Pension Funds Would Be Well-Advised to Reduce Risk
Municipal pension plans are in a tough spot. They have trillions of dollars in unfunded liabilities, interest rates are low, and we’re coming up on the ninth consecutive year of stock market gains in the U.S. Municipalities are going to have a hard time balancing their need to take risk against their reluctance to do so in this environment.
The largest U.S. pension fund is considering making a change by reducing equity risk in its portfolio. The California Public Employees’ Retirement System, or Calpers, is in discussions to slash its stock market allocation and more than double bond holdings to 44 percent of assets, a huge change from the current policy. Here are the current allocation targets, according to the Calpers investment policy:
Calpers said it reviews these types of asset allocation changes every four years and hasn’t made any concrete decisions yet. If it chooses to reduce risk in this fashion it may be making a wise decision, even though institutional investors don’t have a history of timing the markets very well.
A study by Andrew Ang, Amit Goyal and Antii Ilmanen looked at the asset allocation habits of almost 600 large pension plans, with an average fund size of $10 billion, from 1990 to 2011. The authors discovered that these funds allowed equity allocations to drift much higher when markets were rising substantially in the dot-com bubble of the late 1990s, leaving the funds overweight to their target allocation policies. So when the market crashed they were overexposed to stocks based on their targeted asset mix. And after the financial crisis in 2008 and early-2009, these funds became underweight stocks because of the crash. The problem is they never rebalanced out of bonds and into stocks, so they kept a low equity exposure and missed the recovery. To stay within their stated policies, these funds should have been trimming stocks in the 1990s and buying during the crisis, but instead they simply allowed market forces to take over, missing an opportunity to both profit and manage risk.
Another study reviewed over 80,000 annual observations of institutional investment accounts from 1984 to 2007 to determine whether their decisions added value. These funds collectively managed trillions of dollars in assets. The study looked at the buy and sell decisions among stocks, bonds and externally hired investment managers. The researchers found that the investments that were sold far outperformed the investments that were purchased. In fact, the authors of the study figured that these poorly timed investment decisions caused this group of investors to lose out on more than $170 billion.
Whatever Calpers decides to do, a focus on asset allocation makes sense ,since that is likely the most important decision you can make at a portfolio level. Many institutional investors focus much of their time and energy on picking the best money managers 1 when asset allocation has a greater impact on their overall performance.
Investors of all shapes and sizes are probably dealing with similar anxiety about making a huge shift to their allocations because of the current market environment. While there are no right or wrong answers because everyone’s risk profile and time horizon will vary, here are some considerations for those thinking through a change in their asset mix between stocks, bonds, cash or alternative investments:
- What is your plan after you sell? Selling out of stocks is the easy part. Having a plan of attack for what to do if your timing is off is the challenge. This is especially true if stocks continue to rise. Do you sell more? Do you do this type of move in pieces? How will you react if you’re wrong? And what if you’re right? When do you get back in?
- If you were starting from scratch in all cash, would your portfolio look the same? Hitting the refresh button can be a helpful exercise to evaluate current holdings and think through a potential change to your portfolio. It’s easy to become attached to your investments so it pays to remain unemotional and unbiased about your holdings.
- What will you regret more: making a change and being wrong, or sticking with your current holdings and missing out on other investment opportunities? Regret often causes people to react in irrational ways, so figuring out how to minimize that emotion can help. One of the best ways to do this when making a portfolio change is to avoid extremes and do it in steps. Selling out or buying into a position over a number of months makes it easier to take psychologically in the event the move immediately goes against you. And if your timing is perfect, then at least you benefit with a piece of your portfolio.
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