Pension funds embrace non-traditional assets, active management

Constraints in meeting payout requirements forcing pension funds to look beyond bonds, equities

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7 Mar 2018

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WHEN figuring out their asset allocation strategies for 2018 and beyond, pension funds can no longer rely heavily on safe-haven government bonds, or even equities as they have done so more recently.

In fact, pension funds are expected to put more effort on learning how to tap other non-traditional assets such as real estate, infrastructure and alternatives, in addition to equities and fixed income, in order to meet their long-term liabilities.

“We see pension funds figuring out how to meet their responsibilities with the global asset markets that are available to them, and branching out beyond simply buying US treasuries. That’s not going to cut it anymore, and it hasn’t cut it for a while. And even though rates are rising, they are not going to rise enough to meet their liabilities,” says John Bilton, managing director and head of multi-asset strategy, J.P. Morgan Asset Management. Bilton is the author of the Long Term Capital Market Assumptions (LTCMA) which tracks average market returns on a 10-15 year rolling period.

In recent years, pension funds in general have been facing a constraint in being able to meet their payout requirements because of negative or low-yielding safe-haven government bonds. Although the situation is not as dire here in Asia, it’s still a trend that is playing out across global markets.

To address this situation, more Asian pension funds have been diversifying their portfolios with a view to seeking more yield and income from their investments, starting within particular asset classes. Within the fixed income asset class, for example, pension funds began investing in higher yielding corporate bonds – in addition to US treasuries or government bonds – even though corporate bonds come with higher risks

Pension funds have also begun increasing their allocation to equities in a big way as part of their portfolio diversification. Since equities are traditionally considered high-yielding but high-risk assets when compared to bonds, this means that pension funds have been raising their risk appetite or risk profile. This means taking on more risk with the expectation of earning higher returns. This risk can include liquidity risk, equity risk, credit risk, and duration risk.

“I think what the pension funds are beginning to be mindful of is that, if they can take on more liquidity risk, that’s the type of thing which allows them to get additional returns. And if they welcome the guiding principle that financially they should be paid for the risk that they take, and the only risk that they’re prepared to take is market risk, they’re only going to get paid market returns,” Bilton says.

Since market returns may not be enough to fund their liabilities, the pension funds have to take on more liquidity risk to generate more return.

“There is a recognition by pension funds that alternative assets, such as infrastructure and real estate, are attractive because there’s a tacit liquidity risk there. But this is something that a long-term liability investor is better positioned to be able to take than investors who are trading for the next month, quarter or even the next year,” Bilton says.

When it comes taking to on liquidity risks by investing in alternative assets, pension funds are better positioned than other financial institutions because of their longer investment horizons.

“Pension funds have the luxury of being able to have such long investment horizons, that there are alternative investments like infrastructure and real estate that are available to them that may not make much sense for other investors,” says Hannah Anderson, research analyst, global market insights strategy at J.P.Morgan Asset Management.

Active management
In response to this situation, some pension funds as are adopting more active asset allocation strategies that are designed to generate more returns depending on their particular risk tolerance level, as well as providing greater diversification.

“For investors like us, we’re very disciplined, cautious and selective. Active management has led us to global diversification, asset class diversification, and really helped us to generate returns,” says Suyi Kim, managing director and head of Asia-Pacific for the Canada Pension Plan Investment Board (CPPIB), the professional investment management organization that invests the funds of the Canada Pension Plan.

Like all pension funds, CPPIB is a long-term investor, which means it has a focused and consistent investment strategy that transcends year-over-year changes in the market, such as elections or other political developments.

Unlike some pension funds, CPPIB is well positioned to boost investments because it still benefits from Canada’s pension fund reforms undertaken in the 1990s. The reforms have resulted in a structure that provides certainty in the fund’s flow of assets. The impact of the reforms on CPPIB’s portfolio is that it currently has more cash flowing in than flowing out, resulting in substantial investible assets.

“This allows us to invest in less liquid, higher risk asset classes that would give us higher returns. If you are in a pension structure where you have more money going out, you have to manage the portfolio with that in mind, and would invest only in more liquid, lower risk asset classes that give lower returns,” says Kim.

In 2017, for example, CPPIB had an equity-to-debt asset allocation target ratio of 85-15, compared to the traditional 60-40 model for pension funds. This strategy paid off for CPPIB since equities performed well in 2017.

Expected returns for a simple balanced 60-40 stock-bond portfolio are slightly lower than last year’s (around 5.25%, down from 5.50%) as the stock-bond frontier rotates clockwise (i.e., bond returns improve and full valuations hold back equity returns) which is consistent with the prevailing late cycle environment, according to LTCMA.

“For equity investors, it has been a good market. We have seen a very strong emerging market pick up as well, which is also good for Asia. A lot of that came from earnings growth too. That is helpful on average for the investors this year,” Kim says.

Kim, however, expresses some apprehension on the private market because the valuations have been rising steadily during the past years.

“Ever since the global financial crisis (GFC) with the lower interest rates, we have seen the multiples in the market going up. Earnings have picked up, but multiples in the market have been going up with values that are now close to 2007 levels or before GFC levels on private deals in particular, whether it’s a private equity transaction or real estate transaction in most markets,” Kim says.

In the past, CPPIB focused on investing in matured infrastructure assets, for example. But because of the very high level of valuations for such assets at the moment, Kim feels they have been priced out of the market. Because of this, CPPIB is now focusing on more complex transactions where it’s not competing just on the cost of capital.

“We’re competing on our ability to be able to do large and complex transactions that can bring limited competition, as opposed to broad market competition for the capital that anybody can get into,” Kim says.

Although CPPIB is positive on the overall market prospects for 2018, it is also cautious in light of rising interest rates and other uncertainties plaguing the global markets.

Kim, however, emphasizes that CPPIB is a long-term investor with an investment strategy that transcends year-to-year market developments.

“Year-over-year does not really impact our strategy very much, and for the next five to 10 years I’m positive for all our key markets. Year-over-year changes may provide a real buying opportunity, or it may be a waiting opportunity if it’s really expensive, but it does not really change our investment strategy. Overall for 2018, I’m positive about all the markets we’re invested in,” Kim says.

The CPP Fund, which CPPIB manages, ended its second quarter of fiscal year 2018 on September 30 2017, with net assets of C$328.2 billion (approx. US$267.1 billion), compared with C$326.5 billion at the end of the previous quarter. The C$1.7 billion net increase in assets for the quarter consisted of C$2.3 billion in net income after all CPPIB costs, less C$0.6 billion in net Canada Pension Plan (CPP) cash outflows.

“For us to be sustainable we need to generate a 3.9% real return. If you add inflation in Canada, which is less than 2%, it is below 6% that we need to generate. For the last 10 years that we have been doing active investments, we have generated 7%. Over the last five years, we did more than 12%. So I think we are sound and safe. The chief actuary of Canada has confirmed this as well in his latest report,” Kim says.

Date

7 Mar 2018

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