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US Public Pension Funds to Increase Allocation to Hedge Funds at Greater Rate than Corporate Pension Plans

Agecroft Partners predicts that United States public pension funds will increase their allocation to hedge funds at faster rate than corporate pension plans due to sweeping new corporate pension legislation that is just beginning to take hold in the industry. The new legislation does not directly impact public pension funds. Corporate pension fund allocations have historically targeted a higher risk and return profile than public pension funds, but that may be changing due to the passage of the 2006 Pension Protection Act that became effective in 2008. This was the most dramatic pension legislation in the US since the passage of ERISA back in the early 1970s and the legislation will have major implications for corporate pension funds asset allocation, the structure of corporate pension plans and the retirement burden on society.

Historically a vast majority of defined benefit pension funds used a static discounts rate of approximately 7.5% to 8% to determine the present value of their future liabilities. By keeping the discount rate constant year after year and by amortizing unfunded liabilities over a 20 to 30 year period, it allowed for a fairly consistent required contribution to a defined benefit plan on an annual basis. In order for the pension fund to achieve investment returns equal to the discount rate, pension funds used modern portfolio theory to constructed diversified portfolios along the efficient frontier which allowed them to maximize return for a targeted level of volatility. Over the years, this efficient frontier was enhanced as more asset classes were utilized and through the adoption of alternative investments within their portfolios. Over long periods of time, this investment strategy was effective at reaching their return objectives. In addition, this strategy of maximizing long term returns had reduced the long term cost of funding these defined benefit plans.

The new extensive and complex pension legislation includes two provisions which will alter how many corporate pension fund assets are managed. The first provision effects how companies determine the present value of the future liability stream, which includes many variables, but is dominated by the discount rate. The new regulation states that the discount rate will be derived from a “yield curve” of investment-grade corporate bonds averaged over the most recent 24 months, which is updated on an annual basis. This has had major implications for corporate defined benefit plans. The average discount rate to calculate future unfunded liabilities has been significantly reduced from what corporations have used historically. This has caused their unfunded liability to increase significantly. It has also added significant variability to future pension fund contributions because of the unpredictability of future discount rates. The second provision reduced the time period that corporations could amortize these liabilities from 20 to 30 years down to half that time period. The effect of combining these two provisions has been to significantly increase annual funding for many plans over previous levels at a time when many corporations can least afford to incur additional liabilities.

As a result, many corporate defined benefit plans are moving away from maximizing return by utilizing the efficient frontier strategy of portfolio construction to a liability matching strategy for their portfolio which features a significant increase in their allocation to long duration fixed income securities in order to reduce the variability of annual contributions. Agecroft Partners believes that this increased allocation to long duration fixed income will be funded primarily through a reduction in corporate pension funds allocation to shorter duration fixed income and long only equity managers. Some of the more sophisticated corporate plans might match the duration of their assets to liabilities through the derivative markets which will allow them to continue to manage the underlying portfolio on a total return basis.

Unfortunately, this duration matching strategy for US corporate pension funds will reduce the long term expected returns of their portfolios from the 7.5% to 8% range down to 5% to 6.5% which will significantly increase the expense of these plans. This increased expense will enhance the speed of corporations terminating or freezing their defined benefit plans and replacing them with 401k plans. The problem with 401k plans is that they typically do not provide a large enough lump sum distribution to provide for retirement. Additionally, the average retiree lacks the discipline to spend these assets over their expected life span. The end result may very well be that many individuals will run out of their retirement savings and rely on government program for their retirement needs. Another unfortunate aspect of this new legislation is that many corporations are locking in long duration fixed income portfolios while interest rates are at their lowest point in decades. If the massive government deficient creates inflation causing interest rates to spike these long duration portfolio could lose a significant percent of their value.

Public pension funds will not be affected by this legislation and will have no incentive to move away from the efficient frontier structure of investing. Given most state and local government’s shaky budgets and large unfunded liabilities they need to maximize their investment returns on their portfolios in order to reduce the financial burden on their constituencies. As a result of this we will see a significant divergence between the asset allocations of corporate and public pension funds. The current hedge fund allocation by US pension funds to hedge funds is approximately 3% of their portfolios which is up substantial from a decade ago when it stood at less then 1%. Public pension funds will steadily increase their allocation to alternative investments over the next decade, where hedge funds may represent as much as 20% of their portfolio while corporations will also increase their alternative portfolio, but at a slower rate due to their growing allocation to longer duration fixed income.

 
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