Although public pension plans and their corporate counterparts were hit equally hard by the global market crisis, a study from Greenwich Associates shows they are responding to historic funding shortfalls in dramatically different fashions.
With an eye toward constraints imposed by tougher accounting rules, companies that sponsor defined benefit pension plans are shedding risk from their investment portfolios and are apparently preparing for the inevitability of much higher cash contribution requirements.
Public pension funds, meanwhile, are shifting money into riskier asset classes in what is looking like a “swing-for-the-fences” attempt to close shortfalls with future investment returns that far outpace those of the broad market.
“Corporate funds have traditionally invested much larger portions of their assets in equities, while public funds took a more conservative stance with bigger allocations to fixed income,” says Greenwich Associates consultant Dev Clifford. “As a result of their differing strategies in the wake of the crisis, public pension funds and corporate funds are approaching parity in their US equity allocations, and public funds are making and planning meaningful investments in private equity, international stocks, hedge funds and real estate.”
The typical US defined benefit pension plan saw the value of its assets fall by approximately 19 per cent from 2008 to 2009 before the recovery that began in March-April last year, bringing the overall value of assets in the portfolios of US defined benefit plans down to levels last seen four to five years ago. Although recovering markets reversed some of those declines, asset values have yet to return to those seen in 2007. At the same time, the value of pension liabilities soared due to persistently low interest rates and the demographics of an aging population.
The resulting damage to pension funding status was sudden and severe. Among public pension funds, the combination of growing liabilities and a drop in asset values to USD2.7trn in 2009 from USD3.2trn in 2008 depressed average solvency ratios to 83 per cent from 86 per cent. More than 30 per cent of US public funds now have solvency ratios of 79 per cent or lower, and more than one in ten public funds have a solvency ratio of 69 per cent or lower.
Average solvency ratios for state funds declined to 80 per cent in 2009 from 84 per cent in 2008 and average ratios for municipal funds dropped to 84 per cent from 88 per cent. Average funding ratios for the projected benefits obligation of US corporate pension funds fell to 80 per cent in 2009 from 101 per cent in 2008. The proportion of US corporate pensions funded at less than 85 per cent rose from approximately eight per cent in 2008 to 57 per cent in 2009 and the share funded at less than 75 per cent increased from less than one per cent to 31 per cent.
Fearful of eventual — if temporarily delayed — implementation of mark-to-market accounting rules that will ultimately transfer the full impact of pension investment volatility to the corporate balance sheet, companies are electing to take down risk levels in their DB portfolios. Chief among their tactics is lowering allocations to US equities, which declined to an average 33.8 per cent of total corporate assets in 2009 from 40.7 per cent in 2008 and are expected to fall further in coming years.
Free from these accounting concerns, public pension funds are moving in the opposite direction, increasing allocations to higher risk asset classes with the potential to generate higher levels of investment returns. Although public pension funds as a group also allowed US equity allocations to fall last year, they are planning to cut fixed-income allocations in coming years while shifting assets into private equity, international stocks, hedge funds and equity real estate.
According to the study, approximately 17 per cent of public pension funds say they plan to reduce significantly fixed-income allocations over the next two to three years, with only about nine per cent planning reductions.
An impressive 23 per cent of public funds say they are planning to make significant additions to private equity allocations between now and 2012. Almost 20 per cent of publics plan significant increases to international equity allocations and about 18 per cent plan to significantly increase hedge fund allocations by 2012. In each of these asset classes, these proportions far outweigh the much smaller shares of public funds planning to decrease these allocations.
Public funds appear to be banking on the fact that the investment strategies they are implementing will help shore up solvency ratios by generating returns that far outpace the market. Municipal pension funds last year said they expect their investment portfolios to beat relevant benchmarks by 160 basis points — up from a 132 bps expectation in 2008.
Public funds with assets of USD500m or less increased their stated expected outperformance to 180 basis points in 2009 from an already aggressive 135 bps in 2008.
“These are very aggressive expectations,” says Greenwich Associates consultant Chris McNickle. “Most investment managers struggle to generate the levels of outperformance expected by institutional investors; it would be rarer still for an entire portfolio to achieve that level of outperformance for any number of years.”
