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NEPC Recommends Investment Strategies for Pensions in a Low-Return Environment
In a survey of 180 pension plans with $280 billion in assets, NEPC discovered that pension plan sponsors expect their portfolios to return 7% or more, which NEPC says is unrealistic.
Instead, over the next five to seven years, NEPC expects
large-cap equities to return 5.75% and core bonds 2.65%, the company says in
its new report, “Power Up Your Pension Plans.”
The reason returns will be lower, NEPC says, is because in the past few
years, low inflation, declining bond yields and expanding valuations have
boosted the markets. At this point, NEPC says, many assets are now overvalued.
Thus, NEPC suggests several ways that pension plans can boost returns, starting
with investing in Treasury Separate Trading of Registered Interest and
Principal of Securities, or STRIPS. “Capital-efficient instruments, such as
STRIPS, allow investors to achieve long duration with a relatively low amount
of assets compared to a traditional long-bond approach,” NEPC says.
In addition, “Dual-beta strategies allow an investor to obtain two market
exposures in a single fund,” the firm says. “The most common combination for
liability-driven investors is U.S. large-cap equity and U.S. long duration.”
NEPC also encourages pension plan sponsors to consider long-bond allocations
that are actively managed. Not only does this offer better returns on the
upside, NEPC says, but it can “also help avoid or reduce downgrade risk.”
Within fixed income, NEPC encourages sponsors to look for direct-lending
strategies in private markets, particularly for sponsors at the earlier stages
of derisking able to lock up their capital for longer periods of time than
those at later stages. “Skilled managers in this space are able to achieve
returns in the 8% to 10% range on an unlevered basis,” NEPC says.
NEPC also prefers bank loans to high yield. Outside of the U.S., the firm is
interested in emerging market debt denominated in both U.S. dollars and local
currency.
Among equities in the public markets, NEPC is partial to emerging markets,
which it expects will return 375 basis points more than U.S. large-cap
securities. Among equities in the private market, NEPC says it acknowledges “that
generating outsized gains in private equity may be challenging, [but] our
return assumption for private equity is still meaningfully higher than
traditional U.S. stocks.”
Since pension plans need to have at least a portion of their assets in cash to
pay retirees, NEPC says, that can reduce returns by 10 to 20 basis points. To
counter that, NEPC recommends “securitizing cash via a futures overlay that
seeks to replicate [the sponsor’s] policy target as closely as possible.”
Finally, NEPC looks for an additional boost from the lowest-cost investment
vehicles possible. “When we expect low returns, every basis point counts,” NEPC
says.
NEPC’s “Power Up Your Pension Plans” can be viewed here.
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