Canadian pension plan sponsors face a scary investment environment: low bond yields and flat, overly volatile equity markets. Where to invest? T-bills offer the best diversification benefits, but a 1% annual return can’t fund a reasonable pension plan. Time, then, to consider alternative asset classes.
I think of alternatives as all asset classes outside of publicly listed stocks and bonds: real estate, infrastructure, private equity, hedge funds and many other asset classes—even timber and farmland.
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Canadian plan sponsors have significantly increased their allocations to alternatives in recent years, which include all asset classes outside of publicly listed stocks and bonds: real estate, infrastructure, private equity, hedge funds and many other asset classes—even timber and farmland.
Data from the Pension Investment Association of Canada (PIAC) indicates the average Canadian pension plan’s allocation to alternatives in the last decade has increased from less than 10% to more than 25% today (the data include PIAC members only, which represent the larger Canadian pension plans).
This trend is expected to continue. In its 2011 survey of Canadian institutional investors, Greenwich Associates asked plan sponsors what changes they expected to make to their asset allocations over the next three years. The asset classes with the largest percentage of sponsors expecting to increase allocations were infrastructure (32%), real estate (30%), Canadian bonds (21%) and private equity (20%).
The benefits
The allocation process can be complex, but investing in alternatives:
- increases the portfolio’s expected return;
- reduces the portfolio’s expected risk (volatility of returns);
- improves the portfolio’s liability- matching characteristics; and
- increases the portfolio’s income or yield.
The challenges
Alternatives aren’t an obvious investment for all plan sponsors, though, as they have a number of significant drawbacks.
Illiquid investment: Some alternatives require a commitment of 10 years or longer.
High fees: Potentially higher than 2% annually in fees for some asset classes, as well as performance-based fees. Fees are often based on committed capital rather than invested capital, which increases the effective fee.
Minimum required investment size: Many alternatives require a minimum investment of $5 million.
Complexity: Complicated contracts require expert legal and tax reviews.
Lack of historical data: Short or unreliable data histories make quantitative modeling difficult.
Lack of performance benchmarks: Some asset classes such as infrastructure have no readily available performance touchstones.
Currency risk: Many alternative asset classes require investing outside of Canada.
Appraisal pricing: Many alternatives such as real estate require subjective valuations—you won’t know the real market value of your assets until you sell them.
Increased time and expense: Plan sponsors must spend more time on due diligence Illiquid investment: Some alternatives require a commitment of 10 years or longer.
High fees: Potentially higher than 2% annually in fees for some asset classes, as well as performance-based fees. Fees are often based on committed capital rather than invested capital, which increases the effective fee.
Minimum required investment size: Many alternatives require a minimum investment of $5 million.
Complexity: Complicated contracts require expert legal and tax reviews.
Lack of historical data: Short or unreliable data histories make quantitative modeling difficult.
Lack of performance benchmarks: Some asset classes such as infrastructure have no readily available performance touchstones.
Currency risk: Many alternative asset classes require investing outside of Canada.
Appraisal pricing: Many alternatives such as real estate require subjective valuations—you won’t know the real market value of your assets until you sell them.
Increased time and expense: Plan sponsors must spend more time on due diligence when hiring alternative fund managers.
Given the implementation challenges with alternatives, plan sponsors may wonder, why bother? Look at the last 10 years in investment markets. The traditional 60/40 stock/bond asset mix hasn’t delivered sufficient returns (for the 10-year period ending June 30, 2012, the average passive return is about 5.2%—based on 40% DEX Universe, 30% S&P TSX and 30% MSCI World indexes), and the next decade looks no different.
If you can spend the time and avoid the pitfalls, alternative asset classes can deliver satisfactory results for your pension plan.