The strategic evaluation & use of alternative investments in defined benefit pension plans

Alternative investments have become a more prevalent aspect of multi-asset investing. Moreover, defined benefit (DB) plan sponsors are increasingly using alternatives to help address some of the key challenges they face in managing a pension plan such as funding benefits, reducing volatility of funded status and diversifying overall risk at the total portfolio level.

However, alternatives are not a one-size-fits-all solution. An effective alternatives strategy will depend on many factors such as funded status, liability profile, liquidity needs, risk/return objectives and investment beliefs.

Given such considerations, our intent in this blog post is to:

Highlight the available opportunity set across alternative investment strategies, their fundamental characteristics and their potential role in the context of DB pension plans.
Describe how alternatives can be used to address the challenges and issues plan sponsors face in their quest to deliver on the pension promise.
Provide examples of how different alternative investment allocations impact key metrics associated with pension plan management.¹

Understanding the spectrum of alternative investments

PRIVATE CAPITAL

Private capital (which includes private equity, private debt and private real assets) is a broad descriptor of investments in either the equity or debt of privately held companies.

Across the private equity universe, different categories are represented by companies at various stages of their lifecycle and include venture capital, growth equity, buyouts and distressed. Within private credit, there is also a broad range of investable opportunities across corporate (cash flows from operating businesses) and asset-backed (cash flows from physical assets such as real estate).

Investors participate in private capital investments via closed-end vehicles that typically have lifespans in the order of 10 years, in the case of private equity, or five to eight years, in the case of private debt. That said, it's important to understand that given the cash flow pattern of private markets funds, investors do not have to wait until the end of the fund's life to receive money back as distributions will naturally occur as underlying investments are realized (i.e., when a portfolio company is sold, or a loan is paid off).

The strategic case for including private capital in a DB pension plan portfolio includes the opportunity to generate returns that are superior to those in the public markets and to reduce overall portfolio volatility. For example, over the trailing 20-year period to Sept. 30, 2020, private equity outperformed the S&P 500 index by 350 basis points.²

HEDGE FUNDS

Hedge funds are a diverse category of investment strategies (such as equity hedge, event-driven, relative value and tactical trading) where the investment returns are expected to be created by the skill and expertise of the manager. Importantly, hedge funds utilize a broader array of investment techniques relative to traditional equity and fixed income managers such as short selling, leverage and actively managing market risk through hedging.

Liquidity terms for hedge fund investment vehicles vary depending on the underlying strategy. For more liquid strategies such as equity hedge, redemptions may be permitted on a quarterly basis with 30 days' notice while more illiquid strategies, such as event-driven, may offer annual liquidity with 90 days' notice.

Given that equity beta is the dominant risk factor in a return-seeking portfolio, hedge funds in aggregate offer several benefits. This includes generating returns that are independent of (or at least have a lower correlation with) the general direction of markets. By having the ability to deliver absolute returns through time, while preserving capital when markets are experiencing selloffs, hedge funds are an important tool to consider to reduce funded status volatility.

PRIVATE REAL ESTATE

Core private real estate can be characterized by high quality assets located in urban areas that are leased to credit-worthy tenants. Property types include industrial, office, apartments, retail, self-storage, single family homes and senior housing.

There are two main components which underpin commercial real estate returns. The first component is the stable, bond-like income yield that comes from rents based on contractual property leases, which accounts for approximately 70%-80% of the total expected return. The second is a capital appreciation component that is linked to growth in cash flows and an increase in property values.

Core private real estate funds typically offer quarterly liquidity.

Over its history and relative to other asset classes, real estate has provided strong risk-adjusted returns. Over the long term, core private real estate is expected to generate a return between that of public equities and bonds. There are several reasons to include core private real estate in a DB plan, including: low volatility relative to return-seeking asset classes, risk diversification and income generation.

Challenges and issues

In practice, plan sponsors are faced with multiple challenges and issues in delivering on the pension promise—i.e., providing benefits to participants. These include:

Growth

Ultimately, benefit payments need to be funded by contributions or investment returns. Absent the former, pension plans need to generate the required growth in assets to fund the economic value of all benefits that will ever be earned by current (and future) participants. Each year, liabilities are expected to increase due to falling interest rates, while assets flow out of the plan to pay benefit payments, reducing the size of assets that can generate return. With the exception of frozen plans, new benefit accruals also add to liabilities each year. And for underfunded plans, additional returns will be required to reduce the funding deficit. Other DB-related factors may compound the need for additional returns, such as paying plan expenses and service providers out of plan assets. Underfunded plans also need to pay additional premiums to the PBGC.³

Avoidance of negative outcomes

The risk decomposition of typical DB plans shows us that liability-relative interest rate risk, and the volatility of public equity exposures, dominate. As a result, aside from an effective liability-driven investing (LDI) program to mitigate interest rate risks, it is also important to diversify return-seeking allocations. This is particularly noticeable in scenarios where equity markets fall materially in value, precipitating large declines in funded status.

Given the unique investment attributes inherent across the range of alternatives, plan sponsors may utilize alternatives to mitigate investment risks inherent in delivering on the pension promise.

Impact of adding alternative investments

When considering the addition of alternative investments in a portfolio, it is important for plan sponsors to understand the impact on key metrics such as total portfolio expected return, surplus volatility and contributions. In the examples below, we summarize the impact of adding alternatives for three pension plans, each with different circumstances^*.

Example 1 – Frozen plan (US$511 million total assets)

In this case, the plan is frozen and the ultimate goal is to achieve a fully funded plan and evolve the asset allocation mix to maintain funded status. The plan's funded status is currently just over 90%, though ultimately a funded status of 105% is required to progress to the end of the desired de-risking glidepath. The plan sponsors desired to improve funded status without making additional contributions, and, while being conscious of future liquidity implications, decided to make a 5% allocation to private markets. The addition of private markets resulted in an improvement in the efficiency of the portfolio, including a reduction in surplus volatility from 9.4% to 8.7%, a US$4.3 million reduction in the present value of cumulative contributions and a US$7.3 million reduction in contributions in the event of a worst-case downside scenario over a 10-year horizon.

Example 2 – Closed and accruing plan (US$180 million total assets)

In this instance, the plan is closed to new participants, though still accruing benefits for existing participants. As an ongoing plan, an increase in returns is required in order to keep pace with service costs. The plan's funded status is approximately 64%, and as a result closing the deficit also weighs on return requirements. As a result, the plan sponsors desired to increase returns by seeking to implement a 5% allocation in core private real estate and hedge funds. The addition of these alternative investments to the asset mix resulted in a reduction in surplus volatility from 10.2% to 8.3% and a US$6.2 million reduction in contributions in the event of a worst-case downside scenario over 10 years.

Example 3 – Open and accruing plan (US$77 million total assets)

Here, the plan is open and ongoing, though underfunded. In order to generate higher return potential and improve funded status, the plan sponsor wanted to allocate 8% of total assets to private markets. The addition of private markets resulted in an increase in expected returns from 6.2% to 6.8%, a US$1.3 million reduction in the present value of cumulative contributions and a US$3.6 million reduction in contributions in the event of a worst-case downside scenario over a 10-year horizon.

The bottom line

As plan sponsors seek to address the challenges of delivering on the pension promise—including generating returns to fund liabilities, improving / protecting funded status and mitigating downside equity risks via broader diversification—they are increasingly looking to utilize alternative investments in their asset allocation.

Ultimately, while each DB plan's circumstances are different, and there is no one-size-fits-all solution, we believe it is a worthwhile exercise for plan sponsors to consider various alternative allocations to improve potential outcomes.

^* Please note: the above case studies are for Russell Investments global organization and not specific to Canada

¹ See also Lato, “Alternative investing impact on return-seeking portfolios”, 2019

² Source: McKinsey & Company, “McKinsey Global Private Markets Review 2021"

³ See Owens, “Return requirements for DB plan portfolios”, 2019