Should pension plans get involved?
by Ryan McGlothlin and Michael Clark Mr. McGlothlin is a Managing Director and Co-Head of P-Solve’s US business. He has extensive experience advising companies on how to better manage their pension plans. Mr. Clark, FSA, FCA, EA, is a P-Solve Retirement Consultant and Actuary who has worked with companies across various industries on all aspects of their retirement programs.
Ways to help decrease funding volatility or to diversify plan assets are always worth considering. Thus for many the prospect of bringing in so-called “alternative” assets and investments (commodities, real estate, hedge funds, gold) to close a funding gap can be very tempting.
But is bringing these assets into the portfolio a smart way for pension planners to go? By examining the pros and cons of pursuing alternative investments to positively impact pension plan funded status levels, the right answer to this question can be determined. Sponsors of defined benefit pension plans have struggled for years with stubbornly large pension deficits that don’t seem to go away even in spite of large contributions and decent equity market returns.
While this is a problem for all types of defined benefit plan sponsors, this article focuses on US corporate defined benefit sponsors. Many sponsors have turned to so-called “alternative” investments, such as hedge funds, real estate, commodities and private equity to try and improve returns and close pension deficits. These investment strategies each have their merits, but plan sponsors should proceed with caution as none is a panacea and all come with risks that may be beyond the comfort zone of many sponsors.
At the end of 2014, the aggregate level of pension funding for Fortune 1000 companies was 80%, according to data from Towers Watson. This reversed significant improvement seen in 2013 and brings the aggregate funding level back to levels similar to 2008-2012, as shown in the table below.
There are several reasons for the continued low pension funding levels:
- The long-term corporate bond yields used to discount liabilities are again at all-time lows – which pushes pension liabilities up;
- Actuarial assessments of the longevity of pension plan members have changed – people are living longer than expected; and,
- Pension investment returns and contributions have been insufficient to counterbalance the effects of 1 and 2.
These low funding levels are also in spite of many plan sponsors having taken steps to increase their funding levels by such means as freezing benefit accruals in their plans and offering lump sums to terminated vested participants. It is easy to see why sponsors are frustrated and turning to new ideas to try and close the gap.
The single largest determinant of how quickly pension funding levels improve (or not) is what happens to the long-term bond yields used to calculate pension liabilities. As we know, bond yields ended 2014 near all-time low levels and there is a high degree of correlation between the level of bond yields and the level of pension funded status.
Betting on rising rates
Most plan sponsors have not significantly hedged their plans’ exposure to interest rates and are betting on rates moving higher to help close their funding gaps. Investing in any asset that is not a long-term bond designed to match a pension liability leads to two risks: one, the risk that the asset returns less than the liability discount rate at the time of purchase; and two, the risk that the bond yields fall and the asset’s performance fails to keep pace in the growth in present value of the liabilities.
These risks exist because pension liabilities are discounted future benefit payments. This means assets need to return at least the liability discount rate just to stay even (currently in the range of 3.75-4% for many plans). If assets are less than liabilities, then the “breakeven,” or the amount assets need to return in order to keep pace with liabilities, ignoring contributions and changes in liability discount rate, rises. For an 80% funded plan with a 4% liability discount rate, the breakeven asset return is 5% (4%/80%).
If a plan is fully funded, it can largely be de-risked by investing in a liability matching bond portfolio. Many corporate pension plan sponsors plan to de-risk by buying liability-matched bonds as their funded status improves. This is the underlying goal with traditional glide-path models. As it is possible to de-risk by buying liability-matching bonds, it is important to think of corporate pension plan investment strategies relative to the plan liabilities, rather than the traditional total return framework.
The biggest difference between the two is that total return strategies are evaluated on the basis of managing investment volatility in absolute terms, while liability-relative strategies look to manage the volatility of the pension fund deficit (or surplus).
Based on the above discussion of pension investment strategies and goals, alternative assets should have a place in corporate pension plan investment strategies only when they have one or more attributes that can make them attractive relative to the plan’s liabilities:
- Expected returns in excess of liability discount rates;
- Sufficient liquidity to fit into a de-risking program;
- Positive correlation to long-term interest rates (which would act as a liability hedge);
- Very low or negative correlation to equities;
Looking at each of the various alternative asset strategies within this framework gives an indication as to whether a particular strategy is likely to be appropriate for a corporate pension plan. Commodities Long term, buying and holding commodity positions such as oil, industrial metals, or precious metals such as gold do not produce positive expected returns, and certainly not returns in excess of long-term bonds. Positive long-term returns can be generated only through speculation.
Commodity positions are generally accessed via futures (or sometimes in physical form in the case of gold), so they are highly liquid. There is no correlation to long-term rates. Commodities do exhibit low correlation to equity returns. So using our framework above, commodities only satisfy #4 in our attractive attributes list above. Therefore commodities would only be useful in a pension portfolio as an asset sitting alongside something traditional such as equities and only as a diversifier. Due to their lack of positive expected return, any such diversifying position would be small. This asset class is not going to reliably help corporate pension plans close their funding gaps.
Private Equity/Venture Capital
Investing in private equity and venture capital typically means buying units in a limited partnership with an expected investment horizon of 8-10 years+.
The expected returns are positive, and likely meaningful compared to the liability discount rates, as private equity in particular benefits from the same low interest rates that plague pension plans as leverage is employed. There is no positive correlation with interest rates—and returns from private equity are, ultimately, tied closely to returns from public equity, as private equity and venture funds often need strong public markets to achieve liquidity for their deals.
So private equity satisfies only #1 in our attractive attributes list above – it can produce strong returns. This asset class is only really suitable for pension plans that are not planning to de-risk or for those whose de-risking horizon extends beyond 10 years. Even then, care needs to be taken so there will not be a need to liquidate and de-risk over a horizon shorter than the typical life of a private equity fund. Private equity is not going to work for most plan sponsors as a meaningful way of closing their pension funding gap.
Real estate can be accessed in liquid form, via Real Estate Investment Trusts (REITs) or in illiquid form, via limited partnerships with the same kind of structure as private equity.
Anyone with a traditional equity portfolio will also generally already have exposure to REITs, and REITs have very similar risk/return characteristics as other public equity. It is private, illiquid real estate that is usually associated with alternative investing.
Real estate has expected returns that are higher than liability discount rates. It is illiquid and does not exhibit positive correlation with interest rates. It has medium correlation to equity markets. So real estate is positive on #1 and receives ½ marks on #4 in our attractive attributes list above. It therefore has many of the same issues as private equity above, and thus will be of limited use for most plan sponsors trying to close a deficit and de-risk.
Hedge funds are not an asset class, but rather a catchall for a very wide variety of investment strategies. Some hedge funds will have risk and return characteristics similar to traditional equity investments (high risk/high return), while others will be absolute return strategies trying to generate consistent, small positive returns.
“Hedge funds” is too wide a term to try and apply our framework in general, but when evaluating different hedge fund strategies it is useful to keep in mind. For example, many absolute return hedge fund strategies are relatively liquid and exhibit zero correlation to equities, but do not have expected returns above liability discount rates (or at least not until short term interest rates rise beyond zero).
Conversely, some aggressive hedge fund strategies have high expected returns, but also high correlation to equities and can become illiquid. Some hedge funds are used to access sources of positive expected returns that are uncorrelated to equities, such as those that access catastrophe risk.
These strategies can be useful and can satisfy many of the attractive attributes on our list. However, many others will not. Summary Many corporate pension sponsors are looking for new ways of closing their pension deficits. Unfortunately, there are no easy ways to make this happen.
For most sponsors it will take a combination of higher interest rates, larger contributions, time, and decent investment returns to close their gaps. Unfortunately, many alternative investment strategies will not help most plan sponsors realize their dual goals of closing the funding gap, and making sure that the gap stays closed by de-risking the investment strategy. v
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