While defined benefit plans are traditionally known for their paternalism, defined contribution pensions represent the next generation. Learning from their parents’ years of investment experience, DC plans are catching up, but hurdles still exist in the quest to invest like DB plans.
The liquidity question
As more DC plan sponsors consider adding illiquid alternatives to their investment portfolio, the fundamental question is how to manage constraints, such as the requirement of daily valuation or the potential of imminent trading.
The record-keeper platforms used by the majority of Canadian DC plans were built to accommodate daily-traded funds, says Andrew Sweeney, vice-president and portfolio manager of Canadian equities at Phillips, Hager & North Investment Management. “I think we are a decade behind in DC where we are in DB, in terms of where alts are being implemented for plans.”
But do DC assets need to be daily tradeable? “I think that’s an important question,” says Sweeney. “The daily liquidity is perceived as being quite important to plan members and so the plan sponsors place value on it based on plan members asking.”
Of course, the major record keepers can produce platforms that allow for less frequent trading, he adds, noting asset managers are discussing how to fit illiquid asset classes on record-keeper platforms in a functional way.
But Erick Zanker, managing director of alternative investments at RBC Global Asset Management Inc., says it’s important to avoid shoehorning an asset onto a platform it isn’t designed for, at the risk of compromising that asset’s distinct value. “We need to be very mindful how we think about adapting a strategy to a platform when the very nature of the strategy — it being illiquid, as an example — is what drives, to some degree, the additional return and is what clients are actually looking for.”
The real deal
In the U.K., the government is steering the conversation around DC plans using alternative, less liquid assets, says Maria Nazarova-Doyle, head of DC investment consulting at JLT Employee Benefits in London. Following a consultation on the subject, the government is actively encouraging DC plans to consider these alternatives and set clear policies about these investments.
“The government is also hoping this will bolster investments in the U.K. economy — in infrastructure, social housing, all these kinds of projects. So I think it could be a win-win,” says Nazarova-Doyle.
While some alternative investments may seem over the heads of many DC plan members, real estate is one asset class virtually everyone has to come to grips with at some point in their lives, says Sweeney. Indeed, he notes that’s part of why pure real estate plays have been a common stand-alone option in DC plans for a while.
“Absolutely, people who manage [real estate] are thinking carefully because those asset classes are so logical for both DB and DC.”
Infrastructure, another real asset, bears many of the same advantages as real estate: it often involves an income stream and is inflation-sensitive. But standalone options tend to have heavy exposure to listed infrastructure or real estate investment trusts, which don’t have the same asset characteristics as physical real estate investments, says Zaheed Jiwani, principal at Eckler Ltd.
However, he adds, pure exposure to real assets does begin to creep in, albeit in a limited way, in multi-asset strategies such as target-date, target-risk and balanced funds.
In 2015, when Teck Resources Ltd. completed its latest asset mix review, it found its DC plan could benefit from an allocation to real estate and infrastructure, says Sahar Sharafzadeh, senior analyst in the organization’s treasury department. “We’ve had an intention to align, as much as we can, the investments of our DB plan to our DC plan.”
Teck Resources’ five target-risk funds all feature some combination of real estate and infrastructure exposure, plus an allocation to mortgage debt for added liquidity. Its most conservative target-risk fund holds 10 per cent in these asset classes, while the other four funds hold 15 per cent.
While the appeal was clear from a long-term liabilities standpoint, Sharafzadeh says adding these assets was also about fairness: ensuring the company’s DB and DC members both had the same option.
Not so private anymore
As DC plans begin integrating infrastructure and real estate exposure into their investment portfolios, private equity is trickier, says Kevin Albert, a partner at Pantheon Ventures, though he notes it can be done.
It’s in the private equity management industry’s best interest to follow the money as it flows into DC plans, he adds. “DB plans have been the 800-pound gorilla funding private equity, so the leakage or movement from traditional pension plans to DC plans makes it very important to the private equity industry that they figure out how to tap into that market.”
And with fewer organizations sponsoring DB pensions, it’s important for DC plans to find return-generating assets, says Albert. Traditionally, public equities have filled this role, but their volatility can be nerve-wracking for DC members without the more stable promise of a DB plan, he adds, noting it could be comforting to find alternative assets that don’t demonstrate so much volatility.
“From the individual [plan member’s] standpoint, they no longer have any assurance of the cash stream they’d get from the company. The cash stream they get in retirement is going to be based on them saving, . . . the investment decisions they make and market performance. If the market crashes, no matter how smart you are, you’re probably going to see the value of your account go down.”
One hurdle, however, is that private equity as an investment strategy grew up alongside DB pensions, so its current structures and procedures are highly tailored to those plans, says Albert. As an example, he refers to a 10-year, closed-end private capital fund.
“None of the investments flow through an individual’s account and none of them have to be priced. They don’t have to be liquid because it’s a fairly small portion of the pension plan and you don’t have to worry about treating people equally in terms of management fees and gains.”
Indeed, the issue of fees is an important consideration. When joining certain private equity funds, investors will begin paying management fees before their capital is called to make the actual allocation, says Albert, noting what works easily for a DB plan simply isn’t fair in a DC context.
For example, if a DC plan offers a vehicle with an allocation to a private equity fund, the plan members may be required to pay specific management fees when they join. However, there isn’t necessarily a structure to ensure new members who later choose the vehicle retroactively pay their fair share of the management fees, says Albert. Since those new members still receive the potential advantages of exposure to the private equity fund, it would create an inequality between plan members, he adds.
This complexity rules out the practicality of using private equity as a stand-alone option within DC plans, notes Albert, but the asset class can work as part of a multi-asset managed strategy, such as a target-date fund. He says this option is becoming widely used in the U.S., where older DC plans are taking more investment decisions in-house and tailoring target-date funds to a particular workforce.
In that context, it’s important to remember how private equity will blend with a glide-path structure, he adds. When a DC plan member is younger and their equity allocation is high, for example, the private equity component should be at its largest, and should work its way down over the years.
Grinding gears
Fees remain one of the fundamental issues making alternative assets impractical for DC plans, says Niall Alexander, head of DC solutions at U.K.-based River and Mercantile Solutions.
Across the pond, where the DC market is booming, fees are heavily regulated, so the vast majority of alternative funds can’t be used. “We have a fee cap in the U.K. of 0.75 per cent on any DC default,” he says. “That causes a problem because some of these alternatives funds can be quite expensive.”
This fee cap virtually eliminates the possibility of using a fund with a performance fee, he notes. And for DC plan members, who are already likely to have a low allocation to illiquid asset classes, that exposure would be even smaller due to the cash or liquid element required in daily-dealt funds, adds Alexander. As a result, the higher fees that plan members are likely to pay for these funds wouldn’t make the investment worth it.
A similar cap doesn’t exist in Canada, but certain regulators, including the Office of the Superintendent of Financial Institutions, have provided guidance urging DC plan sponsors to be conscious of fees when choosing which investments to make available to plan members.
In the U.K., Alexander sees an impetus for change to make it easier for DC plans to use alternatives. “There is certainly a lot of chatter, . . . particularly in the environment we’re in now, where we’ve just had a bit of a wobble in markets. Everyone here is asking, ‘What can we do to try to protect against that?’”
Indeed, the view that higher returns are possible through alternatives is one driver for using them in the first place, says Nazarova-Doyle. “If you’re going to pay quite a lot more money compared to your passive strategies and your cheap, plain, vanilla funds, then you need to have a reasonably high conviction that you’re going to have better returns. I believe you get better returns, but I’ll say it is important to do your due diligence properly.”
Love the game, but watch the players
While DC plans have started to enjoy the perks of scale traditionally reserved for DB plans, many plan sponsors have yet to realize the new options that scale entails, says Jiwani.
Historically, Canadian DC plans have chosen to partner with a single record keeper with investment management capabilities because it was a more economical choice to bundle the services, he says. But with the evolving scale, DC plans have the option to behave more like DB plans in a number of ways.
“In the DB world, you could . . . do a specific search for private equity or debt or real estate, whereas in DC, you’re doing a search for a target-date suite or a balanced fund. And then you’re hopefully looking at the pieces under the hood.”
A suite of funds managed by a single record keeper is predisposed to include the asset classes already managed by that record keeper, says Jiwani, noting this introduces a bias that plan sponsors should consider. “Very few will actually go outside of their walls and take a different sub-advisory manager, where that really might be in the best interest of DC plan sponsors.”
All of Canada’s major record keepers have alternative asset management capabilities, but they differ in terms of the alternatives they specialize in and so, by extension, do their fund allocations, he says. But that relationship is changing.
“Plan sponsors that were previously tied to only being able to select what is within a record-keeper’s investment platform are now able to go out and do a true search as they would have done on the DB side.”
Teachable moments
In many ways, it comes down to simplification. The final quarter of 2018 illustrated how a simpler portfolio that relies heavily on public equities and fixed income can be affected by a market downturn, says Kevin MacKenzie, investment consultant at Westcoast Actuaries Inc.
“In the fourth quarter, our balanced fund universe fell by almost five per cent, which is just made up of stocks and bonds. With the inclusion of alternatives, that would have been softened quite a bit more. So from the perspective of reducing portfolio volatility, if you’re say, 60 or 65 years old, you don’t want to see your total portfolio fall five per cent over a quarter.”
It’s a good opportunity for DC plan sponsors to learn about the benefits of including alternative assets, particularly in their default fund options, says MacKenzie. But he also notes it’s important they understand that lower volatility doesn’t automatically correlate to lower risk, though it can mitigate behavioural risk. With less volatile assets, fewer situations are likely to arise where plan members are shocked by a sudden devaluing of their investments and sell at an unfavourable time, he notes.
For alternative instruments, risk goes beyond simple jumps in price, says MacKenzie, noting plan sponsors need to understand these assets’ risk characteristics and how problematic scenarios play out in practical terms. “If it’s a private debt fund, what’s the asset recovery? What does the asset recovery look like if the borrower gets into trouble? You have to do a bit of a deeper dive into due diligence and you have to be able to communicate that.”
This is an excerpt from an article originally that appeared on CIR’s companion site, Benefitscanada.com. Download the Top 40 Money Managers Report and read the full story here.
