ANALYSIS

Behind CalPERS’ alternative asset allocation decision

A desire to hedge the portfolio against extreme market risks and rising inflation, has resulted in the $220 billion CalPERS departing from its traditional asset allocation after a year-long review, and introducing the allocation of assets according to five broad groups.

The alternative asset classification introduces the concept of two hedging portfolios to protect against extreme market risks (liquidity), and rising inflation; and allocates according to how those assets function in high or low-growth markets, and the prevailing inflation environment.

The groups and the target allocations, and ranges, are in the table below.

CalPERS alternative asset asset classification 2010

AAC Consists of Purpose Proposed target % New range (plus, minus) Current range(plus, minus)
Growth Public equity, private equity Positive exposure to economic growth – equity risk premium 63 7 7
Income fixed income Provide income return 16 5 5
Real real estate, infrastructure, forestland Provide long horizon income reutrn that is less sensitive to inflation risk 13 5 5
Inflation Commodiites, inflation-linked bonds Public market investments with positive inflation exposure 4 3 2 to 5
Liquidity Cash, nominalgovernment bonds Hedge equity and deflation risks provide liqudiity 4 3 0 to 5

The process to reach the alternative asset class decision was lengthy and complicated, but staff believes the new structure provides a combination of return-seeking and hedging portfolios that will allow for better risk management and capital allocation. There may be some transaction costs assocated with the revised policy portfolio.

At the November asset liability management workshop staff presented eight viable asset mixes with expected returns that ranged from 6 to 7.49 per cent. From the most conservative bond-centric A1 to the equity-dominant A8, each target was expected to be the least risky for its target return. The existing policy portfolio for the fund is most similar to A7.

A decision factor scoring framework was used to assist the investment committee in determining the level of risk tolerance. The final average decision factor scores assigned by the committee, in the table below, varied from those determinied in 2007.

2010 2007
Improve funding level 40% 35.7%
Avoide deterioration in funding level 10 14.6
Minimise employer contribution rates 37 25.5
Stabilise employer contribution rates 13 24.2

The committee then instructed staff to adjust the alternative portfolios 8 and 7 by lowering the liquidity (treasury) allocation from 4 to 2 to 1 per cent and increasing the infrastructure and forestland (real) allocation from 3 to 5 per cent.

The analysis revealed that portfolios 8 and 7 were not very different in terms of expected funded ratios (71 per cent versus 69 per cent) and contribution rates at the end of 10 years (both 24 per cent).

Both portfolios had an expected funded ratio of 53 per cent, lower than the current 65 per cent, in the low growth case where expected returns were lower. Achieving funding progress in the current diminished expected return environment was seen as difficult as liabilities steadily increase, and the downside risk to funded ratio was also significant, so staff recommended selecting the lower risk portfolio (A7), as per the table above.

Chief investment officer of CalPERS, Joe Dear, said: “You can’t get solid returns without taking risk, but we want to make sure we know what that risk is and that we’ll be paid to take it. We have applied the best thinking and our best judgment to the challenging questions about how to uphold the promises we made to our beneficiaries to make their retirement secure.”

All staff had some input into the asset allocation review, which was led in part by Farouki Majeed, together with consultants Wilshire and Pension Consulting Alliance.

The fund’s next step is adoption of its actuaries’ recommendation for an assumed rate of return on investments, which is sechduled for early 2011.

CalPERS historical asset allocation policies

Classifcation 1993 1995 1997 2000 2002 2004 2008 2009
Cash 2% 2% 1% 0% 0% 0% 0% 2%
Fixed income domestic 37 24 24 24
international 4 4 4 4 global 26 26 19 22
Total fixed income 41 28 28 28 26 26 19 22
Equities domestic 33 38 41 39 39 40
international 12 20 20 19 19 20 global 56 49
AIM 4 5 4 6 7 6 10 14
Total equities 49 63 65 64 65 66 10 10
Real estate 8 7 6 8 9 8 10 10
Inflation-linked assets 5 5
Total 100 100 100 100 100 100 100 100
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