The bad arithmetic for pensions

If the expected rate or return or discount rate for a pension fund is 8%, you should ask what you need from equities to hit the target if you hold a 60/40 stock/bond mix and the current 10-year yield is 2.75 percent. 

The math is simple. For this year, you will need 11.5 percent from your equity portfolio. This does not seem like pleasant math. It only gets worse if the pension is underfunded and needs higher returns than  the expected rate of return.

 If equity returns decrease, there has to be a gain from the bond portfolio with rates going down. The worst case scenario is a decline in both equities and bonds which could come if we transition to higher inflation or we do not get the bond hedge from a negative correlation between the two major asset classes.

Many pensions understand this unpleasant math, so they have tried to adjust their portfolios to offset the poor value-added from the the bond allocation of their portfolio. The objective of moving to alternative investments is to counter the poor bond returns. This is the big pension bet that has caused all of the new flows.  In this context, the alternative portfolio has to beat the current bond yield of 2.75 at similar volatility. This actually may not be hard to beat for many alternatives; however, you have to include the value of negative correlation from bonds. The hedging value of bonds was significant during the market downturn. Consequently, there is needed a higher return on the alternative portfolio given the hedge value is not as strong. 

This story also assumes that the alternative allocation addition is coming from bonds. If the allocation is also coming from equities, the alternative returns have to be higher to offset the expected higher returns from equities. In a perfect world, if the alternatives gave a expected return close to the expected overall rate of return, it would be a preferred asset. But, producing an 8 percent expected return is pushing the envelope for many hedge fund strategies.

We are still in an unpleasant pension math world even when we have alternatives added to the portfolio.