Take Off the Rose-Colored Glasses

Robert C. Pozen

The financial crisis has reinforced and accelerated three main trends in asset
allocations by U.S. defined benefit plans. First, overall allocations to equities have
declined, although these plans have shifted to global from U.S. stocks. Second,
allocations to fixed income have increased, as plans have sought safety in U.S.
Treasuries and other highly rated bonds. Third, allocations have also risen for
alternative investments, which include hedge funds and private equity funds.

These three trends have significant implications, because corporate pension plans held $2.1 trillion in assets, and
state and local pension plans held another $2.7 trillion at the end of 2009.

The shift by both types of pension plans to global equities has improved their diversification of risk. However, the shift
to fixed income from equities by corporate pension plans will make it more difficult for them to achieve their return
objectives of 8% per year. The shift at this particular time also will expose them to considerable risk of rising interest
rates. Similarly, the shift to alternative investments from equities by public pension plans is not likely to fulfill their
objectives of higher returns with less risk. Despite their promises of positive returns in all market environments, most
alternative investments suffered large losses during the financial crisis.

Pension plans and other institutions in the U.S. have substantially reduced their overall allocation to equities. Between
2007 and 2009, for example, the equity allocation of U.S. institutions dropped to 47.3% from 59.6%. This trend away
from equities has been apparent even in regions like Asia that have historically low preferences for equities.

At the same time, the prevailing trend around the world has been a reduction in the holdings of domestic equities. In
the U.S., this shift began before the financial crisis and accelerated after the crisis. According to survey data,
institutional investors in the U.S. allocated nearly 47% of their assets to domestic equities in 2005, but only 32% in

Of course, these reduced equity allocations were partly the result of falling equity prices in 2008 through March of
2009. Nevertheless, it is reasonable to assume that executives at large pension plans, with considerable resources
and expertise at their disposal, would have rebalanced their portfolios to reflect their policy objectives at the end of
2009. In particular, the shift away from home-country bias in equities seemed to have been part of a deliberate asset
allocation decision.

This shift to global equities from U.S. equities has provided U.S. pension plans with the benefits of diversification over
the long term. Although the correlation among different geographical stock indexes converged toward 1 during the
financial crisis, it fell back soon after the equity markets hit bottom in March 2009. In addition to the benefit of
diversification, expanding the opportunity set to include global equities allows investors to take advantage of attractive
opportunities in other developed or emerging markets.

As corporate pension plans have shifted away from equities, they have substantially increased their allocations to
high-quality bonds after the financial crisis. Most of this increase was concentrated in U.S. Treasuries with maturities
of one to 10 years. In making this move to high-quality bonds, the trustees of corporate pensions were trying to “derisk”
their portfolios. In their view, more bonds would mean lower annual volatility for their portfolios, which would in
turn minimize future corporate contributions to the plans.

Yet this reduction in annual portfolio volatility comes with a price — lower long-term returns. The expected returns of
U.S. corporate pension plans now are around 8% per year. The average corporate pension plan was 82% funded in 2009, and that will reportedly fall to 75% by the end of 2010.

Like their corporate counterparts, public pension plans are facing large funding deficits. These plans were on average
about 80% funded in mid-2009, and at least eight state plans were less than 65% funded. Even these estimates are
overstated because of the unique accounting rules applicable to public pension plans. If public plans were subject to
standard pension accounting, their funding deficits would be 20% to 30% larger.

Up to now, public pension plans have been allowed to compute their deficits based on the returns they expect from
their portfolios, rather than relevant current interest rates. The Governmental Accounting Standards Board has
proposed that public plans begin to use current interest rates of high-quality municipal bonds. However, this proposal
would be confined to calculating cash flows needed to eliminate a plan’s current deficit. It would still allow expected
returns to be used for valuing existing plan assets.

Given these accounting rules, it is not surprising to see that public pension plans have set expected returns of 8% per
year for their investment portfolios. To achieve these returns, public pension plans have decreased their equity
allocations and instead allocated much more to alternative investments. In other words, public pension plans have not
“de-risked” their portfolios by replacing stocks with bonds. Instead, public plans have “up-risked” their portfolios by
replacing stocks with hedge funds and private equity funds.

Many public officials seem to believe that alternative investments will bring positive returns in all market environments.
In 2008, however, the average return for hedge funds was -19%, although some did well. Moreover, the evidence
shows that investors need to access a limited array of private equity funds in order to earn consistently top-quartile
returns. It is unclear whether public pension plans have the clout and expertise to access the funds that are the likely