Saturday, February 05, 2005

What's a prudent asset allocation?

The prudence of a pension plan's investment decisions including it's asset allocation will be judged based on the "facts and circumstances then prevailing". For a defined benefit plan asset allocation the 3 general categories of facts and circumstances you should evaluate are:
1) the Plan's specific liabilities and cashflow characteristics,
2) long term risk/return outlook for and the interaction of investment asset classes,
3) what constitutes prudent practice within the industry.

One of the easiest ways to benchmark prudent practice is to review what other plan sponsors are doing with their pension asset allocations. Every year in late January Pensions & Investments publishes their Annual Plan survey. This is the 31st annual survey and it reports on the asset mixes of the top 200 and top 1000 (by plan asset size) Defined Benefit and Defined Contribution pension plans that respond to the P&I questionnaire.

The top 1000 DB plans had an aggregate asset mix for 2004 as follows:
  • Domestic equity 46%
  • Domestic fixed income 26%
  • Int'l Equity 16%
  • Intl fixed income 2%
  • Cash 1%
  • Private equity 3.5%
  • Real Estate equity 3.5%
  • Other 2%

Now, this is an aggregate 70% equity portfolio which is obviously not suitable for all plans. Your unique liabilities/cash flow needs and financial and risk appetites should determine your appropriate mix between risky and non-risky assets. What is universally relevant is the fact that these larger plans are aggressively utilizing risky assets, providing some perspective that larger more sophisticated plan sponsors continue to expect an equity premium. The asset mixes can also provide valuable guidance as to what the "industry" believes is prudent and optimal diversification by asset class. For instance, Int'l equity is 23% of total equity. Alternative investments (private equity/real estate) are about 10% of equity assets. Cash should have a minimal allocation in a long term oriented portfolio. Other trends identified in the survey:

  • Enhanced indexing is growing faster than indexing
  • Real estate allocations lost 6% when market value adjusted (plans are taking advantage of high prices)
  • International equity lost 1% when adjusted for market gains
  • Hedge fund growth was high in 2004 though it was slower than in 2003

There is other good material in the survey that can be used to identify investing trends and benchmark your portfolio.


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