How have pension funds responded to economic changes wrought by historically low interest rates? And has their response been effective? Apparently not according to a trio of researchers from Maastricht University and Netspar. In their recent paper, “Pension Fund Asset Allocation In a Low Interest Rate Environment,” Dennis Bams, Peter Schotman, and Mukul Tyagi find that global pension funds (based on the CEM Database) have made substantial changes on the asset allocation front in response to low interest rates – but they’ve loaded up on fixed income and alternative investments. This move, argue the researchers, is inconsistent with literature on strategic asset allocation – it is also inconsistent with the finance literature of return predicability “which would suggest and increase in equity allocation and reduction in fixed income exposure.” As the authors explain:
“We find that pension funds are largely unable to time the market and miss out on benefiting from changes in the investment opportunity set. One of the possible reasons is that various constraints are binding on the pension funds and prevent them from investing as an efficient investor.”
Pension funds do, however, actively rebalance in order to “to neutralize the changes in actual portfolio reflecting changes in predictive variables.”
Canadian plan sponsors well know the constraints they face in dealing with tough market conditions – the need to balance long-term liabilities, low rates, demographics, regulatory requirements, and market changes. Arguably these are constraints most other investors don’t have to deal with.
But, as the authors note: “It would be a question for future research to test which specific short-term constraints on pension funds, for example regulations or short term liability hedging motives, contribute the most to under-performance of the pension funds and restrict them from exploiting the benefits from changes in the investment opportunities set.”
You can download the paper here.