The Markets August 4, 2015

Addressing Liability But Maintaining Growth With Alternatives

Growth without the drawdown risk in a defined benefit plan? Alternatives may be an answer, some experts say.
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According to a white paper from Rocaton, alternative investment strategies can have a place in the growth portfolios of defined benefit (DB) plans. The primary objective of a liability driven investing (LDI) growth portfolio is to provide defined benefit plans with expected returns greater than the expected growth of the plan’s liability, the paper contends. Traditionally, growth portfolios have mostly embraced public equity strategies, Rocaton says, but although they provide strong long-term returns, equities are susceptible to significant drawdown risk that may have a negative impact on a DB plan’s funded status.

The authors of “Incorporating Alternatives in an LDI Growth Portfolio” believe DB plan sponsors should consider certain alternative investment strategies that aim to generate attractive returns with less drawdown risk than the broad equity market. Their paper examines strategies in four primary categories: long/short equity at the more liquid end of the spectrum; convertible bonds; distressed debt; and event-driven strategies.

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Rocaton lists other strategies as well, including private equity, long/short credit, managed futures, low-volatility equity strategies, and various short-duration or high-income real estate strategies.

“We recognize many plan sponsors are likely to use private equity and private real estate,” says Matt Maleri, partner and member of Rocaton’s capital markets/asset allocation group, and a co-author of the paper. Distressed debt funds, which attempt to take advantage of corporate events, are a bit less liquid, Maleri notes, likely with quarterly or annual liquidity, rather than a full lockup. The events can be anything that has an effect on the firm’s debt, from a restructuring to a bankruptcy, or anything that puts serious pressure on the firm’s outstanding securities. “They’ll buy assets cheaply and hopefully that is a way to get equity-like returns,” he explains, adding that some plan sponsors may need more explanation to help them feel comfortable with the strategy.

NEXT: Relatively liquid and easy to understand.

The strategies have a few criteria to recommend them in a DB plan, Maleri says. Convertible bonds and long/short equities, because they fall in the more liquid end of the spectrum, are probably more likely to be accepted more quickly, Maleri says. “And they generally use plain vanilla securities,” he observes. “They’re not trading in anything esoteric. Convertible bonds are pretty transparent. Most public equities traded on the exchange are easy to understand.”

If lowering volatility is the goal, says James Gannon, managing director, asset allocation and risk management at Russell Investments, introduce asset classes that are uncorrelated or less correlated with equities, such as private real estate, infrastructure or hedge funds that don’t fit traditional equities profile, which a lot of DB plans use in their growth portfolio.

The types of pension plans likely to use these strategies are split fairly evenly between plans that are open and ongoing, with new participants entering and a liability that rises every year, and those that are closed or frozen, Gannon says. “We see that closed or frozen plans are less likely to be invested in these alternative classes mostly because of their time horizon,” he explains. “It’s not long enough to gain the advantage of the time horizon. They’re looking at strategies in plan termination or annuitization, and they can’t stand the illiquidity of alternatives.”

But open plans do use alternative investments—most common are private equity investments, as well as hedge funds and private real estate—as part of the growth portfolio, as a way to control volatility and to grow, Gannon says.

Gannon notes that substantial resources are needed to oversee a program with alternatives, and that plan sponsors must be confident their time horizon and strategy won’t change for the length of time the plan is to be invested, in order to achieve the full value.

Illiquidity would make these asset classes very restrictive for plan sponsors considering ending or freezing the plan. “It makes it difficult to operate some of the risk transfer strategies,” he says, “so advisers need to gain an understanding of what the plan sponsor has in store for the plan, so the chief investment officer is not caught off guard.”

NEXT: How to balance high returns with volatility.

LDI is a comprehensive strategy, maintains Jeremy Kish, managing director of TeamCo Advisers. But many people lose sight of this during implementation when they divide the portfolio into two parts, a hedging portfolio and a growth portfolio.

“The challenge with the growth portfolio is the balance between high returns and volatility,” Kish explains. “Including high-volatility allocations in the growth portfolio is a slippery slope. The higher the volatility of assets, the greater the chance of increasing the volatility of pension plan contributions, the very thing LDI is attempting to reduce.”

An allocation to alternatives generally, and to select hedge funds specifically, can be a way to help sponsors carry less exposure to equities while preserving return generation, Kish says: “There is less risk to plan funded status—which is the goal of an LDI strategy.”

But Kish warns that including alternatives in the growth portfolio is not always simple, as all alternative investments are not created equal. “The degree of the fund’s liquidity is one such consideration that plan sponsors should ponder carefully,” he says. “If the goal is to sell the pension plan once it becomes over-funded, then any allocation to alternatives leading up to a sale should be very liquid, as the insurance companies that purchase pension plans often charge a premium for illiquid allocations.”

To that end, hedge fund strategies can be a good fit, Kish says, since they can be quite liquid (daily, monthly, quarterly) and allow sponsors to exit hedge fund investments as they prepare to sell the pension plan. 

Manager selection is critical, according to Maleri, and one of the biggest challenges in alternatives. “Strategies can look very different from one another, but performances can also be very different,” he says. “Unlike traditional public equity strategies, you could have two long/short strategies with very different performance, quarter to quarter, or year to year.”

A hefty amount of research goes into manager selection, from surveying the broad landscape through databases, to good connections with various providers, Maleri says. A compliance review or deep dive into a firm’s operations, such as their trading and compliance policies, is a good practice.

NEXT: The right manager has policies for a range of issues.

Other factors to examine are the manager’s policies for cash management, handling excess cash or trade allocation. “How do they allocate a particular security across multiple accounts?” asks Maleri, adding that the optimal policy would be to allocate trades evenly across all accounts.

“This is a field where you really have to know managers and be up to date on new shops, which open all the time,” Gannon says. “Have a fairly rigorous due diligence process, and make sure to have a process in place to keep on monitoring the managers.”

If hedge funds are under consideration, Kish recommends taking special care to educate the investment committee, since hedge funds are seemingly much more complex than many other alternatives like private equity and real estate. Since the investment committee often meets on a quarterly basis, it can be challenging to get their time and attention, but Kish calls it “critical to find a way to help them understand the benefit of how a portfolio of select hedge funds might improve the risk-adjusted returns of the plan.”

Research will be needed for the different fee schedules, Gannon says, noting that a long/short equity strategy might have different share classes with different fee schedules for each. A lower fee for a manager might have a higher performance fee, and vice versa, he explains. “For a plan sponsor to understand the implications of different fee schedules is critical,” he says.

The fees should be in line with the manager’s expectations for the product, Gannon explains.” If it’s a low-tracking error, low-expected return product, we wouldn’t want high fees,” he says. “But if the manager and consultant have high expectations for returns, maybe higher fees are worth it. The fees being charged should be aligned with the manager’s investment philosophy. If someone’s charging much higher or much lower fees, you should question why that is.”

Ultimately, Gannon says, the message for plan sponsors is that for all their caveats, alternatives can be worthwhile. “It makes a ton of sense for pension plans,” he says.

The Markets August 4, 2015

A 60/40 Approach to Decumulation

Experts suggest a “portfolio” approach can be an adaptable and effective means of controlling retirement spending.
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The decumulation phase challenges both users and providers of retirement plan services, explains Steve Vernon, a consulting research scholar at the Stanford Center on Longevity and a former actuary.

He says the Center for Longevity has tested a “portfolio” strategy for directing the drawdown of retirement assets—with good results. The strategy involves a participant building “a floor consisting of one or more sources of guaranteed income—Social Security, a pension, maybe an annuity—which won’t go down with the stock market and will last as long as you do,” he says.

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Money from the secured portion of the portfolio should be earmarked to cover basic living expenses. The rest of the participant’s savings can be invested aggressively and used at discretion, say for travel, hobbies or gifts, says Vernon, who is also a retirement adviser at the nonprofit Institutional Retirement Income Council. This strategy resembles a traditional 60/40 investment portfolio of stocks and bonds, except that the bond portion is now a guaranteed lifetime income source.

This is especially effective when the market plummets, he says. Withdrawing money from investments in decline is “the worst thing you can do. The floor psychologically helps people. They can let the money ride.”

Plan sponsors can facilitate the approach, he says, by offering an annuity through the plan and educating employees about how the strategy works and how it can be implemented.

To plan sponsors that have simply put off adding a product because they’re waiting for the market to evolve, Vernon says his advice to this group is that “there are plenty of good, credible ways now to generate retirement income. Not to say there might not be more innovation in the future, but there are robust offerings now, and plan sponsors that are motivated don’t have to wait.”

NEXT: Insurance pros and cons 

Basically, what plans have to choose from are deferred and immediate annuities, with fixed or variable payments—the latter, in some products, adjusted for inflation. Each manages risk in a different way. “I’d want to walk through with my client the risks the participants face in retirement, and how each of those products and services addresses those risks,” adds Bruce Ashton, a partner in the employee benefits and executive compensation practice group at Drinker Biddle & Reath LLP says.

“The insurance companies have been fairly innovative in developing insurance features that could be placed inside a plan,” says Vernon. A popular option is the guaranteed lifetime withdrawal benefit (GLWB), or guaranteed minimum withdrawal benefit (GMWB), Prudential’s IncomeFlex series being an example, he says. This provides monthly payments but gives the participant more flexibility and control than does an annuity.

Stewart Lawrence, senior vice president and national retirement practice leader with The Segal Group, says of the annuity products available, he likes longevity/deferred annuities, which generally begin to pay out when the retiree reaches 85. Today’s low interest rates make these expensive, though, he says. Assuming that rates will climb, a retiree could spread out the purchase—five payments over five years—to average out the cost. Keep in mind, however, that this will mean five execution fees, versus just the one, Lawrence says.

Lawrence is less impressed with immediate lifetime annuities, which he describes as the opposite of life insurance: Make one grand payment and immediately begin to receive small payments back. “The purchase of one requires irrevocably locking up a large amount of capital—perhaps $15 to $20 per $1 of annual annuity.”

NEXT: Products outside the plan

The plan sponsor should also investigate products available outside the plan, as well. Vernon likes managed payout funds, a systematic withdrawal strategy offered by most mutual funds. “Those might be good for someone who has money in an IRA and doesn’t want to think hard about it. You set up an IRA with Vanguard and say, ‘I want to put my money into a managed payout fund.’ Vanguard will say, ‘Tell us where to send the check.’ They automatically send a check every month and will do the asset allocation for you.”

Performing asset allocation is an important benefit, Vernon says. “It’s even more critical after retirement, compared with accumulating money before.”

If the strategy itself does not offer this service, the plan adviser can provide it, in the early stages when helping the participant arrive at a personal plan. Because an employee may have several abandoned defined contribution plans and/or IRAs, the adviser could also suggest consolidating them into one—such as the managed payout fund. He should first review the details of each with the participant to ensure the money stays where fees and expenses are most favorable.

Some plan sponsors may wish to hand off all such responsibility, though. For them, the alternative could be an advisory service. Increasingly, plan administrators supply this service, not to mention retirement income solutions, annuity products and communications, Vernon says. “That can be a feature if you’re doing a vendor search for a new plan administrator—what support does the plan administrator have for retirement income?”

Fees will always be an issue to some degree, whether participants are accumulating money or retirees drawing it down. For one final strategy, he suggests that advisers urge their clients to adopt institutionally priced funds whenever they can. “There will always be administrative or investment fees,” he says. “If retirees keep their money in a 401(k) with lower fees, that will make their money last longer.” 

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