Asset allocations: past, present and future

This slide looks at several distinct periods in the evolution of corporate DB plans. The mid-1980s and early 1990s showed some conservatism and reflected high short-term interest rates with an almost 7% allocation to cash.The late 1990s reflected the belief that public equities could continue to deliver double-digit returns year-in and year-out. There were numerous plans with allocations to equities of more than 80%. The all-time high probably goes to Kohler, whose DB plan in 1999 had a 96% allocation to equities split evenly between domestic and international equity.After the tech bubble and before the financial crisis, there were only minor changes, with alternatives pulling more assets from listed equities.Since the financial crisis, there has been a dramatic change in the allocation to fixed income and alternatives, and a dramatic decrease in the amount of listed equities in the typical corporate DB plan. Listed equity allocations dropped 1,600 basis points while fixed income picked up 900 basis points and alternatives increased 700 basis points.

Ford's DB plan is a great example of what has been seen in the aggregate. In many ways, Ford has been a leader in asset allocation changes several years ahead of its peers.One can see in 2006 that Ford started to shift its portfolio into more fixed income and out of equities. In recent years the company accelerated the trend and now is targeting the supermajority of pension assets to fixed income. The remainder is in a growth portfolio that consists of alternative investments and listed equities.

Looking at public plan sponsors, they have taken a completely different path.Traditionally, public plans had a more conservative allocation, in part because they were required to do so by state law. It was only in 2012 that the $48 billion Georgia Teachers retirement system was permitted by the Legislature to invest up to 5% in alternatives.Fixed income and cash used to comprise more than 55% of public plan portfolios. In the late 1990s and early 2000s, public plans continued to move out of fixed income and into listed equities and alternatives.Since the financial crisis, there has been a continued move out of fixed income. Allocations to listed equities have come down slightly, but the real dramatic change has been in alternatives. In 2012, for the first time ever, alternatives might have a larger allocation among public pension plans than fixed income.Historically, public plan sponsors' exposure to alternative investments was solely through real estate. Recently, they have started to invest across a spectrum of alternatives, especially private equity and hedge funds.

This slide lays out year by year the allocations to fixed income. Starting in 2008, you can see a dramatic change to fixed income by corporations. Numerous corporate plan sponsors now have allocations to fixed income of more than 75%. Intel's DB plan, for example, has an 85% allocation to fixed income.The trend is pretty constant for public plans: down.

The Yale endowment's allocation illustrates the trend with endowments. It now has an almost non-existent allocation of 4%. Yale executives have stated that bonds have an expected real return of 2% with risk of 10%. Not to second guess a great investment mind, but it is interesting to observe in hindsight that CIO David Swensen was a little early getting out of fixed income. The average large endowment now has an allocation of only 9% to fixed income.

Home-country basis had been seen in pension funds for many years. In the early 2000s, plan sponsors started to change this in a major way. As the slide illustrates, home-country basis has been removed for the most part.The other large trend recently within equities has been a movement to global allocations. Numerous pension funds have switched to a completely global view on equities. PG&E's $11 billion pension plan went to a 100% global equities allocation, as did the $45 billion Massachusetts Pension Reserves Investment Management board.

This first slide on alternative investments shows the hundreds of billions of dollars that have flowed into alternatives. All of the major alternative asset classes have seen growth. Real estate has grown the slowest, as most investors have had meaningful exposure for some time. Real assets have seen an explosion as DB plan sponsors have started to adopt the asset class.

Private equity has seen more than its fair share of growth, with both corporate and public plan sponsors increasing their allocations.As one could see from the overall alternatives chart, private equity makes up the biggest proportion of alternatives.

Washington State Investment Board has been investing in private equity for a very long time. This slide shows the current composition of its portfolio. It is pretty typical, with buyout funds being the dominant allocation. The board is slightly underweight venture capital, however, which typically represents around 10% of private equity.

There was an enormous bubble in venture capital during 1999 and 2000. Assets have just recently surpassed the 2000 high.

For corporate pension plans, the main issue causing them to re-evaluate their asset allocation has been the funding volatility over the recent decade. There have been two $500 billion swings with the bursting of the tech bubble and the recent financial crisis.

More than declines in investment values, lower interest rates have been the main culprit recently. One very important side effect of quantitative easing — QE1, QE2 and QE3 — has been multidecade lows in discount rates. The lower discount rates overwhelmed any recovery of asset prices, causing a lower funded status.The desire to match liabilities and assets more closely explains in large part the higher allocations to fixed income for corporate DB plans.

The decrease in equity pertains to its significant volatility in the short term. The chart highlights the non-normal distribution of returns: 12 quarters had sharply negative returns.

Public plans' lower fixed-income allocations can largely be explained by falling interest rates.The difference between open defined benefit plans' assumed rates of return and interest rates is dramatic.Meeting an 8% assumed rate-of-return assumption used to be easy when long-term Treasuries were yielding more than 10%.Now 10-year Treasuries are more than 600 basis points below a typical assumed rate of return.

The next question is why are corporations, public plans and endowments and foundations allocating such significant amounts to alternatives?There are two key reasons. First and foremost, institutional investors are interested in assets with a different risk profile. The 45% to 50% drawdowns of equities are no longer welcome. Secondly, close to equity-like long-term returns are important.The next couple of slides highlight the risk pattern of alternative investments, which is very different from listed equities.The first chart shows a huge positive skew with limited tail risk. It includes private equity, venture capital, hedge funds, real estate, timber and farmland.

This is one of the most unbelievable charts: How, in a 20-year period with several significant financial crises, has farmland as an asset class not seen a single quarter with a negative return? Going back to 1985, however, there were periods with significant losses.

This slide shows the percent of quarters with a loss for all alternatives.

This slide shows the percent of quarters with a loss greater than 5% for all alternatives.

Alternative investments historically have provided equity-like returns. Excluding the venture capital bubble, alternatives have steadily outpaced listed equities and fixed income.

Besides significant changes in asset allocations for the typical corporate DB plan, there have been two recent developments that could reshape the corporate pension space. First, there have been billions of dollars in lump-sum offers to employees at some of the largest plan sponsors. This list shows some of the largest offers this year.Second was the $33.5 billion group annuity contracts purchased by General Motors and Verizon.Both of these trends move the assets and liabilities off the corporate balance sheet.

There have been two other significant invest trends of note. First, there have been significant increases in allocations to risk parity. This has been done both at the portfolio level and as a specific allocation. The State of Wisconsin Investment Board, Texas Teacher Retirement System and Ohio Public Employees Retirement System have all made allocations.Also, tens of billions of dollars are going to outsourced CIO providers. This was first seen with midsize endowments and foundations, but now is in evidence among medium to large pension funds. Both the San Diego County Employees Retirement System and Weyerhaeuser use an outsourced CIO provider.

Corporations will continue to contribute significant sums of money to shore up their defined benefit plans.There will be increased adoption of LDI strategies among corporations.Corporations will continue to move the assets and liabilities off their balance sheets and onto individuals and insurance companies.

As for public plans, there should continue to be smaller allocations to fixed income. More importantly, fixed-income allocations will shift from Treasuries and high-quality corporate securities to ones with more risk and more income. The days of only allocating to core and core-plus are limited.There will be even higher allocations to alternative investments: To 20% to 30% of the portfolio from the current 10% to 20%.

The alternative investment that has the brightest future is real assets.This slide shows its rapid growth in the past five years. The asset class has garnered $40 billion more in assets during that period, as allocations have doubled or tripled. We expect the trend to continue or even accelerate.The changes are driven by a desire to hedge inflation risk, which is critical for endowments and foundations, and often meaningful for public plans with cost-of-living adjustments.

Commodities have been the most widely understood and accepted real assets. Since P&I started collecting information on the topic, one can see the significant increase in the number of investors in commodities.