A practical look at institutional investors exposure to different asset classes

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1 A practical look at institutional investors exposure to different asset classes Vanguard research October 21 Executive summary. This analysis steps away from the theoretical aspects of asset allocation to provide a snapshot of how actual Vanguard institutional clients and prospects are allocating their assets. We find that in general the plans we observed adhered to a traditional 6%/4% equity/fixed income allocation. We also find that these plans had only limited exposure to alternative investments. Author Liqian Ren, Ph.D. Connect with Vanguard > vanguard.com > global.vanguard.com (non-u.s. investors)

2 Our analysis looks at 187 individual studies made between January 27 and June 21 at the request of Vanguard institutional clients and prospects, who provided extensive data about their portfolios. Eightyfour of the studies were performed for defined benefit plans, and the rest for nonprofit entities. For our asset allocation analysis, we decided to examine these types of investors separately in recognition of their different goals and regulatory regimes. This distinction allows us to highlight some of the variables involved in the asset allocation decision. The defined benefit (DB) plans we analyzed included traditional pension plans, certain corporate asset accounts, cash balance plans, money purchase pension plans, and annuities. The nonprofits included traditional endowments and foundations (E&Fs), contingency reserve accounts, and voluntary employees beneficiary association (VEBA) portfolios, along with certain other portfolios appropriately studied as E&Fs. We began our analysis by looking at the ownership of four major asset classes. As might be expected, equity assets (both domestic and international) and fixed income assets were widely owned across both DB plans and nonprofits (Figure 1). In fact, all of the DB plans we surveyed held both asset types, as did the great majority of nonprofits. When we examined the ownership of cash and alternative investments, however, the differences between the two types of investors were distinct. The percentage of nonprofits that held cash or alternatives was more than twice that of DB plans. Figure 1. 1% Asset-class ownership of institutional nonprofits and defined benefit plans Based on 187 studies of individual plans in the period January 27 June 21 Percentage of portfolios that owned asset class 1% 93% Nonprofits 1% 92% DB plans 18% 7% 29% 14% Note: includes U.S. stocks, international stocks, and REITs. includes non-treasury bonds as well as Treasury Inflation-Protected Securities, extended-duration Treasury bonds, and other Treasury securities. include commodities, hedge funds, and market-neutral funds. The plans include actual Vanguard clients and prospects. Source: Vanguard. All investments are subject to risk. Investments in bonds are subject to interest rate, credit, and inflation risk. Although U.S. Treasury or government agency securities provide substantial protection against credit risk, they do not protect investors against price changes due to changing interest rates. Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index. 2

3 Figure Average asset allocations for nonprofits and defined benefit plans 2a. Nonprofits: Vanguard data compared with NACUBO survey data 8% 2b. DB plans: Vanguard data compared with Bfinance survey data 8% Allocation percentage % 46% 33% 21% 25% Allocation percentage % 44% 34% 37% 16% 1 2% 5% 8% 1 1% 1% 3% Vanguard data NACUBO data Vanguard data Bfinance data Note: In Vanguard data, the averages are equal-weighted. The standard deviation is 22% for equity and 19% for fixed income. Sources: Vanguard and NACUBO. Note: In Vanguard data, the averages are equal-weighted. The standard deviation is 12% for both equity and fixed income. Sources: Vanguard and Bfinance. Decisions about whether to hold certain asset classes and in what proportion are often governed by a plan s investment policy statement. Although many DB plans have restrictions on owning alternative investments, such as commodities, hedge funds, or market-neutral funds, a growing number of public pension plans have increased their allocation to alternatives in recent years. In its biannual global pension fund survey, conducted in May 21, Bfinance found that the pension plans surveyed allocated 16% to alternatives on average. The U.S. Government Accountability Office (GAO) has expressed concern about this rising trend because some alternatives, such as private equity and hedge funds, lack transparency and have low liquidity. Still, in the plans the GAO studied, private equity and hedge funds represented less than 4.7% of assets overall. We found that our plans allocated 1% to alternatives on average a figure resulting in part from the fact that, as Figure 1 shows, most of them held no alternatives at all. This relatively small percentage may indicate uncertainty among plan sponsors about the merits of alternative investments. Indeed, recent Vanguard research found that, on average, hedge funds as a category did not contribute either diversification or performance benefits above those of a long-only balanced index fund in recent years (Bhardwaj, 21). 3

4 Figure 3. Trends in the funded status of DB plans Average Standard Time periods of Number of funding deviation of U.S. stock Vanguard studies studies ratio funding ratio market returns January June % 1% 8% July December % 4% 2% January June % 11% 11% July December % 12% 29% January June % 16% 4% July December % 14% 23% January June % 21% 6% Source: Vanguard. Market returns are based on the MSCI US Broad Market Index. As we show in Figures 2a and 2b, the average asset allocations of the portfolios we analyzed were in line with a traditional 6%/4% split between equity and fixed income. The average equity allocations were 6% for nonprofits and 64% for DB plans; the average fixed income allocations were 33% for nonprofits and 34% for DB plans. The nonprofits displayed wider dispersion around the averages, a finding that may be explained by differences in their objectives, investment policies, and views toward risk. We then further dissected DB plans by looking at their funding ratios. Figure 3 is a snapshot of the average funding ratios over our study period from January 27 through June 21. The average ratio reached a low point in 29, in the wake of the financial crisis. Although the markets have moved upward since then, many plans remain underfunded. In Figure 4, we examine the plans funding ratios in more detail. Of the 84 DB plans in our analysis, 79% were underfunded at the time they provided data. Approximately 45% were severely underfunded as defined by the Pension Protection Act (Ehrhardt, 29). The PPA currently requires plans to be at 96% funding status; the requirement will rise to 1% in 211 (Vanguard, 29). Sponsors of underfunded plans sometimes increase their allocation to riskier assets in hope of making up the shortfall; however, we did not observe this tendency in the plans we analyzed, perhaps because our sample was limited and the data in each study represented only a snapshot in time. As Figure 5 shows, even the most underfunded plans maintained an average fixed income allocation of 34%. Fully funded or overfunded plans also maintained sizable equity allocations, as illustrated in Figure 5. Vanguard suggests that once a plan is fully funded, the sponsor should consider decreasing the equity allocation and investing more in long bonds a liability-driven investing (LDI) approach (Stockton, 28). The data provided by our plans imply, however, that the total-return approach to pension investing is still quite prevalent. In summary, we find that the portfolios we analyzed are in line with Vanguard s core investment philosophy of having a broadly balanced, diversified portfolio. In this regard, the DB plans and nonprofits 4

5 Figure 4. 2a. 1. Percentages of DB plans at various funding levels Based on 84 individual studies conducted in the period January 27 June 21 Percentage of plans 5% % 25.% 8.3% 21.4% Figure 5. 2a. 1. Asset allocation of DB plans at various funding levels Based on 84 individual studies conducted in the period January 27 June 21 Allocation percentage 1% % 65% 1% 4% 6% 33% 64% 3% 2% 1% 31% 66% 84% and below 85% 91% Funding ratio 92% 99% 1% and above 84% and below 85% 91% 92% 99% 1% and above Note: The percentages are based on the funding ratios that existed at the time each client requested a study. We did not track changes in funding ratios over time. Source: Vanguard. Funding ratio Note: The percentages are based on the funding ratios and allocations that existed at the time each client requested a study. We did not track changes in either ratios or allocations over time. Source: Vanguard. we studied stand in contrast to some public pension funds and to the findings of a NACUBO survey, which indicated that many plans were increasing the percentage of assets allocated to riskier investments, such as alternatives. Vanguard believes that a well-designed asset allocation strategy, followed consistently and regularly reviewed, can reduce risks and costs in the long term. As part of such a strategy, it is important that a plan s or nonprofit s investment policy statement include clear triggers for asset allocation changes, so that shifts are not made in reaction to short-term market movements. For pension plans, one way to achieve this is by using a dynamic investment policy statement, or Dynamic IPS. Based on a concept developed by Vanguard, the Dynamic IPS establishes the funding ratio as a key driver of portfolio design and helps the plan s investment committee manage shifts in the asset allocation. By providing a structure that recommends portfolio adjustments when certain funding levels are reached, a Dynamic IPS can help investment committees respond more quickly and productively to market developments when they arise. See the Vanguard paper Pensions Dynamic IPS: A Plan for Action (Bosse, 21) for more information. 5

6 References Bfinance, 21. Bfinance Bi-annual Pension Fund Survey: Investors Move Down the Liquidity Scale Investing in Riskier Assets. Available at bfinance. co.uk/content/view/12718/1244/. Bhardwaj, Geetesh, 21. Alternative Investments Versus Indexing: An Evaluation of Hedge Fund Performance. Valley Forge, Pa.: The Vanguard Group Bosse, Paul M., 21. Pensions Dynamic IPS: A Plan for Action. Valley Forge, Pa.: The Vanguard Group. Ehrhardt, John W., and John Pirone, 29. Funded Status of Corporate Pension Funds. Webcast. New York: Pensions & Investments. NACUBO (National Association of College and University Business Officers). 29 NACUBO Commonfund Study of Endowments. Available for purchase at Endowment_Study.html. Stockton, Kim, 28. How a Pension Plan s Funding Level Should Influence Its Investment Strategy. Valley Forge, Pa.: The Vanguard Group. U.S. Government Accountability Office, 28. Defined Benefit Pension Plans: Guidance Needed to Better Inform Plans of the Challenges and Risks of Investing in Hedge Funds and Private. Available at gao.gov/new.items/d8692.pdf. Vanguard, 29. Summary of Key Provisions of the Worker, Retiree, and Employer Recovery Act of 28. Regulatory Brief. Valley Forge, Pa.: The Vanguard Group. Acknowledgement: The author would like to thank Natasha Towles for her contribution to this research. 6

7 P.O. Box 26 Valley Forge, PA Connect with Vanguard > vanguard.com > global.vanguard.com (non-u.s. investors) Vanguard research > Vanguard Center for Retirement Research Vanguard Investment Counseling & Research Vanguard Investment Strategy Group > 21 The Vanguard Group, Inc. All rights reserved. ICRII 121