With more than $23 trillion in assets under management, pension funds represent the largest asset class in the global financial marketplace. Managing this massive amount is the responsibility of pension plan sponsors who, supported by investment managers and other service providers, are charged with delivering results to plan participants within an ever-changing and ever-challenging economic environment.
The principal reason for the changing landscape of the pension arena has been the shifting economic and capital markets environment.
In relative terms, the last couple of decades have seen a significant amount of interest rate volatility. Because the present value of a pension fund's liabilities is partly-one could even say largely-a function of long-term interest rates, pension funds have frequently vacillated between overfunded and underfunded positions. If layered on top of that are the global capital markets environment, uncertain regulatory conditions and dislocations in the asset side of their portfolios, there has been created an almost perfect storm within which pension plan sponsors have operated over the last several years.
On the asset side of pension fund sponsors' business, several factors-including the tremendous financial crisis of 2007/2008-presented major challenges to pension plan sponsors: the relative underperformance of traditional long-only active managers; alternative investments, which in some cases did not fully deliver on what they were intended to do; and the breakdown of the correlation between different asset classes that were supposed to have added diversification to pension plan sponsors' portfolios in periods of high volatility.
This combination of market conditions is giving rise to a different paradigm in the way pension plan sponsors look to achieve their investment objectives. And as a result, their service providers-investment managers and other service providers alike-have had to, and will continue to, adapt their business model to accommodate this shifting paradigm.
Paradigmatic Change
For the better part of the last 10 years, pension plan sponsors and their consultants and advisers have been talking about separating the manufacture of their beta, which is their market returns, from their alpha, which is their ability to add value above an appropriate benchmark. In the new paradigm, pension plan sponsors will form a small handful of key strategic relationships with outside firms that they will depend on for their manufacture of alpha and beta, and the infrastructure necessary to facilitate that.
This shift will require a fundamental change in the working relationship between plan sponsors and their service providers-from a conventional buyer/vendor association to a strategic partnership.
That's not to say that sponsors will have only two or three or four fund managers. Certainly, there will be pension plan sponsors with dozens and dozens of relationships, and will be able to do so very successfully. However, there are others that may find greater value in managing a smaller, more strategic group of investments managers and other service providers. Importantly, this concentration of strategic relationships isn't about getting the best price. It's really about developing the strongest possible relationships with firms that understand the culture of a particular pension fund.
The new paradigm also includes fund sponsors being able to efficiently and cheaply get access to beta. The most fundamental way to accomplish that is through passive investment management by indexing portfolios in developed equity and fixed income markets around the world. In the new paradigm, plan sponsors have the ability to access beta returns through ETFs or other passive structures, and efficiently manufacturing beta exposure with derivatives.
Finally, in the new paradigm, plan sponsors may manufacture beta themselves, which does require some investment in technology to build or strengthen an infrastructure that may or may not exist in-house. Several market studies indicate that over the next three to five years, more plan sponsors may consider doing that, particularly the larger public pension plan sponsors-less so in the corporate pension plan space-and even in the endowment and foundation space.
For pension fund sponsors to attain alpha in this new paradigm, alternative investments will still play a meaningful part, but they won't be the whole story. It will be more about the way pension plan sponsors manage their business.
Of course, alpha generated from portfolio performance will continue to contribute to a fund's overall returns. Another factor is "organizational alpha." Citi recently sponsored a CREATE-Research study that indicated that investment managers with strong back- and middle-office infrastructures are correlated to those that tend to out-perform their benchmarks and create alpha. If that concept is transferred to the beneficial owners of the assets (i.e., the pension funds), it could be argued that organizational alpha will become critically important for pension funds, particularly those that manage their business relationships and their strategic partnerships in-house.
The Next Five Years
Interest rates, at least in the United States, are at historic lows. And the consensus among economists and other market watchers is there's a good likelihood they will head higher over the next five years. Rising interest rates actually lower the present value of pension liabilities. If asset values were to stay the same, which is not realistic, rising interest rates would improve the funding position of many pension plans in the country.
A pension plan is the ultimate exercise in asset/liability management. And the science of asset/liability management will increasingly weave its way into pension management over the next five-plus years. The reason is straightforward: Pension plan sponsors-particularly those whose sponsoring entities are cash-strapped or earnings-strapped-have to minimize the contribution that the sponsoring organization has to make to keep funding levels where they need to be. As a result, the science of asset/liability management will become more and more important in the pension arena over the coming several years.
Also, macro-economic changes such as rising or falling interest rates or increasing or decreasing asset prices are factors that pension funds can't control. There is, however, another issue that pension plan sponsors can manage and will increasingly focus on-their tail, or down-side risk. Sponsors, given their worst-case-scenario experience of the recent financial crisis, might be willing to give up some upside returns for protection on the down-side. So products are being developed that are aimed at helping pension plan sponsors put a collar around the potential return distribution. This is not going to be universal or transcend all pension funds, but it will be considered by many sponsors of defined benefit plans, particularly in the public space.
A New View of Asset Allocation
In the traditional model, pension plan sponsors typically express their asset allocations as the percentage allocated to equities, to fixed income, to cash and perhaps to alternative investments. They might also refer to the percentage allocated in their domestic market or globally, or the percentage allocated to large cap versus small cap equities, or their investment style-how much was allocated for value investing versus growth. Those are all vectors in the traditional pension plan asset allocation model.
Going forward, the model might emphasize the allocation to beta returns and the allocation to alpha returns. Certainly, the traditional approach is not going to disappear, but it will be supplemented by-perhaps heavily supplemented by-this alternative view of measuring asset allocation.
Concerns About Risks
The risk that most concerns pension plan sponsors face is the lack of sufficient cash to meet their liabilities and therefore needing to infuse cash from the sponsoring organization. This is particularly worrisome in today's budget-constrained environment. To mitigate that risk, pension plan sponsors should embrace this new paradigm. Investment managers that most quickly adapt to the fundamental shift in the mind-set and needs of pension plan sponsor will be the most successful. Those that don't adjust to the changing paradigm are risking the future of their firms.
The Role of Alternative Investments
The primary reason alternative investments have been a growing component of pension portfolios has been the promise of alpha. In certain cases, they've achieved it. Yet, in many instances the promise of alpha on a risk-adjusted and fee-adjusted basis has not been delivered. Even so, private markets still offer a tremendous potential to out-perform public markets. Going forward, alternative strategies that utilize long/short techniques as well as relative value plays between different markets, different securities and different asset classes will offer the potential for material alpha generation. Those opportunities will therefore continue to be heavily utilized for both defined benefit and defined contribution plans-and certainly in endowment and foundation portfolios. For asset managers in the alternative investment space, it will all be about continuing to manufacture alpha in an efficient way that pension plan sponsors need to attain their performance objectives.
