Alternative investments for pension schemes
An introduction to alternative investments: Can your scheme handle more illiquidity?
Alternative investments for pension schemes
The challenge for pension schemes
In the last few years, defined benefit pension schemes have become increasingly strained due to a combination of factors. By and large, schemes are suffering from widening deficits as a result of increased member longevity as well as lower returns from the volatile performance of traditional asset classes (equities, fixed income, and cash). Investing only in traditional asset classes means that schemes’ portfolios may not be as diversified as they can be. Pension schemes that want greater diversification, and the potential for higher yield, can look to alternative investments to solve both of these issues. Alternative investments fall outside of the three standard asset classes and are often (but not always) private, illiquid, and longer-term investments.
Alternatives within a scheme's portfolio: Features and benefits
To really understand what alternatives can do for a portfolio, trustees of DB pension schemes should consider the role of each alternative within the context of a broader portfolio (as when investing in traditional asset classes). This is crucial in appropriately constructing a goals-based investment portfolio they can stick with for the long term. Broadly, alternatives can provide return generation, risk management/diversification, inflation hedging, and allow investors to take advantage of emerging opportunities and dislocations (thematic investing).
- Return/liquidity premium: Alternative asset classes can tend to offer a fairly high rate of return compared to their traditional counterparts. However, this can come with higher levels of risk and with capital tied up for much longer. Therefore, there is also a liquidity premium: the extra compensation you would expect for the risk of locking up your capital for a long period of time.
- Risk management/diversification: Alternative asset classes tend to reduce overall portfolio volatility due to less volatility on a standalone basis, lower or no correlation with other traditional asset classes and potential outperformance relative to other investments in the event of an economic downturn.
- Inflation hedging: Certain alternatives are meant to outperform other assets when inflation is unexpectedly high. Since income is linked to inflation, investing in this type of alternative can benefit investors.
Solving the illiquidity conundrum
Institutional investors, especially defined benefit pension schemes, are long-term investors and as such may wish to consider including illiquid asset classes in their portfolio. However, as of 2020, around 82% of defined benefits pension schemes are experiencing negative cashflow1. Thus these schemes are increasingly reliant on the assets held to meet their cashflow needs and would therefore prefer that the assets are liquid rather than illiquid.1
2020 in particular presented challenges for schemes without ample liquidity in their portfolio. Why?
- Some of these schemes had fewer contributions coming into their accounts as sponsors were given the option to take contribution holidays.
- There was additional demand for cash as transfer values increased and in some cases experienced demand of 2-5x normal volume.
- Collateral calls reduced leverage on liability-driven investment allocations as long-term interest rates spiked.
- Finally, cash calls for commitments previously locked into for alternative asset classes.
Meanwhile, equity markets, where investors usually seek liquidity, fell dramatically and unexpectedly.
To meet these challenges, and ensure that none of our clients were impacted, we used our liquidity framework to first analyse the specific needs of each scheme. The asset classes in any scheme’s portfolio are classified into different liquidity and transaction cost levels ranging from those easily realisable on any given day with low transaction costs (1) to those that are daily liquid with increasing transaction costs (2 and 3) to those that are locked up for 5-10 years (5).
Many advisers stop short at the above. We take this analysis further in our second step, which is shocking the portfolio. The scheme’s assets and liabilities are stressed for economic scenarios that are expected to pose a liquidity challenge to investors, such as higher interest rates and significant drawdowns in equity markets. The stress test ensures that allocations to illiquid assets are sized to levels that are suitably robust to withstand a range of market stresses.
This gave our clients comfort that even in extreme scenarios, they were likely to have ample liquidity in their portfolio to meet their scheme’s cash needs. It is important for schemes to have access to the latest opportunities within alternatives, but to balance that opportunity with managing their liquidity needs appropriately.
Unique considerations when investing in alternatives
Though alternative investments can bring several benefits to a pension scheme, there are some additional considerations when deciding whether to include them in a portfolio, such as:
- Level of transparency
- Level of fees
- Regulatory reporting such as Competition and Markets Authority Cost and Charges of MiFID II requirements
As a scheme’s investment partner, a fiduciary manager can significantly reduce some of the challenges of investing in alternatives, helping schemes to reap the benefits from these investments.
Technology - The technology and experience to carry out operational due diligence on alternative investments is key in this space. Within alternative asset classes, whereby operational risks are potentially more pronounced, SEI has a dedicated operational due diligence team that has veto authority over manager appointments. For illiquid assets where we do not have daily transparency in the underlying holdings, we have in place a continuous monitoring platform where the service scrapes various databases for legal matters, bankruptcy and changes in regulatory filings; this informs us in real time whether further assessment of the manager is required.
Scale - Our scale means that we can directly negotiate terms for managers on our platform, including potentially lower fees. We give our clients access to specialised managers that might not be accessible in standalone investments, providing them with multi-asset expertise in a diversified, tactical portfolio.
2020 highlighted to many trustees and fiduciary managers the need to balance competing liquidity needs with appropriate diversification and opportunities for enhanced return. A robust liquidity framework, can help schemes understand their appetite for illiquidity clearly and simply to ensure that potential additional return is not left on the table.
To find out how a fiduciary manager can help your scheme achieve this balance, do not hesitate to contact us.
1. "European Asset Allocation Insights 2020", Mercer, mercer.com.
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