DB Plans Can Afford to Loosen Up on Target Allocations

Two separate reports suggest that public pension plans’ strict adherence to target allocations and corporate pension plans’ focus on bonds and de-risking their portfolios may be hindering potential performance.

Public defined benefit (DB) plans set allocation targets for different asset classes and often rebalance their portfolio allocations to match these targets. A report from the Center for Retirement Research (CRR) at Boston College notes that some public pensions allow for a target allocation “range” for different asset classes, and its research suggests this looser standard could generate greater returns.

Similarly, many corporate DB plans use liability-driven investing (LDI) strategies which use trigger points (similar to targets) at which time the portfolio will be rebalanced to lock in funded status gains, usually allocating more to fixed-income instruments, such as long-term bonds. A report from Cambridge Associates notes many DB plan sponsors have focused predominantly on de-risking their pension plans, but contends that all corporate DB plans should be actively addressing growth in the context of their plan’s unique circumstances, and that current market conditions make this need even more pressing.

According to the CRR research, each year, about one-third of public plans must shift money between equities, bonds, and other asset classes in order to stay within target ranges.  A simple model of annual asset class flows from 2001 to 2017 shows that, in aggregate, public plans moved 8% to 10% of their assets each year. Its report says when equity values declined during the financial crisis of 2008/2009, money flowed out of equities because plans were shifting their target allocations away from equities and bonds and into alternatives, based on their evolving beliefs about the capital markets and adequate portfolio diversification. The timing of this shift locked in some of the decline in equity values and partially excluded plans from the stock market rebound experienced from 2010 to 2017. 

“Clearly, shifting money into and out of asset classes to remain close to target allocations incurs direct transaction costs. But it can also incur an opportunity cost if it requires moving money away from asset classes that are expected to achieve relatively higher returns,” the report says.

The CRR researchers modeled both an approach that assumes public plans annually move money into and out of asset classes so that the end-of-year asset allocations precisely match the target allocations and an approach that assumes plans annually move money into and out of asset classes only to the extent required to keep asset allocation within the maximum or minimum “target” ranges. It found that in addition to lower transaction costs, the looser approach to rebalancing results in overweighting an asset class when it outperforms and under-weighting when it underperforms.  Over the 2001 to 2017 period, a loose allocation approach would have modestly improved plan performance compared to a strict rebalancing approach.

As defined by Cambridge Associates in its report, “Reviving Pension Plans’ Funding Engines,” the corporate DB plan growth engine encompasses a variety of investment strategies including global equities, private investments, and hedge funds. The report also explores fixed income, not only as a liability hedge, but as an asset class that can drive excess returns through allocations to actively managed credit, including alternative credit.

“Plans of all stripes need to focus on their growth portfolio. In today’s market—with high valuations, continued volatility in the equity markets, and the economic and credit cycles nearing a tipping point—it is essential to maximize return potential, while still controlling risk, across both growth and liability portfolios,” says Alex Pekker, senior investment director in Cambridge Associates’ pension practice and co-author of the report. “Even well-funded plans should not neglect this exercise because returns play a large role in offsetting administrative expenses and funding liability gaps, both of which are critical to plan health over time.”

The report describes the parameters for establishing a growth portfolio for corporate DB plans, and says, “For plan sponsors willing to invest the required resources in portfolio implementation, a capital-efficient, risk-diversified portfolio can significantly outperform a traditional pension portfolio.”

An analysis shows, for an open plan that is 75% funded, replacing a portfolio of 60% global equities/40% long-duration bonds with one that has 70% allocated to diversified growth assets (including private equity and hedge funds) and 30% invested in efficiently implemented liability-hedging assets may moderately improve expected beta return and reduce funded-status volatility.

“Plan sponsors of all stripes, even those that are well on their de-risking journey, still need to generate meaningful asset returns, not just to close deficits, but also to fund pension risk transfers and offset ongoing plan administrative expenses,” the Cambridge Associates report says.