(January 9, 2013) – California’s $157.8 billion teachers’ pension fund may soon follow a growing trend among asset owners and kick the asset bucket in favor of risk-based allocation.
For the third board meeting in a row, the California State Teachers’ Retirement System (CalSTRS) discussed the pros and cons of a six-point (plus sub-sections) risk class framework. Neil Rue, a managing director at Pension Consulting Alliance (PCA), CalSTRS’ private equity consultancy, presented the model depicted above. It could be used alongside asset class buckets, according to meeting documents. However, if the committee preferred it to the traditional framework, PCA and staff could “deftly make the switch”—which PCA recommends they do.
“From a quantitative modeling perspective, the risk-class framework is a better solution for organizing your assets at the highest level," Rue said. "The arguments for risk classes is pretty strong here...We propose you move in that direction in a major way.”
At present, CalSTRS’ massive portfolio is 50.2% equity, 18.7% fixed income, and about 14% each real estate and private equity. Cash and overlay account for the remainder. PCA’s models show that risk-based allocation would boost CalSTRS’ returns while maintaining the current risk level, or could maintain returns while minimizing risk.
For instance, a risk-based allocation to minimize volatility would have a median 10-year return of about 6.9%, with an average standard deviation of 7.7%. An asset-based allocation for low volatility would return 6.6% with higher (8%) standard deviation, according to the models. Rue did caution the board members to take the figures in their projections with a grain of salt: "Quantitative modeling has a lot of assumptions--It's imperfect. Just because the number appears on a slide doesn't mean it will play out perfectly."
Overall, a risk framework “provides favorable return-risk tradeoffs” compared to asset classes, according to the results of PCA’s quantitative analysis. Just a handful of very large institutional funds have made the switch, including ATP, Alaska Permanent, and the New Zealand Superannuation Fund. Still, the idea is gaining significant traction among industry players.
"Having a mismatch between our assets and our liabilities was just crazy...Asset classes are effectively dead," one CIO of a mid-sized corporate pension commented during aiCIO’s recent Influential Investor Forum.
A fixed-income investment adviser agreed: "An asset-only world doesn't work."
CalSTRS' Chief Investment Officer Chris Ailman urged a cautious approach, however. "I think this is yielding valuable perspectives," he said, following PCA's presentation. Despite the potential extra costs, Ailman recommended using both frameworks in parallel for a period of time before deciding to make the transition. "I hate to toss out something we've used for twenty years."