How DB plans benefit from using comingled pools in an SMA

In many cases, comingled investment vehicles are the more effective tool for corporate plans pursuing liability-driven investment (LDI) strategies

After last year’s positive trends for corporate pension plans that helped improve funding ratios, the outlook for 2025 and beyond has become increasingly uncertain. Concerns about economic growth, inflation, and potential market volatility are making it more difficult to navigate the investment landscape.

To protect the gains they’ve achieved so far and strengthen their ability to meet long-term obligations, corporate plans need a well-designed, nimble, and liquid investing strategy that can withstand turbulent market conditions while staying aligned to the plan’s unique liability profile. That goal often inspires plan sponsors to establish a separately managed account (SMA) with an experienced asset manager and then direct that manager to assemble a portfolio of handpicked individual securities.

The widespread assumption behind this approach is that individual securities are the best way to deliver a truly customized asset allocation for each plan’s unique liability profile. In reality, allocating to individual securities inside an SMA can often limit a plan’s ability to meet important objectives, such as matching liabilities and reducing tracking error.

Instead, there is a better solution for many plans: Creating a customized portfolio using comingled funds, such as State Street’s LDI building blocks.

Here are four advantages of using comingled funds inside an SMA.

1. Lower costs

Choosing comingled funds instead of individual securities can be a more cost-effective way to build a customized portfolio. All else being the same, an SMA of comingled funds can have lower management fees than an SMA of individual securities because the scalability of pooled assets makes those funds cheaper to manage.

Likewise, the availability of low-cost hedging index funds targeting different segments of the fixed income markets can create lower trading costs when building or rebalancing portfolios. Investing and rebalancing in comingled vehicles often does not require the actual buying or selling of securities. By contrast, it’s not uncommon to see bid/ask spreads in excess of 0.5% when trading long corporate bonds.

As a result, the net cost for an SMA that contains comingled funds can be substantially cheaper than one that contains all individual securities. That cost-effectiveness also means that SMAs of building blocks are likely to outperform SMAs of securities.

2. Enhanced diversification

Using comingled funds can help achieve appropriate levels of diversification for defined benefit plans of any size.

For example, it would be very challenging to build a stand-alone $100 million hedging portfolio of individual securities that is not over-concentrated in a handful of issuers. Using a large, comingled credit vehicle containing hundreds of issues can solve that problem.

It’s also easier for a smaller plan to gain exposure to the full breadth of the fixed income markets using comingled funds. For example, State Street’s 17 LDI building block funds cover a spectrum of maturities across rates and credits, with options to gain exposure to additional segments such as high yield, leveraged loans, and emerging market debt. The holdings in a comingled fund can also include “seasoned securities” that are attractive to investors but are no longer available for purchase in the markets.

What’s more, most investments made in comingled vehicles get immediate exposure to the underlying characteristics of the fund. That means a plan can avoid the ramp-up period that managers need to source desired bonds when assembling an SMA of individual securities.

3. Greater liquidity

The ease of trading comingled funds compared with individual securities can make an LDI portfolio much more liquid and responsive to changes in a plan's liabilities, interest rates, or other market conditions.

For example, even a 5% adjustment to an asset allocation of individual securities would require identifying which bonds to sell, engaging a trading desk to complete the transaction, and then deploying the proceeds into new securities. With comingled funds, investment managers can make smaller adjustments like that in almost real time by transferring funds across different pooled vehicles as needed.

It can also be easier to allocate new money that comes into a plan when using comingled funds. The SMA manager can simply allocate the new money across existing comingled fund holdings, rather than undertaking the more complex and costly process of sourcing the specific bonds needed to re-optimize an LDI allocation of individual securities.

4. Proven record of tracking error reduction

Perhaps most important of all, the ability to build a more precise and liquid portfolio of comingled funds can reduce tracking error against the plan’s liability.

SMA managers can continually analyze the plan’s characteristics and the portfolio’s allocation, making small adjustments to the asset mix as needed. By continuing this process over a number of years, plan sponsors maintain an optimized allocation for liability hedging at a lower lifetime cost than they would pay in an SMA of individual securities.

Contact State Street to learn more about our LDI building block custom solutions, which are supported by a successful track record of improving and protecting our clients’ funded status.