Asset Allocation Like The Pension Funds

The Real Estate Espresso Podcast

Asset Allocation Like The Pension Funds

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Asset Allocation Like The Pension Funds

Welcome to the Real Estate Espresso Podcast, your morning shot of what’s new in the world of real estate investing. I’m your host, Victor Menasce. On today’s show, we’re talking about how pension funds manage asset allocation. But first, at my development company, Y Street Capital, we have a number of development projects in the storage and light industrial arena. Our storage fund is a great way to gain exposure to a breadth of projects in the storage space that touch on several segments, including retail storage, industrial storage and boat and RV storage.

As of today, these assets are geographically diversified across three states, with more being added all the time. To find out more, visit whystreetcapital.com and register for our investor portal. Now this is not a solicitation; any investment would be by prospectus only for accredited investors residing in the US, in compliance with US SEC regulations.

On today’s show, we’re talking about how pension funds manage asset allocation, and whether individual investors can learn anything from mirroring what professional money managers do. Pension funds are the bedrock of retirement security for millions of people worldwide. Their primary mission is to ensure that future liabilities – those pension payments – can in fact be met. Achieving the balance between growth and stability hinges critically on asset allocation decisions. These aren’t simple choices, they involve complex financial modeling and a deep understanding of the market with a keen eye on long-term obligations.

Market volatility in each sector means that diversification is key to risk mitigation. Now, unlike individual investors who may prioritize wealth maximization, pension funds operate under a fiduciary duty to pay out defined benefits, often for decades to come. This long-term view allows for investments in less liquid, higher returning assets, but also exposes the fund to prolonged periods of market volatility.

Whether we’re talking about a defined benefit or a defined contribution pension plan, the principles are the same, even if the details differ slightly. Pension funds typically have a long investment horizon, often spanning 30-50 years or more. This allows them to stomach short-term market fluctuations and pursue illiquid, higher return strategies that might not necessarily be suitable for individual investors with a shorter time frame.

One critical element is the funded status – the ratio of assets to liabilities. A well-funded plan may have more leeway to take on risk, whereas an underfunded plan might need to prioritize higher returns to close the gap, potentially leading to a more aggressive asset allocation or perhaps increased contributions in order to preserve cash. When interest rates hit near-record lows for nearly a decade, we saw some pension plans make more aggressive investments in search of higher yield.

Professional money managers do not discount the possibility of a market downturn; it is expected. Part of their role involves assessing the potential impact of market downturns on the plan’s ability to meet its obligations, both in the short term and in the long term. Pension liabilities are sensitive to changes in interest rates and inflation. Therefore, an allocation strategy must consider how different asset classes perform under various scenarios to hedge against these risks. For example, long duration bonds are often used to match interest rate sensitivity for some long-term liabilities.

When investing, we’re not solely focused on placing money into new investments. There needs to be a pathway for money to go in and for money to come out. After all, investing needs to be forward-thinking. Pension fund managers use asset liability studies to discern what they can invest in for the long term, when money needs to be withdrawn, and so on, in order to make appropriate risk decisions.

Based on these considerations, they assemble their bedrock portfolio, defining the target percentages for different asset classes. These can include public equities, fixed income, private equity, real estate, infrastructure, cash, and so forth. This allocation is designed to achieve the fund’s objectives over the long term and is reviewed and adjusted periodically as market conditions, regulations, and liability profiles change.

A core principle of asset allocation is diversification both across and within asset classes. This means investing in a broad range of assets – domestically and internationally, including government and corporate bonds, private equity, real estate, infrastructure and so on. The aim is to minimize the impact of single asset class performing poorly.

When observing pension funds, it’s noticeable that they have a large percentage allocated to what they label as ‘alternative investments’. These increasingly include private equity, real estate, infrastructure, and hedge funds. These segments offer diversification benefits and potentially higher returns, plus a hedge against inflation. However, they are often less liquid and usually come with higher fees.

To understand better, let’s consider a few of the large pension funds out there. To start with, we have CalPERS – the California Public Employees Retirement System. As of June 30 last year, CalPERS had a policy target asset allocation with 40% in public equities, 29% in fixed income, 15% in private equity, 15% in real assets and 3.5% in private debt. Worth noting is the fact that CalPERS has been aggressively reshaping its private equity exposure and is on track to increase its total private asset allocation to 40% of its plan assets;—with private equity specifically increasing to a target of 17% and private debt to 8%.

Moving on to the Washington State Investment Board: as of March 31 this year, it had 26.35% in public equity, 29% in private equity, 19% in real estate, 17% in fixed income, 7% in tangible assets (such as commodities), 1% in innovation portfolio and almost zero in cash.

Lastly, the California State Teachers Retirement System has 38% in public equities, 14% in private equity, 15% in real estate, 7% in something labelled ‘inflation sensitive’ (details not provided), 10% in risk mitigation strategies, 14% in fixed income, and only 2% in cash.

So, the question posed to each of us, as investors, is this: what is our ideal asset allocation? Do you have an asset allocation you consider ideal for you? Have you consciously thought about it, and does it guide your investment decisions? If your portfolio is out of balance, how would you adjust it and over what timeframe? As you ponder these questions, have an awesome rest of your day. Go make great things happen, and we’ll chat again tomorrow.