allocation has a mean expected return of 6.8% with a standard deviation of 10.3% over the next 10 years,” Mr. Koch said.
But that expectation is not a reality yet.
In the one- and three-year periods ended June 30, the pension fund portfolio's respective returns were 10.12% and an annualized 11.06%. Both far exceeded the fund's assumed return but underperformed its benchmark returns of 10.64% for the year and an annualized 11.79% for the three years. For the 10 years ended June 30, it returned an annualized 7.78%, surpassing its assumed return but underperforming its 8.07% benchmark return.
The equity market has been strong in recent years, Mercer's Mr. Love pointed out. “Because the equity market has been so strong, it raises valuations over time” making equities not as attractive as they have been.
For the next 10 to 20 years, Mercer projects annualized returns of 7.1% for U.S. large-cap equities, 7.2% for U.S. small-cap equities, 3% to 4% for fixed income, close to 8% for international and emerging markets equities, and at least 8% for private equity and opportunistic, or aggressive, real estate, Mr. Love said.
Mr. Koch, in his response to questions, said: “IPERS' objective is to fund all future benefits when they come due. Those payments stretch out considerably longer than 10 years. Investments play an important role in meeting the objective, and our investment policy states that we will strive to earn a return that will fund the liabilities over the long term, but always within the risk tolerance of the board.”
“It is important to understand that actuarial discount rates are used to discount liabilities over a much longer time horizon then 10 years,” Mr. Koch continued. “So the fact that the current asset mix is not expected to earn the actuarial investment return assumption of 7.5% over the next 10 years does not mean that IPERS needs to rush out and load up on stocks or hedge funds, or leverage so that the optimizer can spit out a 7.5% expected return.
“I'm not saying that IPERS will never use those strategies, but I believe ... those possibilities introduce risks that the board and staff are not comfortable taking at this point in time, or they do not improve things enough to justify the change. We live in interesting times.”
This article originally appeared in the October 28, 2013 print issue as, "Iowa PERS nixes risk-parity proposal amid fears of rising interest rates".