Although the headlines on defined benefit (DB) pensions often depict a shrinking universe, as sponsors de-risk their plans through liability-driven investing and pension risk transfers, plenty of DB plans remain open and add new layers to their benefit liabilities each year. Accordingly, sponsors continue their contributions and need portfolio destinations offering growth through risk in the markets.
For years, DB plans have unwound their exposures to public equities, and diverted some of their risk investments into alternative assets such as private equity, real estate and hedge funds, among others. These can offer not only diversification away from volatile equities, but risk-adjusted returns that are superior to public market counterparts.
The listed equity cutback continues, especially in reaction to several years of stellar returns pushing the U.S. stock market to great heights. But sponsors’ attraction to alternatives has driven their valuations higher, too, leading investors to rethink prospective returns and investment approaches. “Market valuations are high across the board, and we’re hard-pressed to see a repeat of strong recent returns,” says Jon Pliner, senior director of investments in the New York office of Willis Towers Watson. “So we think owning a robust portfolio of alternatives, where one or two assets aren’t dominating the risk, gives a plan the best opportunity to succeed.”
Managers of alternative assets have raised capital in prodigious amounts from investors globally—for the three years that ended December 2019, totals reached $1.9 trillion in private equity, $438 billion in private real estate, $272 billion in infrastructure and $359 billion in private credit, all according to Preqin, a firm researching alternative assets. U.S. DB plans have taken their share. Since the passage of the Pension Protection Act of 2006, a watershed for funding rules and asset allocation, U.S. DB plans have raised their allocations to private equity from less than 3% to nearly 6%, and in private real estate from 4% to 5%, as reported by consultants CEM Benchmarking, Toronto (through year end 2017, its most recent tally).
Hedge funds are a contrary example: Owing to several years of disappointing returns, DB funds’ hedge fund allocations slipped from a peak of 8.4% in 2014 to 6.6% in 2017. Hedge fund analytics firm HFR reports that hedge funds as a group suffered net capital outflows of over $100 billion from 2016 through 2019, the first since the financial crisis.
Still, “The marginal dollar going into DB plans is most likely being invested in the private markets,” observes Andrew McCulloch, portfolio analyst and partner at Albourne Partners in Norwalk, Connecticut. “For institutions overall, a lot is devoted to private equity, while for DB plans in particular, more is going to private credit. And infrastructure in particular is attractive, given its ability to lock in long-duration assets, with links to inflation.”
“There’s no obvious place to invest in the private markets, in that nothing is screamingly cheap,” says Sona Menon, head of the North American Pension Practice at Cambridge Associates in Boston. “That said, there is more room for excess return. The difference between the return of the average manager and the first quartile can be several hundred basis points, so the premium for private market illiquidity can be quite high. But getting into the right investment and manager is probably more critical now than ever before.”
All the adoration for alternative strategies brings consequences. One is a rising price of investments. “Private equity managers today are paying twice the valuations they were in 2007,” notes David Lindberg, managing director in the Pittsburgh office of consultants Wilshire Associates. That means forward return expectations may be marked down, he adds, but, “Investors may still think they can get more from private equity than public equity.”
Second is a buildup of private asset capital waiting for investment, or “dry powder” in the industry’s argot. Preqin reports a mountain of dry powder in the private equity market of $1.4 trillion, or more than twice the amount managers were able put to work in 2019. “There is an unlimited amount of capacity,” Pliner observes.
Notwithstanding all the attention paid to alternative assets, the largest risk-seeking allocation for DB plans as a group, and for many individual plans, is still listed equities. CEM Benchmarking reports that at year end 2017, the large U.S. DB plans in its survey held about 42% of assets in public equity, well down from 60% in 2007. Within public DB plans, public equities made up 40% of assets, according to the database of the Center for Retirement Research at Boston College, versus 60% in 2007.
Investors’ disappointment over actively-managed equity strategies has been well publicized, and it’s the active group that has suffered nearly all the outflows, say researchers at eVestment, an investment data firm. Net flows to passive strategies, however, have hovered around breakeven for the past several years.
“Funds are more than 50% passive in large cap stocks, and for good reason,” observes Alex Beath, senior research analyst at CEM Benchmarking. “Over the very longest term, those portfolios have earned under two basis points in annual return, and net of fees, lost 37 basis points.” Small caps have fared far better, returning 53 basis points net of fees over time.
Recent performance letdowns notwithstanding, consultants continue to advise DB clients to stay the course with active managers, and allocate broadly across growth, value, quality and momentum styles. “Active management continues to be a key tool for generating returns, particularly in a time when many expect future market returns to be lower than those of the past,” Pliner says. “Value won’t be out of favor forever, and we think owning a broader range of fundamental factors offers a better opportunity to outperform.”
“We lean toward public equity portfolios that are largely active,” Menon says. “We don’t think of the large cap market as more efficient, because there are plenty of large cap managers who can beat their benchmarks. The managers we choose invest with a high active share and run portfolios that are truly different from the indexes.” She adds: “In 2019, equity performance was concentrated in a few technology stocks, and that makes a strong argument for not wanting to own the entire market—just the attractive parts.”
Bridging the public and private markets are strategies constructed from academically robust risk premia, or factors, such as value, momentum and volatility exploited across the equity, fixed income, credit, currency and commodity markets. “Managers can build strategies that earn absolute returns that are modest, but uncorrelated with other markets,” says McCulloch. “DB plans like them for their liquidity, and that they charge low fees.”
McCulloch also points to additional private markets that are outside the mainstream, such as aviation leasing, insurance or pharmaceutical royalties. These out-of-the-way markets might call for even more education to make investment committees comfortable but are notable for the low volatility and correlation in their returns to public equities. “Although there’s still a lot of interest in conventional private equity, we’re having more conversations with sponsors on these ‘esoteric’ private market strategies that offer higher returns than many public market strategies.”
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