A research paper published by the Pension Research Council examines three levers that defined benefit (DB) plans can use to enhance portfolio outcomes in a low-interest-rate environment: increased contributions, reduced investment costs and increased portfolio risk.
Researchers from Vanguard note that, “As fixed-income yields hover near historic lows, defined benefit pension plan sponsors must grapple with a rise in the present value of their plan liabilities and a fall in prospective investment returns.” Their asset class projections find a portfolio with a 60% allocation to global equities and a 40% to global fixed income generated an annualized 5.5% return from 1926 through 2016. However, they estimate that, for the 10 years through 2026, the median return for the same portfolio will be about 2 percentage points lower.
In a Pension Research Council white paper, “Getting More From Less in Defined Benefit Plans: Three Levers for a Low-Return World,” researchers contend that an increase in contributions is the most reliable strategy to improve DB plan funding levels. While the decision to increase contributions must compete with other uses of corporate cash flow, such as capital investment and returns to shareholders, the benefits to active and retired participants is clear.
In its analysis, using certain assumptions, the researchers find that annual contributions of $1 million raise the probability of reaching full funding from 47% to 66% over a 10-year period. Contributions of $2 million per year increase the probability to 81% and also increase the plan sponsor’s flexibility to implement liability-driven investment (LDI) strategies that limit the plan’s vulnerability to changes in interest rates and asset and liability values.
The Pension Research Council paper notes that retaining the services of in-house or external portfolio managers has a cost. Reducing costs has a positive impact on the future value of a portfolio.
For example, in the case of a portfolio with an initial value of $100 million, assuming a rate of return (ROR) of 7% per year before fees, the researchers found that, net of 100 basis points (bps) in annual fees, the portfolio’s value would grow to about $178 million over 10 years. If fees were reduced to 50 bps, the portfolio would have accumulated an additional $9 million in assets. Over 30 years, annual savings of 50 bps would translate into more than $90 million in additional assets.
NEXT: Increasing Portfolio Risk
As the Pension Research Council researchers note, increasing portfolio risk is a different strategy than increasing contributions and cutting costs. It seeks to accelerate the rate at which portfolio assets grow.
According to the paper, “Among the widely used risk-oriented strategies are increased allocations to global equities; style-factor tilts; allocations to traditional active equity management; and allocations to alternatives.”
Raising a plan’s strategic equity allocation represents a move along the efficient frontier to a risker portfolio, with a higher expected return. The researchers note that a higher expected return can help close DB plan funding shortfalls; however, they concede that the higher volatility also diminishes the certainty that this benefit will be realized.
For active management to be successful, three elements must be present: talent, cost and patience, the researchers say. Talent is key to beating the odds against outperformance. According to the paper, “In the 17 rolling three-year periods for the 20 years ending in 2016, only 15% of U.S. equity funds, on average, outperformed their benchmarks. When those results are weighted by assets under management [AUM] rather than the number of funds, the odds improved to 38%.”
Lower costs equal higher net returns, but the researchers also cite other research that found cost is the most powerful predictor of higher performance.
Still, “even if an investor identifies talent and secures it at a low cost, success requires patience,” the researchers say. They note that, of the 2,085 U.S.-domiciled active equity funds in existence at the start of 2000, only 552 (26%) outperformed their prospectus benchmarks over the subsequent 15 years. Of that 26%, almost all (98%) failed to outperform in at least four calendar years over the 15-year period. More than 50% of these top performers delivered seven or more years of underperformance. “Only those investors patient enough to hang on through these periods of weakness managed to realize the superior long-term returns delivered by these exceptional managers,” the paper says.
According to the Pension Research Council researchers, the use of alternative investments is more about reducing volatility than increasing returns. For a hypothetical DB plan the researchers used based on certain assumptions, they modeled two widely used hedge fund strategies: market-neutral and multi-strategy. While a 5-percentage-point allocation to each reduced the portfolio’s annualized expected return, it produced a sizeable decline in the volatility of returns.
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