By Ian Hamilton
Today’s pension funds face severe headwinds. Weak investment returns combined with typically longer lifespans for retirees have left many funds facing a growing funding gap.
The scale of the problem is huge. In the UK for example, the aggregate deficit for the DB schemes of FTSE 350 companies stood at £90bn as of 31 August 2014.(1) More than a quarter of European pension schemes currently have negative cash flow, a figure that is expected to double in the next five years.(2) Meanwhile, the US market for defined contribution (DC) schemes is forecast to have a negative cash flow by 2020.(3)
These challenges are driving pension funds to strike a new balance on risk and return. State Street research, based on a global survey of 134 senior executives in the pension fund industry, found that 77% of respondents expect their institutions’ investment risk appetite to increase over the next three years.
Pension funds are undertaking a root-and-branch reassessment of their portfolios. They are looking to find the right mix of assets to drive higher returns, while also keeping costs under control and minimizing their overall risk exposure. It is a delicate balancing act.
The big move into alternatives
Alternatives traditionally made up just a small part of pension funds’ portfolios compared with equities and fixed income products. Now many pension funds are making bigger bets on alternative assets. Recent figures suggest that pension investors are increasing their exposure to alternative assets faster than any other investor group. Pension fund investment held by the top 100 alternative asset managers increased by 8% to US$1.3trn in 2012.4
According to our survey, private equity is the top priority of all alternative asset classes, with three-fifths of respondents planning to increase allocations into this area. Impressive returns in recent years make private equity an attractive option. Strong equity markets and exit activity helped investors to achieve a record-high payout of US$568bn from private equity investments in 2013.5
A significant proportion of pension funds also say they will invest more in infrastructure (39%) and real estate (46%). These investments are popular partly because, as long-term assets that deliver returns over their life cycle, they match well with pension funds’ long-term liabilities.
Pension funds are also targeting hedge funds for investment. Globally, 29% of pension funds that already invest in hedge funds will increase their allocation, while 25% will invest in this asset class for the first time. CalPERS’ announcement in September 2014 that it would pull US$4bn from its hedge fund investment program sparked speculation that other pension funds might follow suit. But the general trend still looks positive for the hedge fund managers who are able to offer a reliable source of alpha returns.
A new approach to risk management
The surge in investment into a range of alternatives has significant implications for the way pension funds think about their risk budgets, and is driving them to become more innovative in how it gets spent. As pension funds re-weight their portfolios into higher-growth assets in a bid to boost performance, they’re also seeking to construct a mix of de-correlated assets that can keep the overall risk profile down.
Understanding how different combinations of alternative and traditional asset classes affect total risk exposer remains difficult, however. And the challenge is exacerbated because many alternatives require a different approach to risk modeling. Pension funds will need to factor these complexities into their calculations as they adopt a new risk budgeting model.
The ability to evaluate risk-weighted performance at multiple levels — from individual asset classes and instruments right up to a total fund perspective — will increasingly distinguish the leaders in the industry. Such an integrated view is difficult to achieve with traditional risk management tools, since they tend to focus on a single asset class. Pension funds therefore need to invest in analytics technology that can provide a coherent view of risk and performance across a multi-asset portfolio.
At the same time, far greater emphasis will need to be placed on strong data governance and ensuring better quality of data. Finally, to fully benefit from these improved tools and data, pension funds will need to bring in specialist skills in analyzing risk across multi-asset portfolios.
The shift to alternatives is gathering pace. The state of today’s investment environment and the growing strain on retirement funds exerted by an aging population suggest this trend will continue to accelerate going forward. Pension funds must respond with new ways of allocating their risk budget if they are to achieve the right balance of risk and return across an increasingly complex mix of asset classes.
Ian Hamilton is head of asset owners at State Street
1 “Historically low bond yields hit pension scheme deficits during August,” Mercer, 5 September 2014
2 “Pension funds seek ‘sweet spot’ in alternatives,” Financial Times, July 13, 2014.
3 “US pensions ‘cash negative’ by 2016,” Financial Times, June 8, 2014.
4 “Pension funds press forward on alternative route,” Financial Times, 7 July 2013
5 “The 2014 Preqin private equity performance monitor,” Preqin, August 2014
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