In the second post of a three-part series exploring the changing asset allocation among Canadian institutional investors, I examined the changing needs of pension plans as a result of demographic shifts and increased emphasis placed on short-term relative to long-term investment performance. In this final post, I will discuss how alternatives can help to address these needs and overcome potential challenges related to liquidity.
A key benefit presented by alternative investments is the improved match to pension liabilities’ risk profiles compared to traditional asset classes. To gain a better understanding of matching asset and liability risk profiles, let’s take a de-risking approach to asset allocation in which we consider three risk factors: fixed payments, inflation and return driven.
Read: The evolution of asset allocation: How did we get here?
Components of both a pension plan’s liabilities and assets can be attributed to these different factors. Retired employees are effectively a liability that can be attributed to both the fixed payment and inflation factors as these employees collect regular pension payments that are adjusted based on the cost of living (if indexed).
Real estate is an asset that can be attributed to all three risk factors since rent is collected, rent prices usually move alongside inflation and there is the potential for capital appreciation of properties. As illustrated below, we can apply this concept to other asset classes. Using this framework, a pension plan can determine an appropriate asset mix based on its specific liability needs.
Source: Greystone for illustrative purposes
Relating this back to the potential problem of baby-boomer retirement (as discussed in Part II), a pension plan with a larger proportion of older, retired employees has a greater need for guaranteed fixed payments compared to a plan where the majority of employees are younger and further away from retirement age.
Such a plan may opt to invest in mortgages and real estate to address this need. An advantage over fixed income, which also addresses the need for fixed payments, is that mortgages and real estate provide a degree of inflation protection and, as mentioned above, real estate further provides an opportunity for potential capital appreciation.
Read: The evolution of asset allocation: Trends and implications for asset managers
As discussed in Part II, we can also address the need to maintain a solvent position, the main reason for an increased emphasis on short-term performance. Alternative investments, specifically direct alternative investments, exhibit low correlations to Canadian and global equities (see figure below). This means that an appropriate mix of alternatives in a portfolio can prevent a pension’s total “plan assets” value from dropping significantly during market turmoil, which in turn can help maintain a healthy solvent position.
Source: Greystone for illustrative purposes
To end off our series, let’s discuss how a pension plan can address one potential challenge associated with investing in alternatives – the potential for less liquidity. Compared to selling shares of a public corporation, for example, selling alternatives investments can take more time.
Read: What does liquidity risk mean for pension funds?
We recommend investors take the following steps when investing in alternatives:
- Ensure the target mix allows for less liquid assets in recommended/appropriate weights;
- With a single asset manager, ensure there is additional room given to rebalance as needed with other asset classes;
- As an annual exercise, forecast the cash-flow needs of the plan to meet its obligations to its members;
- Communicate forecasts with the investment manager to optimize investment decisions;
- As an annual exercise, ask the investment manager to estimate how long it would take to exit a given percentage of ownership and at what cost.
The appropriate planning and management of liquidity can mitigate it as a risk or challenge. For example, a year in which many members celebrate their 65th birthday and start collecting benefits will begin a period where higher liquidity will be required as opposed to years when the age demographic of the plan is dominated by members in their 20s. Planning ahead and determining how much cash will be needed for the benefit payments can reduce the risk that a plan faces liquidity challenges.
Read: How to use a buffer to manage liquidity risk
This series has taken an all-encompassing approach to exploring the evolution that we have observed with respect to asset allocation among Canadian pension plans. Part I explained where we are in the present day, including recent trends in the evolution and what they have meant for asset managers. Part II took a retrospective approach to explain the reasons in past years that led to the evolution.
And, in Part III, we took almost a prospective approach to explain the benefits and challenges as a result of the evolution and how investors can take advantage of such benefits or mitigate risks in the future. The hope is that this series provides a good, holistic view of the evolution.