US public and private pension funds adopt opposite strategies

US defined-benefit (DB) plans suffered losses in their asset value of 19% from 2008 to 2009 before the recovery began around March last year. The drop in total value from $7.2 trillion to $5.9 trillion led both corporate and public funds to react -- but in very different ways, according to survey findings* released yesterday by US-based Greenwich Associates.

Both private and public funds are continuing a longer-term trend of shifting money out of US equities; US institutions' allocation to domestic stocks fell to 32.2% of total assets last year from 37.6% in 2008. However, they are adopting nearly opposite strategies when deciding where to put the freed-up cash.

Fearful of the eventual implementation of mark-to-market accounting rules that will transfer the full impact of pension investment volatility to corporate balance sheets, companies are cutting risk levels in their DB portfolios. They have reduced allocations to US equities to an average 33.8% of total corporate assets last year from 40.7% in 2008, and this percentage is expected to fall further in coming years.

Meanwhile, 20% of corporate funds plan to significantly increase their fixed-income allocation -- which makes up 36% of total assets among such plans -- while only 6% intend to make significant reductions. They are also looking, to a lesser extent, at shifting money into alternative investments.

Free from the accounting concerns of corporate plans, 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.

Some 20% of public pension funds plan significant increases to international equity allocations, and 18% plan to significantly increase hedge-fund allocations by 2012. These proportions far outweigh the much smaller share of public funds planning to reduce these allocations. A substantial 23% of public funds say they intend to significantly boost private-equity allocations between now and 2012.

Moreover, 17% of public funds plan on significantly reducing fixed-income allocations over the next two to three years, with only about 9% planning increases.

"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."

Public funds seem to be banking on the shift in investment strategy to shore-up solvency ratios by generating returns that far outpace the market, says Greenwich. Municipal pension funds last year said they expect their investment portfolios to beat relevant benchmarks by 160 basis points -- up from a 132bp expectation in 2008. Public funds with assets of $500 million or less increased their stated expected outperformance to 180bp in 2009 from 135bp 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."

* From July to October last year, Greenwich Associates conducted interviews with fund professionals at 520 corporate funds, 234 public funds and 232 endowments and foundations in the US.