Alternatives has been the buzzword among pension investors for the past few years. Investments in alternative asset classes were going to solve everyone’s problems—improve returns and funded positions, and reduce reliance on equity markets and their associated volatility. Unfortunately, this has not turned out to be the case for many.
In 1999, pension funds in the seven largest pension markets (Australia, Canada, Japan, Netherlands, Switzerland, the United Kingdom and the United States) had allocated 6% of their pension plan assets to alternative investment strategies. By 2009, this had grown to 17%, with substantially larger allocations starting in 2004. Allocations among Canadian plan sponsors mirrored this trend, starting at 6% in 1999, but jumping to 22% in 2009. If the largest plans such as the Canada Pension Plan, Teachers’, etc. are excluded, then this allocation would range between 5% and 15% in 2009, depending on whether the plan was less than $500 million or more than $1 billion in size. The ability to access the alternative asset classes in a cost effective manner and the additional governance requirements associated with alternative asset classes are large determinants on the size of the allocation. While there are some pooled products that have become available to plan sponsors, the cost of these can be prohibitive for many of the smaller pension plans.
Given the equity market collapse in 2001/2002 following the burst of the tech bubble, it was not surprising to see plan sponsors move away from reliance on the equity risk premium. What was more surprising was how many plan sponsors failed to act at that time. The credit and liquidity crisis of 2008/9 was a wake-up call for many who continued to rely on equity market returns, though there were performance issues with some of the alternative asset classes too (more on this to follow). Declining bond yields also contributed to the move away from fixed income into real estate and infrastructure, as they provide a decent match to a pension plan’s liabilities and offer the prospect of inflation protection and higher returns than bonds.
Recently, Towers Watson released its annual Global Alternatives study, which it conducts each year in conjunction with the Financial Times of London. The focus of the study is alternative assets under management on behalf of pension funds. 149 asset managers participated in the study, though many offer more than one alternative asset class to pension fund investors. For purposes of the study, alternatives were defined as real estate, private equity fund of funds, hedge fund of funds, infrastructure and commodities.
The headline conclusions of the study were:
• there was little change between 2008 and 2009 in total alternative assets managed by the top 100 managers for pension funds ($817 billion);
• of the five alternative choices, real estate remains the largest block of alternative pension fund assets at 52%;
• in 2009 infrastructure, commodities and private equity fund of funds grew at the expense of real estate and hedge fund of funds; and
• North American pension fund investors continue to account for the largest amount of pension fund assets in alternatives, followed by Europe and Asia.
While these results are interesting, they merit greater exploration and a little bit of context.
In terms of geographical differences, according to the study, there were much higher allocations to commodities in the United States. Eighty-five percent of U.S. pension plans had an allocation to commodities as reported by the managers surveyed as opposed to only 13% of European plans and 2% of Asian plans. While European plans had diversified their alternatives allocation across all five categories, they showed a preference for real estate and infrastructure over hedge fund of funds and real estate. In general, U.S. plan sponsors had the most diversified alternatives portfolios with allocations across all five categories, though the allocation to infrastructure was significantly lower than allocations to the other asset categories.
Asian pension plans are still in the very early stages of alternatives allocations, with infrastructure and fund of hedge funds featuring prominently in their portfolios. In Canada, we tend to see much larger allocations to real estate, private equity and infrastructure, if assets of the largest plans are excluded. Allocations to commodities are quite low, as are those to hedge fund of funds.
A key difference between U.S. pension plans and those sponsored by Canadian and U.K. investors is the lack of indexation in U.S. pension plan formulae. Without an explicit inflation link, there is less need to invest in real return assets to protect against excess inflationary times. That being said, U.S. plan sponsors are clearly concerned about the potential for inflation given the large number of plans that have allocated to commodity strategies.
In addition, the U.S. pension market tends to be dominated by defined contribution (DC) plans. While defined benefit (DB) plans in the U.S. have engaged in liability matching approaches (mainly derivatives based), 45% of U.S. pension plan assets are in DC plans. This is markedly different than Canada where on a dollar weighted basis, 97% of pension assets are in DB plans. Given the relative lack of derivative instruments in Canada and a very small inflation linked bond market, many Canadian plan sponsors have turned to allocations in real estate and infrastructure as part of their liability matching and inflation protection strategies.