Magazine article Government Finance Review

Asset Allocation Practices in the Public Sector: A Primer for Finance Officers

Magazine article Government Finance Review

Asset Allocation Practices in the Public Sector: A Primer for Finance Officers

Article excerpt

This article focuses on the key decision affecting the investment performance of public-sector pensions--asset allocation. It reviews some fundamental concepts, examines how pension plans arrive at their allocation decisions, and then examines the historical shift toward equities.

The investment of retirement assets is a complex business requiring individual and institutional investors to make a host of decisions to plan and execute an investment program. Despite the complexities, the ultimate success or failure rests to a surprising degree on just one decision: the asset allocation decision. This article examines the importance of the asset allocation decision, determinants of asset allocation choices, and the historical shift toward equities. In addition, it highlights how such decisions should be carried out, as documented in GFOA Recommended Practices.

For the purpose of this article, asset allocation is defined as both a decision and a process. It is the investor's decision to parcel out individually held (in a defined contribution retirement plan) or collectively held (in a defined benefit plan) assets to broad categories of investments, such as stocks or bonds. Typically, the decision is reached after either a simple or elaborate process of evaluation, depending upon the individual or organization making the decision. The process for organizations operating defined benefit plans is discussed in this article.

How Is an Asset Class Defined?

To actually select a specific asset allocation, investors may find it useful to ask the simple question, What is an asset class? The answer is not as straightforward as might be expected. The most familiar categories are stocks, bonds, and cash equivalents such as Treasury bills. However, some observers add an entirely new layer of asset classes such as real estate, timberlands, private equity, and others that are deemed "alternative asset classes," in a GFOA Recommended Practice. Moreover, the historical record shows that some "exuberant" investors have tended to invest in a narrow category such as technology stocks (1990s) or railroad bonds (1890s) as though it represented a distinct asset class.

Two criteria are important in distinguishing asset classes: function and performance. Functionally, equities are distinct from bonds in that the legal claim of the holder of an equity security is different from the claim that a holder of a fixed-income security has. This would come into play during a bankruptcy proceeding, for example, in which a bondholder would have priority claim to the assets of a defunct corporation in comparison to the stockholder. The stockholder would be a "residual" claimant.

The interests of a stockholder tend to align more closely with the managers of a corporation. Increases in the value of a corporation's stock would benefit both the investor and the corporate owners, all things being equal. In recent years, this alignment has, if anything grown stronger, as private-sector managers derive more income from stock options that become more valuable as the stock price increases. [1] In contrast, bondholders' interest may collide with the interests of the corporation or government that issues the bonds. For example, when prevailing interest rates fall, the bond issuer may be tempted to call the bonds, which is detrimental to the bondholder. (After the bonds have been called, the bondholder would have to reinvest the bond proceeds in a lower-yielding security.)

Many governments classify real estate as a distinct asset class. For example, many governments separate real estate in comprehensive annual financial reports. Functionally, real estate can be viewed as a hybrid of a stock and bond. [2] Like stocks, real estate represents an ownership position. Like bonds, the economic value can be predominantly in the form of a stream of payments (e.g., obtaining lease payments from owning a shopping mall). …

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