“Real assets” is an asset class that covers investments in physical assets such as real estate, energy and infrastructure. Some definitions also include intangible assets, such as loans.
Over the years, institutional investors, such as corporate defined benefit (DB) plans, have turned to real assets to seek diversification and/or better returns, and experts have recommended the asset class for public DB plans.
However, some DB plan sponsors might be hesitant to use real assets, considering their generally illiquid nature. Willis Towers Watson says there are many myths associated with building a real assets allocation, and it has published an article, “Top Five Myths of Investing in Real Assets,” to dispel some of the most common ones.
Christy Loop, director of investments and portfolio manager, Willis Towers Watson, says the catalyst for writing the article was the arrival of COVID-19 in the U.S. and the resultant short-term market crisis.
“It made investors second-guess real assets, and we think they have incorrect assumptions,” she says. “And there are some real asset investments that have been overlooked that could provide protection in down-market scenarios.”
The Benefits of Investing in Real Assets
Loop says the overall benefit to a DB plan of investing in real assets is portfolio diversification. Real assets reduce the overall volatility of a portfolio, introduce more efficiency and improve risk-adjusted returns.
Loop notes that many DB plans are using liability-driven investing (LDI), with a strong emphasis on fixed-income investments, to meet liabilities, but real assets play a role on the return side of the equation.
“For underfunded plans, investing in real assets can reduce underfunding, and, if a plan is well-funded, real assets can reduce volatility in the funded status,” she says. In addition, during large market dips, certain real assets can narrow the dispersion of returns and reduce drawdowns, Loop adds.
Real assets are underpinned by physical assets that produce long-dated cash flows that are contracted, Loop explains. The stability of cash flow helps produce a return profile that reduces volatility.
“Real assets are absolutely, 100% outstanding investments for DB plans, but they must be used correctly and wisely,” says Christopher Zook, chairman and chief investment officer (CIO) at CAZ Investments. “If they are, they should deliver significantly higher rates of return and higher predictability to meet the underlying objectives for beneficiaries of the plan.”
Zook says his only concern about real asset exposure comes if a plan is overallocated in these investments. “In certain cases, DB plans have misused private assets and were not properly diversified, so they experienced bad outcomes. But for the vast majority of DB plans, real assets are the best performing asset and offer the best chance to meet actuarial assumptions,” he says.
Zook says his firm oversees some public plans in Texas, and these plans need the returns generated by real assets to meet actuarial assumptions in a 1.5%, 10-year Treasury return environment.
Managing Cash Flow Needs
A common concern of DB plan sponsors when thinking of allocating a portion of their portfolios to real assets is that the funds will be “locked up” and the plan will be unable to meet obligations to pay benefits.Zook says the amount to allocate to real assets depends on the plan.
“If the plan has more outflows than inflows, it’s harder to meet cash flow needs when invested in real assets,” he says. “But even if a plan has a 5% negative cash flow per year from greater distributions than contributions, as long as it doesn’t have the majority of investments in real assets, it should have more than enough liquidity to meet cash flow requirements.”
As an example, Zook says even those most negative cash flow plans in Texas—those with a higher retiree population than active employee population—can still have 10% to 30% of their portfolio invested in real assets because they have up to 10 years before they need to meet payment obligations.
The amount DB plans invest in real assets is in part based on the size of their cash obligations.
“Where plans get into trouble is when they have a negative cash flow of, say, 10% to 15% and they are invested 50% in real assets,” Zook says. “But if a plan has a minor amount of negative cash flow and has 10% to 20% of its portfolio invested in real assets, that is not only prudent but a wise decision to meet its obligations to beneficiaries of the plan.”
To manage cash flow needs when some capital is “locked up” in real assets, Loop suggests that plan sponsors first determine the annual cash flow needs in terms of benefit payments. This will be the current percent of liquid assets needed. Plan sponsors next need to evaluate how liquid their existing investments are.
“Doing that planning allows plan sponsors to get a handle on how to fund commitments over time and continue to meet benefit payments,” she says. “It’s worth the effort for the upside benefits of real assets.”
That said, investing 50% of a DB plan’s portfolio in real assets is not good. Loop says, typically ,DB plans allocate 8% to 15% of their portfolios to real assets; the range will differ with plan sponsors’ objectives, risk and return needs, and where they are in the lifecycle of the plan. “For plans that have lower growth needs—more retirees than active participants—the investment into real assets would be lower,” she says.
Zook notes that not all assets have the same illiquidity. As an example, he says purchasing a single piece of real estate in the middle of nowhere is different than purchasing an apartment building in downtown Charlotte, North Carolina, because the former is harder to sell than the latter.
“But, the same is true if plans are investing in private credit,” Zook adds. “A loan with a five-year maturity will get money back in five years unless there’s a problem, and it is also tradeable in the secondary market. Even if the plan sponsor doesn’t like the price, it can sell the loan.”
As a rule of thumb, private credit is usually a three- to five-year investment; private equity is five to 10 years; real estate is three to seven years; and venture capital is five to 15 years, Zook says. “There are exceptions for all types of assets, but that’s the general rule. That’s the advantage of using different types of assets, and some assets are not as illiquid as some people think,” he adds.
The Willis Towers Watson article echoes this point about real assets. “Real asset constructs should include an array of strategies, spanning traditional and specialist mandates, and be inclusive of different liquidity terms and/or capital lock-ups. These diversified allocations and vehicle types can offer varying contribution and redemption terms, while providing an expanded breadth of opportunities to deploy capital and source liquidity throughout time,” it says.
Zook says most plan sponsors overestimate the illiquidity of real assets, but he also notes that they can get into trouble when they underestimate illiquidity. This could be a problem for plans, such as very small ones, that do not have people with investment expertise working for them.
“For plans with experts—in-house, advisers, a board or consultants—[investing in real assets] is a necessity because, otherwise, they will not meet actuarial rate assumptions in the current interest rate environment,” Zook says.
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