The current investment environment is scary for Canadian pension plan sponsors: low bond yields and flat equity markets with too much volatility. Where do they invest? The asset class with the best diversification benefits is T-bills, but no one can fund a reasonable pension plan on a 1% annual return. Canadian plan sponsors, then, have been forced to consider alternative asset classes.
Although everyone has a different view on what alternatives are, I like to think of them as all asset classes outside of publicly listed stocks and bonds. This would include real estate, infrastructure, private equity, hedge funds and many other asset classes—even timber and farmland.
The Teachers’ Retirement Allowances Fund (TRAF) in Winnipeg, for example, has been investing in alternatives for almost 50 years: mortgages (since the ’60s), real estate (’70s) and private equity (’80s). The fund’s last additions in alternatives were high-yield bonds in 2001 and infrastructure in 2004. “At the moment, we have no intention of investing in other alternative asset categories,” says Jeff Norton, president and CEO of TRAF, “but we do monitor ongoing develop-ments in other alternative strategies, such as timber and hedge funds.”
Canadian plan sponsors have significantly increased their allocations to alternatives over the past 10 years. According to data from the Pension Investment Association of Canada (PIAC), 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). (TRAF’s current target allocation to alternatives is 40%; this includes 15% in real estate, 9% in mortgages and 8% in private equity.)
This trend is expected to continue in the future. 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
Making an allocation to alternatives is not a simple process, as each asset category is unique and brings different potential benefits to pension plan portfolios. But investing in alternatives has its benefits:
- increases the portfolio’s expected return;
- reduces the portfolio’s expected risk (volatility of returns) by investing in asset classes that have low correlations of return with traditional stocks and bonds or asset classes with low volatility of returns;
- improves the portfolio’s liability-matching characteristics—although nothing is better than long-term Canadian bonds, some asset classes (such as real estate and infrastructure) provide a reasonable match to plan liabilities or cash flows; and
- increases the portfolio’s income or yield.
The challenges
Alternatives are not an obvious investment for all plan sponsors, though. Implementation challenges can be significant and will cost more time and money than investing in traditional stocks and bonds (see chart above). Investing in alternatives can have a number of drawbacks.
Illiquid investment: Some alternatives require a 10-year or longer commitment.
High fees: Potentially higher than 2% per year in fees for some asset classes, as well as performance-based fees. Fees are often based on committed capital instead of invested capital, which increases the effective fee.
Minimum required investment size: Many alternatives require a minimum investment of at least $5 million.
Complexity: Contracts are complicated and require legal and tax reviews by experts.
Lack of historical data: Short data histories or unreliable data make quantitative modelling difficult.
Lack of performance benchmarks: Some asset classes such as infrastructure do not have readily available performance bench-marks to judge investment performance.
Currency risk: Many alternative asset classes require investing outside of Canada.
Appraisal pricing: Many alternatives such as real estate are not traded on a public exchange, thus requiring subjective valuations. Therefore, you won’t know the real market value of your assets until you sell them.
Increased time and expense: Since manager selection is key for alternatives, plan sponsors need to spend more time on due diligence when hiring alternative fund managers.
The process
Due to potential challenges, investing in alternatives requires a lengthy and carefully planned implementation process. “You should fully think through the implementation and administration process before investing any money,” says Norton. “Also, the skills needed are not necessarily the same as stock and bond investing. Internal staff, consultants, tax and legal advisors need to be experts in alternatives. Not all ‘generalists’ have the appropriate skills.”
A typical implementation process for a new investment in private equity, for example, could take a board up to two years to complete. The board should complete the following.
- Educate board members on the reasons for investing in alternatives and on the pros and cons of various asset classes.
- Select the short list of alternatives.
- For pension funds with less than $200 million in assets, there would be a practical constraint on the number and type of alternative investments they could consider.
- Model the risk/return impact of various asset allocations (including short-listed alternatives) as the modelling could incorporate currency hedging strategies and geographic diversification.
- Set the policy asset mix weight in alternatives as a percentage of the total portfolio.
- Investigate alternative vehicles (including direct investments, segregated funds, pooled funds and fund of funds), as the type of vehicles available to a particular plan are dependent on fund size.
- Decide on the implementation timing schedule to achieve full allocation.
- Select the fund manager.
- Negotiate the fund manager contract and fee.
- Select the investment performance benchmarks.
- Update the investment policy document.
- Fund the initial investment.
Once the initial investment is made, plan sponsors will need to commit significant time to their alternative investments to manage ongoing cash flows and capital calls, monitor investment performance and fund manager developments and review the portfolio’s asset mix against the target asset mix. Fund rebalancing procedures require careful planning, since some alternatives are not sufficiently liquid to allow for regular rebalancing.
Given the implementation challenges of alternatives, plan sponsors may wonder, why bother? The main reason is the experience of the last 10 years in the investment markets. The traditional 60/40 stock/bond asset mix has not delivered sufficient returns to adequately fund pension plans (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 this asset mix will be challenged to generate sufficient returns over the next 10 years. “Investing in alternatives has been a necessity for [TRAF] to achieve its long-term return and risk objectives,” says Norton. “Our 10-year net return is 6.6% per year at Dec. 31, 2011, and our alternatives allocations have outperformed our traditional allocations. They have also improved the liability-matching characteristics of our portfolio.”
If you spend the time to implement alternatives and avoid the pitfalls, they can deliver satisfactory results for your plan. “Given our plan size, the costs and effort have not been a barrier for us,” says Norton. “Your return from alternatives, net of all internal and external costs, needs to make sense—and it does for us.”
Brendan George is partner with George & Bell Consulting Inc. bgeorge@georgeandbell.com