The Role of Alternative Assets In a Liability-Aware Portfolio
In this paper, we discuss the role of alternative assets in liability aware portfolios. The COVID 19 pandemic has caused significant market turmoil, temporarily freezing some markets, such as real estate, whilst providing opportunities in the private and public credit markets. The long term strategic case for including alternative assets in liability aware portfolios has not changed; we would help clients think about a suitable entry point and appropriate implementation program.
Pension sponsors seeking to reduce risk and improve cash flow in their portfolios are faced with a two-part challenge. First, demand for traditional, liability-aware assets such as bonds is growing, as more and more sponsors move to reduce volatility in funded status.1 Second, even as demand for bonds intensifies, the supply of high-grade fixed-income assets is falling.2
To meet this challenge, we’re working with our clients to think more expansively about the full range of liability-aware assets that’s available to them. We’re finding contractual assets with expected returns in excess of traditional liability-aware investments. These assets can provide the inflation protection and cash flows that pensions need, while complementing their liability-matching fixed income exposures and diversifying their traditional return-seeking assets.
This type of solution is possible only by breaking down the bright line that has conventionally divided the growth and liability-aware portfolios of a typical pension on a glide path to maturity. This bifurcation can cause portfolios to focus only on the most growth-oriented (and therefore, often the riskiest) and the most liability-matching (and therefore, often the safest assets), while missing opportunities in more middle-of-the-road assets. By thinking less dogmatically about the split between growth and liability-matching assets, we can identify opportu¬nities that serve the overall portfolio better.
Rethinking the role of private investments
Private investments are an area where we’re finding compelling risk/return opportunities with liability-matching characteristics. Pension plans have typically relegated private investments to their growth portfolios. We believe a more nuanced approach can uncover attractive investments for the liability-matching portfolio as well. Like publicly traded securities, private assets span a range of risk/return profiles – a range that has only increased over the last decade.
For instance, many of our UK clients include long-lease property (LLP) investments in the matching portion of their portfolios. These properties generally have 20 to 30 year leases, with cash flow characteristics similar to bonds. They offer contractual income backed by high-quality tenants, sometimes companies that issue investment-grade bonds. Expected returns for LLP investments are currently in the range of 4% to 5% – meaningfully higher than those of government or even high-grade corporate bonds. Moreover, these leases generally incorporate escalators every five years, providing an inflation-protected return stream that matches pensions’ liability attributes.
Other private assets offer similar characteristics and are thus candidates for liability-aware portfolios. Cash flowing real estate offerings go a bit further out on the risk curve, while offering regular and stable income consistent with the needs of a matching portfolio. Core properties, as represented by the National Council of Real Estate Investment Fiduciaries’ Open End Diversified Core Equity Index (NFI-ODCE), generated a 5.6% annual return as of third quarter of 2019.3 Some of these funds are struggling with exposure to the retail sector or capital intensive projects, but larger investors can structure more defensive, income producing real-estate investments through separate accounts. This approach provides the ability to customize the mandate and gain more control over the timing of the exit, often at lower fees.
Private corporate debt, real estate debt, and core infrastructure are other areas that offer attractive cash-flow yields, currently around 4% to 7% for senior debt.4 Although real estate, infrastructure and private credit investments provide duration, it is typically shorter than pension plan liabilities. We seek to customize our use of these investments in combination with longer-duration, traditional liability-aware assets, in line with each client’s particular profile.
Keeping an eye on liquidity
Of course, there is no “free lunch” in finance. The tradeoff for private assets’ compelling cash-flow characteristics is illiquidity of principal. These investments cannot be sold easily, and if a plan absolutely needed to monetize these investments quickly, it could take a meaningful haircut on the valuations.
Here the nature of pension liabilities works to plan sponsors’ advantage. The liabilities are often highly predictable decades into the future, making it relatively easy to manage illiquidity. Over our more than 40-year history of investing in private assets on behalf of corporate pensions, State Street has developed tools and expertise to manage illiquidity of principal within the context of an overall pension plan.
In the current market regime, where traditional liability-matching assets offer low returns and pension sponsors expect and require healthy 3% to 6% returns to meet their promises to their participants, we believe that pension plans need to rethink historic definitions of matching assets. Sponsors should consider incorporating private investments into the liability-matching portions of their portfolios. With highly predictable cash needs, the risks of illiquidity are far more manageable for pensions than the potential for low returns or losses in competing with central banks and other investors for a dwindling supply of bonds.
By thinking more expansively about assets that can match pension liabilities, State Street can help pension sponsors and other investors with long-term investment horizons to find the opportunities that can enable them meet their objectives and settle their liabilities as they fall due.
1 A growing number of pension plans are reaching maturity or finding themselves in a cash-flow negative position and seeking to de-risk as a result. As they do so, they typically shift from risk-seeking assets including equities to traditionally liability-aware assets, such as bonds. In the UK, pension plans have increased their allocations to bonds from 18% in 2001 to 50% in 2018 on average. (Source: Willis Towers Watson, 2019.) In the US, pension plans have increased their allocations to bonds from 31% in 2003 to 50% in 2018 on average. (Source: Mercer Asset Allocation Study, 2018.)
2 Government and high-grade corporate bonds have become increasingly scarce. Central banks around the globe are competing to buy government bonds in an effort to pump liquidity into the banking system, causing yields on government bonds to collapse. High-grade corporate bonds are also increasingly difficult to find. Central banks have been snapping up corporate debt in recent years. As of the end of 2018, for example, the European Central Bank was carrying approximately €24 billion of corporate bonds on its balance sheet. (Source: European Central Bank, https://www.ecb.europa.eu/pub/annual/balance/html/index.en.html, 31 December 2018). At the same time, growth of publicly traded debt has been slow. In the first nine months of 2019, US mortgage-related securities issuance fell 1.5% versus the prior year. US investment grade corporate-bond issuance grew only 2.6% over the same period (Source: SIFMA, as of 30 September 2019).
3 Source: National Council of Real Investment Fiduciaries (NCREIF), as of 30 September 2019.
4 Source: State Street Global Advisors, as January 2020
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