When large public plans, particularly state plans, face funding crises, it's rarely because they had a few years of weak returns. The reason most states face underfunding issues is almost always because of the funding itself, investment consultants said.
"It really becomes a question of contributions," said Eileen Neill, a managing director and senior consultant at Verus, Seattle.
Still, although asset allocation isn't the solution to becoming fully funded, it can help bridge the funding gap at least a little bit. Ms. Neill said Verus assists its underfunded pension plan clients in focusing on downside risk mitigation.
"In a negative capital market environment, that can result in a significant impairment to funded status, depending on how deep the drawdown is and how long it persists," said Ms. Neill. "So, when we talk with clients, we talk about what we can do to reduce these drawdowns."
One option is to target options-based strategies, or strategies like risk parity or risk balancing and diversification. Essentially, it's important for these plans to focus on strategies that can serve as anchors during periods of equity drawdown, she said.
Pension obligation bonds can also be a good tool to offset liabilities, although "they're not without risks," and require "a fair amount of education," Ms. Neill said.
The Verus consultant noted there are also several strategies that cross different asset class segments and many of which involve derivatives that can help reduce asset return volatility without sacrificing long-term growth. These include risk parity, portable alpha and overlay strategies.
Other strategies that public plans can employ to help bridge the funding gap are using more illiquid strategies, such as private equity as a substitute for equities, and private credit as a substitute for fixed income, according to Sona Menon, head of Cambridge Associates' North America pension business, Boston.
"There is a focus on true diversification," said Ms. Menon. "There's a lot of different strategies, but not different sources of exposure. So, we're trying to build portfolios that have different sources of exposure."
Ms. Neill said there are some plans that have negative cash flows.
"That's very difficult to improve upon in a low return environment; there's no way to asset allocate that's going to help them," said Ms. Neill. So, those plans "must address their funding issues. That's the only solution for them."
