The toolbox for defined benefit pension plan sponsors has expanded recently, and the profusion of new compartments available to pension plans might finally mean the end of the typical 60/40 asset mix. As we've read on these pages, plan sponsors have lately added more active risk from products such as 130/30, portable alpha, private equity and infrastructure, in many cases while reducing interest rate exposure through liability-driven investing.
It might be that a shift is upon us in investment policy — from a percentage allocation to various asset classes to an approach that targets specific risks with both skill-based active returns and market-based passive returns. The adoption of many of these engineered investment strategies by plan sponsors represents a significant migration from the typical pension portfolio allocation of 60% equities and 40% bonds. This approach might result in a portfolio whose exposures might actually add up to more than 100% but that has less risk from an asset/liability perspective. We propose 180/100, but we believe that each pension plan will gravitate to a mix that best matches the plan's liabilities while keeping contributions at a reasonable level.
What makes us think that pension plans are ready for this shift in thinking? The most prominent example is the rapid embrace of 130/30 and other so-called extension strategies by pension plans and their consultants. Recent performance issues aside, the willingness of plan sponsors to seriously consider and allocate in large numbers to these products reflects a significant shift in mindset by pension plan boards. According to data compiled by Pensions & Investments, 53 managers ran $66 billion in active extension strategies as of March 31 (P&I, April 28).
As recently as two years ago, if an investment manager described a vehicle that shorted stocks and contained considerable leverage, many trustees would have stopped the discussion. They would have likely concluded that the fund in question was a hedge fund and would have ended the meeting because their plan did not invest in alternatives.
However, one of the appeals of 130/30, of course, has been that these strategies do not seem so different to plan sponsors from long-only allocations even though such extension strategies are closer to previously forbidden investments like hedge funds and portable alpha than to long-only equity investing. Indeed, they are typically managed by many of the same firms that already handle portions of existing long-only equity allocations. Pension plan boards are finding out that the line between alternative and traditional investments may be less sharp than previously imagined.
We would welcome the end of this artificial traditional/alternatives distinction. This undue focus on asset compartments calls to mind a carpenter who overlooks the function of his tools as he obsesses over where they can be found in his tool box. Looking at an asset allocation as a continuum instead of a series of compartments allows DB plans and their consultants the flexibility to adopt a broad range of investment strategies that run the gamut from pure alpha to pure beta and everything in between. The old 60/40 starts to become unrecognizable under this continuum approach.
For a more specific example, we could extend the concept of a 130/30 fund to the analysis of a defined benefit plan as a whole. If a pension plan board allows an asset manager to run 130/30, why would the plan still limit itself to 60/40? We can start by thinking of a defined benefit plan as being “short” a long bond position, because the plan owes payouts to retirees in the distant future. We might then regard the starting exposure for the plan as “/100,” as in having a 100% short position. To manage this interest rate risk, a plan manager might enter into offsetting interest rate swaps so the plan can now be thought of “100/100.”
Because swaps do not typically require cash upfront, the plan can still invest in a diversified array of active and market exposures (we're not using “alternative” and “traditional” terms anymore). As long as the return of these exposures exceeds the cost of the swap (somewhere around LIBOR), we can add value for retirees. If a plan invested 80% of its assets in this way, you would have a 180/100 portfolio that has neutralized much of its interest rate risk and yet maintains upside return opportunity to improve the plan's funded status and keep costs in line. This example is not hypothetical — our firm recently worked with a defined benefit partner to implement just such a solution.
This is but one example of the flexibility offered to plan sponsors once old constraints are loosened or jettisoned altogether. The forward-thinking and rapid embrace of 130/30 by pension plan executives and their consultants should proceed to a review of the entire DB plan in a whole new light. We have proposed 180/100, leaving the old 60/40 tool in its narrow compartment, but each plan can now rummage through the entire investment toolbox to see what else might improve the ability to meet promises to plan members while decreasing the risk and burden to the sponsoring corporation.
Bob Kulperger is New York-based vice president-marketing and client services, Northwater Capital Management Inc., based in Toronto.
