After a speech the other day, I was asked, “Why are corporate pension plans still allocating to hedge funds?” This question was fascinating for two reasons: (i) it assumes they are still allocating and (ii) it forces one to think about why corporate pension plans find hedge funds to be an attractive investment.
As often is the case at PAAMCO, we first went to the data. While there are many statistics on state pension plan allocations to hedge funds (given the mandatory public disclosures), there seem to befar fewer readily available statistics on the activity of U.S. corporate pension plans. As it is earnings season, I realized that the recently released annual reports of public companies provides an apples-to-apples accounting-based insight into what corporate pension plans are doing.
Pulling the annual reports from the 25 companies with the largest corporate pension plans, we found the following:
- All of the top 10 corporate pension plans have an allocation to hedge funds (although one has recently rebucketed it as “other alternatives”). Only four of the top 25 plans have less than 2% of their assets in hedge funds.
- The median allocation averages 7% of the pension plan assets (slightly greater than the exposure to private equity or real estate) with the largest allocation being approximately 24% (a bank pension plan) and the smallest a few basis points.
- Most of the percentage allocations over the past several years have been relatively stable; however, on a total dollar invested basis, the amount allocated to hedge funds increased by 8% over the past year as overall plan assets increased in value. In fact, one quarter of the top 25 plans saw an increase of more than 15% in the dollar amount allocated to hedge funds.
In other words, hedge funds are a material component of the largest U.S. corporate pension plans along the same order of magnitude as their other alternative asset class allocations to private equity and real estate.
This then leads to the second part of the question, what is it about hedge funds that causes corporate pension plans to hold these allocations.
- Better Asset/Liability Management: Regardless of whether the pension plan is closed, corporations are shifting their focus from an asset-only investment-based strategy to an integrated asset/liability or “funding gap” driven approach. While investments such as private equity may compound at higher rates of return over long periods (given their substantial equity market risk compared to hedge funds), they also introduce more risk into the equation as their higher volatility increases the potential mismatch with a plan’s funded status.
- Eye on Rates: Almost every recent CIO-level conversation I have had has touched on the impact of the interest rate environment. While views for the 10 year Treasury outlook may differ, there has been an increasing trend of pension plans utilizing hedge funds as an alternative to traditional fixed income allocations.
- Rebalancing Discipline: Following the robust three year performance of equity and credit, particularly in the U.S., many pension portfolios have seen long-only allocations move above target weights. Disciplined rebalancing of portfolios bolstered by recent market beta moves has led to recent flows into hedge funds.
- Portfolio Integration: Hedge funds can provide exposure to a diverse set of risk factors and pension plans are increasingly customizing their hedge fund investments to meet specific portfolio-level needs. From decreasing interest rate sensitivity to focusing on quickly deploying capital to tactical opportunities, hedge funds can provide additional investment levers. The customizable nature of many portfolios of hedge funds allows one to adapt the overall risk exposures to the needs of a pension plan independent of the funded status or position on the glide path to full asset/liability matching. Due to their diverse nature, pension investment teams increasingly view hedge funds alongside the underlying securities they trade instead of bucketing hedge funds as a separate asset class. This allows for more representative risk versus return comparisons while also facilitating the sharing of insightful information across relevant investment themes.
While every pension plan has a unique situation (i.e., open, closed, funded status, percent retired), it is interesting to note that hedge funds remain a significant part of most large corporate plans. In conclusion, while the rapid growth in percent allocations seen over the past decade is slowing (as to be expected for a not-so-new asset class), the absolute investment size on a dollar basis continues to grow.
2014 Top 25 U.S. Corporate Pension Plan Median Allocations by Sector as Shown in Their Annual Reports*
Source: 2014 10-K and Form 20-F Annual Report Filings
* Included in this analysis is a U.S.-based company who was purchased by a European-based company in 2014. The top 25 corporate pension plan median allocations included here are limited to publicly available information (10-K and Form 20-F Annual Report Filings) and may not reflect the actual top 25 pension plans as measured by defined benefit AUM. The above sector allocations are categorized and presented by PAAMCO and do not necessarily reflect allocation categories as would be described by the individual pension plans. Allocations represent median normalized percentages.
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