After the simultaneous sell-off of both equities and bonds in the first half of 2022, many defined benefit pension plan sponsors were forced to “pay much more attention to the liquidity profiles of their portfolios” and manage risk by implementing a temporary policy reprieve, halting new investment activity or selling assets in the secondary market, said Samantha Cleyn, head of institutional sales and service at BMO Global Asset Management, during a session at the Canadian Investment Review’s 2023 Defined Benefit Investment Forum in December.
That liquidity challenge was a decade in the making. As DB plan sponsors struggled to maximize returns in the ultra-low interest rate environment of the last 10 years, many chose to increase their exposure to private assets and assume the complexity and illiquidity premiums that came with them, rather than taking on significantly more equity risk. According to data from the Pension Investment Association of Canada, plan sponsors’ allocations to private investments during that time was, on average, 10 per cent of their portfolios, while it’s currently between 20 per cent and 30 per cent.
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“During a liquidity challenge, the big question is how to manage that risk while also ensuring you can maintain the same risk/return exposures you sought out in your investment policy [and] your hedge ratios, [while adhering] to rebalancing policies and [putting] new capital to work to keep your strategy on track,” said Cleyn. “Not an easy problem to solve but that is why having a plan and additional tools in your toolkit can really help.”
Liquidity is often sourced from plan assets, with cash as a good first option, followed by public bonds or equities — with developed markets and federal bonds more ideal than small cap and high yield. On the private asset side, open-ended funds can also be a source of liquidity, or selling closed-end funds on the secondary markets.
Also speaking during the session, Mark Webster, director of exchange-traded fund distribution for institutional sales and service at BMO GAM, said listed assets can give DB pension plans sponsors comparable exposure to that of unlisted assets, while increasing plan sponsors’ control and giving them a source of liquidity when they need it. “[ETFs are] as liquid as any pooled fund or any segregated or separately managed account in the same asset class with underlying market-making inventory.”
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Listed infrastructure also demonstrates the benefits of listed assets. While institutional investors tend to gravitate toward unlisted infrastructure given the asset’s long lifespan — which aligns well with pensions’ long-term liabilities — and its inflation-hedging properties, listed infrastructure and real estate investment trusts tend to have the same high operating margins that institutional investors seek in unlisted assets. Webster noted pure-play listed infrastructure most closely resembles unlisted assets, while core and broad infrastructure don’t necessarily have the same inflation protection and high operating margins.
When adjusting for the smoothing effect and reporting lags inherent in unlisted assets, “all of a sudden, listed and unlisted start to look achingly similar. . . . You can satisfy your requirement for an alternative risk and return profile using listed as opposed to unlisted assets.”
Moving from unlisted to listed assets can also help institutional investors save on fees for accessing the private markets plus performance fees. For plan sponsors seeking to implement a total portfolio approach, it would make sense to incorporate complementary positions in listed assets, as well as to use a deep and transparent data set to model risk and return and to access liquidity as required in changeable markets.
Read more coverage of the 2023 Defined Benefit Investment Forum.