When examining investment strategies for public pension plans, a driving factor for establishing investment policy is meeting the plan’s actuarial expected return on assets assumption as efficiently as possible. While this is an important long-term goal, funding short-term payments should also be a key focus, especially if there is a material allocation to illiquid assets.
The challenge is simultaneously addressing both goals. In setting asset allocation, we not only attempt to maximize return, but also to maximize the likelihood of making the next 10 years of payments. More practically, we also examine the likelihood of making the next 10 years of payments solely with the liquid assets available.
Below we compare a typical asset allocation1 for a public pension plan to a proposed, custom allocation. We group the portfolio asset allocation into five categories, each with a different role in achieving success. By effectively using these levers, we are able to develop a proposed allocation that increases the likelihood of successfully funding 10 years of costs with liquid assets from 90% to 95% while also improving expected return.
Table: Public pensions: Tomorrow’s costs, today’s liquidity needs
*Private Equity, Private Debt, Real Estate, and ½ of Infrastructure IMPORTANT: The projections or other information generated for the above analysis regarding the likelihood of various investment outcomes utilize Monte Carlo simulations. These outcomes are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results. No projection or forecast can offer a precise estimate of future returns or volatility in global asset classes or markets. Forecasts are inherently uncertain, subject to change at any time based on a variety of factors and can be inaccurate.
In addition, we measure how this probability might change during an economic downturn. The proposed allocation improves the likelihood of funding 10 years of costs after experiencing a 20% loss of assets from 55% to 70%. In today’s higher-risk environment, this may be a key measure to consider.
The immediate wake of an extreme economic event may be an inopportune time to sell equities in order to fund cash flows, and illiquid assets are likely not a potential source of funding. Therefore, we believe an effective portfolio should address short-term liquidity needs through:
- Cash-flow-matched fixed income to support near-term cash flows
- Liquid alternative assets, which seek to protect against a downturn through diversification, maintain participation in a strong market and provide liquidity in case of emergency
We believe outcomes are optimized if the decision-making process focuses on customized measures of success and risk. For public plans, this typically means seeking long-term return while also maximizing the likelihood of meeting immediate cash needs. In this example, we were able to develop a portfolio that simultaneously improved the likelihood of achieving both long- and short-term goals.