In a survey of 180 pension plans with $280 billion in assets, NEPC discovered that pension plan sponsors expect their portfolios to return 7% or more, which NEPC says is unrealistic.
Instead, over the next five to seven years, NEPC expects large-cap equities to return 5.75% and core bonds 2.65%, the company says in its new report, “Power Up Your Pension Plans.”
The reason returns will be lower, NEPC says, is because in the past few years, low inflation, declining bond yields and expanding valuations have boosted the markets. At this point, NEPC says, many assets are now overvalued.
Thus, NEPC suggests several ways that pension plans can boost returns, starting with investing in Treasury Separate Trading of Registered Interest and Principal of Securities, or STRIPS. “Capital-efficient instruments, such as STRIPS, allow investors to achieve long duration with a relatively low amount of assets compared to a traditional long-bond approach,” NEPC says.
In addition, “Dual-beta strategies allow an investor to obtain two market exposures in a single fund,” the firm says. “The most common combination for liability-driven investors is U.S. large-cap equity and U.S. long duration.”
NEPC also encourages pension plan sponsors to consider long-bond allocations that are actively managed. Not only does this offer better returns on the upside, NEPC says, but it can “also help avoid or reduce downgrade risk.”
Within fixed income, NEPC encourages sponsors to look for direct-lending strategies in private markets, particularly for sponsors at the earlier stages of derisking able to lock up their capital for longer periods of time than those at later stages. “Skilled managers in this space are able to achieve returns in the 8% to 10% range on an unlevered basis,” NEPC says.
NEPC also prefers bank loans to high yield. Outside of the U.S., the firm is interested in emerging market debt denominated in both U.S. dollars and local currency.
Among equities in the public markets, NEPC is partial to emerging markets, which it expects will return 375 basis points more than U.S. large-cap securities. Among equities in the private market, NEPC says it acknowledges “that generating outsized gains in private equity may be challenging, [but] our return assumption for private equity is still meaningfully higher than traditional U.S. stocks.”
Since pension plans need to have at least a portion of their assets in cash to pay retirees, NEPC says, that can reduce returns by 10 to 20 basis points. To counter that, NEPC recommends “securitizing cash via a futures overlay that seeks to replicate [the sponsor’s] policy target as closely as possible.”
Finally, NEPC looks for an additional boost from the lowest-cost investment vehicles possible. “When we expect low returns, every basis point counts,” NEPC says.
NEPC’s “Power Up Your Pension Plans” can be viewed here.