Warnings continue to pile up for public pension funds with asset allocations that are heavily invested in equities and alternatives in order to maintain expected rates of return north of 7%.
A report last month for the world’s largest sovereign wealth fund — Norway’s ‘oil fund’ — highlighted a debate over whether or not government institutions should be shifting towards riskier asset classes in order to chase higher yields, or embrace the lower investment return environment that we are expecting to see over the next few decades. As returns on bonds and fixed income investments have fallen over the past few decades, public sector funds — such as state administrated pension plans — have had to increasingly diversify their portfolios in order to maintain expected return rates of 7%, 7.5%, or 8%. That diversification has increased the volatility in return rates and exposed the taxpayers guaranteeing underlying liabilities of pension funds to greater investment rate risk. However, as a special commission in Norway has had to grapple with as well, there are downsides to the lower yields from keeping safer asset allocations in place. For pension funds across the U.S., the downside would be growing contribution rates (given lower expected returns on investments) consuming budgets in the near-term.
In the case of the Norwegian oil fund, the majority of the special commission in Norway recommended increasing the equity holdings of the fund from the current 60% target up to a 70% target. Why? Because the current asset allocation’s expected real return for the next 30 years is just 2.3% (or 4.3% if we assume 2% inflation). The fund’s other asset allocation is about 36% to fixed income and 3% in real estate, according to PIOnline.
In contrast to many public pension funds in the United States, the Norwegians supporting the increased allocation to equities explicitly recognize they’ll be taking more risk with the assets if they make this change, and said so in their report. But that increased risk was too problematic a prospect for some on the commission, leading a minority of the Norwegian commission members to recommend lowering the equity holdings of the fund to 50%.
A key takeaway for pension funds in America from this debate and report should be that actuarial assumptions using 7%, 7.5%, and 8% returns are either unreasonable for plans with a primary mix of stocks and bonds, or are going to require significant returns from alternative investment classes, such as private equity, hedge fund strategies, real estate, infrastructure, etc. As John Hussman wrote earlier this year: “the expected return on a traditional portfolio mix is actually lower at present than at any point in history except the 1929 and 1937 market peaks. [The Federal Reserve’s program of quantitative easing] has effectively front-loaded realized past returns, while destroying the future return prospects of conventional portfolios.”
Of course, the irony is that if all pension plans across the country were to simultaneously shift out of their equity holdings into increased fixed income, or reduce their alternative asset class holdings in favor of bonds, that the moves would likely drive down yields on fixed income even further. From this perspective the first pension plans to make moves will likely be in a better position for yields on long-term bond holdings, assuming that investment boards for pension plans across the country begin to act on the existing challenges.
For the moment, though, this doesn’t look like a problem of the near future, since pension plans have mostly stuck with asset allocations and expected returns above 7% over the past decade. Hussman warned that this reflects short-term thinking and a “belief that high realized past returns are representative of future outcomes.” Hussman expects that a “conventional portfolio mix of stocks, bonds and Treasury-bills is likely to average scarcely 1.5% annually over the coming decade.” (emphasis added)