... as funds eye alternatives hike

Industry sources agreed with Mr. McHugh and said to better match liabilities, many corporate chief financial officers — who likely will play a much bigger role in pension oversight than they have to date — are already moving assets into long-duration bonds and using swaps to control interest rate risk.

Data from JPMorgan's survey of investment decision-makers at 75 large corporate U.S. defined benefit plans this summer found that 17% already are using an LDI strategy and another 41% are considering doing so. (See related story, page 6.)

In addition, sources predict many pension funds will invest more heavily in alternative asset classes and non-correlated alpha sources such as real estate, private equity, hedge funds and venture capital.

The JPMorgan Survey found 11% of the corporate plans anticipate raising their real estate allocation; 27% will increase private equity; and 17% will increase hedge fund investments.

Mr. McHugh — who has both a pension fund management and corporate finance background — predicts traditional final-average-pay defined benefit plans will move to about 30% of assets in alternatives because they still are interest-rate sensitive and will need to have more assets in duration-controlled strategies. Cash balance plans, on the other hand, will move closer to a 50% alternatives allocation to pump up returns, Mr. McHugh said.

Moving to an alternatives weighting of between 30% to 50% represents a huge leap for most corporate defined benefit plans, given that JPMorgan survey data showed that as of Dec. 31, private equity, real estate and hedge funds collectively accounted for just 8% of total assets. Drilling down for more specifics, JPMorgan researchers found corporate plans included in their survey had an average allocation to real estate of 6.1%; 4.9% to private equity; and 6.9% to hedge funds in midsummer.

The new requirements of FAS 158 and the funding requirements of the Pension Protection Act are changing the investment horizon, Mr. McHugh said.

"When pensions were off the balance sheet, pension managers had a very long investment horizon. Now that the pension number is on the balance sheet, they need to manage that plan on a short-, mid- and long-term basis. And pension managers now have the dual job of enhancing benefits for participants and enhancing shareholder value. The last thing a CFO wants to have to explain on an analyst call is why the pension plan is creating so much volatility in the company's earnings," he said

Many money managers are gearing to meet demand for both LDI and alternative investments, as well as to offer clients consultative advice about portfolio construction using these as well as traditional asset classes.

Sources said money managers that will thrive in the changing investment landscape of the next three to five years must offer both liability-driven fixed-income strategies (with in-house swap contract capabilities) and a broad range of alternative strategies. Bigger shops will integrate these investment approaches with an in-house consulting unit or "solutions" group.

Those picked by sources as most likely to succeed are JP Morgan, Goldman Sachs Asset Management LP, Morgan Stanley Asset Management, Bridgewater Associates Inc., Pacific Investment Management Co., UBS Global Asset Management, Barclays Global Investors, BlackRock Inc. and Wellington Management Co. LLP. No two sources had identical lists.

"Everyone is talking about how to meet changing client demand. There is not a serious global asset management firm that hasn't been thinking about this," said vendor consultant Yariv Itah, a partner at Casey Quirk & Associates LLC, Darien, Conn. "You will see money moving out of equities and into (liability-driven investing) and alternatives as soon as corporations start feeling the pain of FAS 158," he said.

Mr. Itah predicted about one-third of companies with defined benefit plans are "ready to stop worrying about this problem that has been inserted into their lives and will take action (such as large shifts into LDI and alternatives strategies), possibly as soon as the first quarter."

Another one-third of corporations, with funding levels of between 85% and 110%, will be comfortable enough that they won't feel the need to take any immediate action, while the remaining third are too underfunded to do anything, Mr. Itah said.

Michael Peskin, managing director and head of global pension solutions for Morgan Stanley, New York, agrees that client demand for LDI and alternatives is rising sharply, although he doesn't fully accept the contention that corporations will move quickly to allocate between 30% and 50% of assets to non-traditional strategies.

"It's becoming very clear to CFOs that they are caught in a bind. They are definitely moving to alternatives in order to de-risk the portfolio and to keep current corporate income up," Mr. Peskin said. In fact, he said he moved earlier this year to the pension group from the investment banking side of Morgan Stanley.

BGI officials think the drive toward LDI soon will cause a fundamental shift in client benchmarks from traditional ones such as the Wilshire 5000 or Lehman Aggregate to "liabilities plus X basis points, be that 50, 100 or 200," said Carter Lyons, a strategic account manager.

"The returns portion of the portfolio will come from the alpha and will dial up or down depending on the risk budget of the client," he added.

Managers will have to develop a wide breadth of abilities to provide solutions for clients, said Greg T. Fedorinchik, executive director and a strategist in UBS' global investment solutions group.

Those skills include an understanding of liabilities; broad experience and understanding of derivatives in order to write interest rate overlays; abundant alpha sources; asset modeling and active asset management experience; the ability to separate and manage beta; critical risk management processes that are purpose-built internally; and an open-architecture investment platform that permits inclusion of third-party managers needed for diversification.

"People think (managing defined benefit portfolios) is as simple as plopping an interest rate swap onto the portfolio and hedging liability, but it's just as important to make sure that alpha generation is as big a part of the equation," Mr. Fedorinchik said.