Asset Mix | Published in December 2000

Strike Up The Bond

Why plans that have been riding the bull market may wish to explore more stable seating

By Steve Bergsman | December 2000

Why plans that have been riding the bull market may wish to explore more stable seating

» Risky Schemes?

The $42 billion Virginia Retirement System is undergoing an asset allocation study to determine a new asset mix and, according to its board chairman, an increased allocation to fixed-income investments is on the horizon. The Richmond-based retirement system, with a 70%/30% equity-to-fixed-income split at present, is contemplating a 50%/50% mix of stocks and bonds, says Edwin Burton III, chairman of the VRS board of trustees.

"We want to reduce the risk of the fund," he explained early last month. Over the long term, Burton suggests, the returns on equity will not be as buoyant as in past years.

"We have been very heavy equity players for a long time, but, looking to the future, it is time to change."

Clearly, even the most disciplined plan sponsors have likely found their asset-allocation strategies tested, if not tempted, by the consistent strong overall performance of US equities during the past several years. But, fund officials are discovering once again that the ability to match cash flow requirements, while achieving a stability of return, can be just as exhilarating—particularly in a market that takes away as readily as it gives.

For instance, at the $120 billion New York State Common Retirement Fund, the strategic plan for the past five years has allocated 33% of the portfolio to bonds and 50% to domestic equities, providing returns of 8% and 25.5%, respectively.

"Obviously, we do some rebalancing, but we have tried to keep the pieces of the pie basically stable in regard to the overall portfolio," notes Jeff Gordon, spokesman for the Common Fund. "Our strategy has been to develop an asset allocation [policy] and reexamine it every few years" for market circumstances or fund growth that necessitates change, says Gordon.

In the midst of change, at the end of the day, the ability to meet benefit obligations is a key consideration for many plan sponsors. Bond investments can offer a consistent, predictable flow of income, as well as the return of principal.

"The fixed-income portion of the portfolio holds a very practical role for us. It gives the overall fund stability and allows us to project what funds will be available for pensions," according to Gordon.

Particularly in volatile markets, the commitment to consistent approach also can provide great comfort. While many plan sponsors bulked up on equity investments in the late 1990s, DuPont Capital Management kept a self-described "moderate" allocation to equity (60%), while making a conscious effort to maintain its 25% commitment to bonds (15% is directed toward venture capital investments). The Wilmington, Delaware-based asset management firm's core business is the $18 billion DuPont pension fund, but it has continued to branch out, managing pension monies for DuPont's former affiliates like Conoco as well as other third-party pension systems.


Risky Schemes?

Plan sponsors like to say that they do not react to immediate movements in markets, but stick to their strategic plans. There is, however, a certain tendency to let asset allocations ride, in view of the stock market's successful run, rather than leave the party too soon. Still, plan sponsors should reconsider bonds, if for no other reason than to reduce risk and volatility.

"This year, there have been about 100 days when the market has been up by more than 2% and, with that kind of volatility, it is a good time to take some of your chips off the table," notes Joan Batchelder, chief fixed-income officer for MFS Investment Management. The Boston-based company boasts $160 billion under management, $25 billion in fixed-income funds.

"When the stock market was doing so well, people felt less incentive to be disciplined," Batchelder observes. "But, when volatility is way up, as it is this year, you have a lot of people asking 'Is overweighting in equities appropriate?' and the answer is 'no' for an awful lot of investors."

"Besides," says Batchelder, "this is a good time to be looking at bonds because of macroeconomic factors. If you are worried about inflation, either because we are late in the economic cycle or because of oil prices going up, then the outlook for fixed income is constructive."

During the late 1990s, when equities were red hot, the Employee Benefit Research Institute reported that domestic equity allocations rose from 45.3% of total portfolios in 1996 to 48.1% in 1998, with nearly all of that coming from domestic bond allocations.

This year, Neil Wolfson, partner-in-charge at KPMG in New York, expects bonds to outperform large-cap equities, with expected bond returns at 3.6% and large-cap equity returns at 3.3%. This is a big change from 1999 when large-cap equities were up 18.3% and bonds were off 2.2%.

In fact, through mid-October, with the S&P 500 down 4.5% and Nasdaq down more than 17.5%, bonds were performing quite handily: Long-term Treasurys were up 12.02%, municipals 6.40%, and corporates 5.73%. Over the long haul, large- and small-cap equities will again outperform bonds, says Wolfson, but likely by a narrower margin. According to a KPMG study, over the next five years, 90-day US Treasurys should climb 2.4% and intermediate maturity bonds will rise 3.8%. For the same period, large-cap equities are expected to grow by 6.6% and small-cap equities by 9.9%, a far cry from 1996 to 1999, when large-caps rose 25.8% and small-cap equities gained 13.8%.

Even with the big numbers produced by equity investments over the past five years, a number of large pension systems have maintained a relatively high level of bond investments. The $1.3 billion City of Austin Employees Retirement System in Texas holds about 35% of its assets in fixed-income instruments, of which about 32% is in bonds. While admitting big pension systems such as Austin "do things at glacial speed," says Catherine Herrington, pension director of the plan, it did undertake an asset-allocation study in October and eventually rebalanced toward fixed income.

"We looked at some alternative investment classes as opposed to fixed income but, at that point, we decided there wasn't any need to take additional risk. We were not interested, for example, in moving into real estate," Herrington says.

What happens when bonds have a good year, as in 2000? The psychology is such, says Bill Brock, executive vice president of Evaluation Associates in Norwalk, Connecticut, "that most plan sponsors, at this point, believe they're not making money, just recouping losses from prior years. Even if the plans are reevaluating for the future, they are primarily looking at their equity components—the growth driver. Bonds are just a second or third priority."

Still, even Brock concedes that plan sponsors need to use bonds on a strategic basis, "as a strategic offset to the volatility of equities."