Pension Investing – A Brief History and Future Questions

Authored By: Jeremy Bell | Publish Date: June 26, 2018

In this article, I discuss the changes in pension investing, particularly related to the relationship between pension sponsors and pension investment consultants.  My intention in this article is to provide a rough sketch of the last 20 years to provide a perspective on current investment policies, processes and habits related to pension plan investments.

The ultimate goal of the article is to challenge plan sponsors to consider how they carry out their investment function going forward.  At the end of this article, I suggest a handful of specific areas that plan sponsors might consider.

My thinking is informed by my work experience, nearly 20 years in Western Canada.  As a general rule, I have found:

  • Western Canadian sponsors and consultants are generally more skeptical of hedge funds and other similar “manager skill” products than sponsors in the rest of Canada [1].
  • Western Canadian sponsors and consultants are generally more attracted to investments in real assets (e.g., real estate and infrastructure) than sponsors in the rest of Canada.

Finally, I have used specific years in this article when talking about the history of the industry.  I felt that specific years assisted the narrative, although I recognize that different sponsors, firms and geographies evolved at different speeds.  I recognize, for example, that some jumbo pension plans (like Ontario Teachers Pension Plan and Canada Pension Plan Investment Board [2]) evolved earlier and past the scope of this article.

Investment Consulting – Early Years: Pre-2007

In the 1990s, large actuarial consulting firms in Canada created standalone investment consulting departments.  Prior to that point, investment advice was generally either not provided by anyone, or provided by plan sponsors’ actuaries in addition to their roles calculating liabilities and service costs as well as provide general ad hoc consulting related to governance, regulations and plan design.

Investment advice was initially provided on the fee model in place for actuarial consulting, fee-for-service at hourly rates.

Investment options were fairly limited in this period: fewer options were readily available to most pension plans and even if more were available, pension sponsors would have been unlikely to dramatically depart from 60%/40% equity/fixed income allocations [3].  Investment consulting was largely limited to:

  • Investment manager monitoring, selection and termination
  • Advising on strategic asset mix:
    • Small variations in the equity and fixed income allocations (say between 50/50 and 70/30 equity/fixed income allocations)
    • Small variations within equity allocations (e.g., addition of small cap stocks, increasing global equity allocations at the expense of Canadian equities)
    • Extending the duration on fixed income investments (i.e., moving from mid-term bonds to long-term bonds)
    • Potential introduction of investment in direct real estate, mortgages or private equity
  • Advising on investment manager structure (i.e., the number and types of managers)

Pension sponsors that lengthened bond duration benefited from the advice of their investment consultant [4] in hindsight.  Similarly, adding real estate was generally beneficial in hindsight based on the level and stability of returns earned.

The primary activity of investment consultants during this period was the search for traditional investment manager (i.e., public stocks and bonds) skill:

  • Much of the search was predicated on the assumption that investment manager research would be able to identify investment managers with persistent skill in managing traditional asset classes, those investment managers who would, going forward, perform better than others or beat an index.
  • Based on this assumption, consultants naturally concluded that pension plans should use specialty manager structures (hiring specific managers for each asset class as opposed to balanced managers, which invested across various asset classes) and that hiring multiple managers in each asset class (say two or more global stock managers) is even better (often by hiring managers that presented different tactics or outlooks – top down vs. bottom up; growth vs. value; quantitative vs. qualitative). The advice essentially boiled down to: hire our highest-regarded managers and hire more of them.
  • Further, plan sponsors, on the advice of consultants, adopted detailed monitoring processes and were predisposed to making changes in investment managers.
  • Consultants began looking for opportunities to take further positions in traditional asset class manager skill through synthetic products, like 130/30 (a stock fund that invests 130% of its assets in chosen stocks and shorts 30% of its assets in other chosen stocks), portable alpha funds and market neutral hedge funds.

The Benefits of Investment Manager Research for Traditional Asset Classes

That deep investment manager research in traditional asset classes would be expected to result in skilled managers and better outcomes over time is an attractive concept.  An industry exists that charges money to sophisticated investors for this service: why would sophisticated investors choose to purchase that service if it didn’t add value?

Unfortunately, the logic and evidence in support of value from manager research on traditional asset classes is weak:

  • Logic:
    • It is accepted to be very difficult (or nearly impossible) for traditional investment managers to manage a portfolio of individual stocks or bonds selected from the universe of stocks and bonds that will persistently add value over the market over time. Choosing a manager from amongst the universe of managers (all of whom will manage portfolios of stocks or bonds) that will have better returns than other managers is more abstract, and thus should be presumed more difficult (in absence of compelling evidence).
  • Evidence:
    • There would be enormous financial benefits for consulting firms with deep investment manager research functions to show that their recommendations add value. For consultants with a rating system, this would involve subjecting the performance of their highly-rated managers to external, rigorous and ongoing scrutiny across time and geographies.  Over the last 20 years (around the time that consulting firms started manager research in earnest), no consulting firms have presented anything external, rigorous and ongoing to the market supporting their abilities in choosing traditional investment managers [5].
    • At various times, some consulting firms, and other market participants, have offered funds-of-funds for traditional asset classes, essentially funds managed by their highly-rated (or highly-regarded) investment managers. These funds are available for independent review and returns have not supported the position that manager research leads to better return outcomes.
    • Finally, in reviewing the marketing materials for delegated investment managers (essentially allowing a consultant, or other provider, to make investment manager decisions on behalf of a client), there are no clear claims of better fund performance from manager choice. The arguments in support of these offerings are largely speed of execution (i.e., speed in changing managers [6]), implementation of consulting firms’ best ideas and freeing up of committee/sponsor time.

Given the inherent difficulty of the task, the existence of sufficient data within large consulting firms to perform analyses (and to support ongoing analyses) and the enormous financial benefits associated with providing evidence of this ability, one should be very skeptical that manager research can provide benefits in traditional asset classes [7].

Plan sponsors must consider this lack of evidence when considering what investment committees spend their time on and what they pay for providers to do on their behalf.

Investment Consulting – Alternative Assets: 2007-Present

In the next phase of investment consulting, the search for added value (alpha) in traditional asset classes was largely set aside.  The manager structure and habits in place to support this search largely remained in place (the amount of committee time and money spent on monitoring), but manager termination decisions became less frequent and, where managers were terminated there was more consideration of passive options.

Sponsors and consultants did not give up on the value of manager research providing added value in traditional asset classes, instead their efforts were redirected toward introducing alternative asset classes to portfolios.  Many sponsors would have started this period with 0-10% of assets (perhaps real estate and/or another asset class) in alternative asset classes and would have ended this period with 10-30% in alternative asset classes.

Alternative asset classes were introduced with the aim of providing some combination of bona fide diversification from stocks, interest rates and credit (the dominant risks in most pension funds) and attractive returns for a given level or risk [8].

By the end of this period, pension plans were generally making better use of their advantages (scale and long time horizons – required for some, but not all alternative asset classes) and were slightly more resilient (i.e., able to handle very poor economic environments).  For many pension plans, however, the changes have been incremental.  A deep, prolonged economic contraction combined with an increased pace of corporate competition would put significant pressure on pension plans: public stocks, corporate bonds, private equity and real estate would all be affected to varying degrees.

Investment Consulting – Today Forward

There are currently two distinct investment implementation paths:

  • Global consulting firms are all proposing delegated investment management, essentially delegating responsibility for manager structure and selection to the consulting firm.
  • Smaller consulting firms are generally proposing that clients apply a lighter touch to manager monitoring (decreasing the frequency of manager changes) and minimizing the lower-value activities that have become habits of plan sponsors, but maintaining decision-making responsibility with plan sponsors.

There is no correct answer to this choice.  In fact, if delegated investment managers present external, rigorous and ongoing evidence of added value relative to the current state, smaller consulting firms will present this option to their clients.  Today, however, it would be difficult to recommend this option.

The implementation options (i.e. whether to engage investment managers directly or indirectly) are less important than the asset allocation going forward.  Plan sponsors should be thinking about the following:

  • Are you spending too much time/money on the search for traditional asset class manager skill?
    • Clearly, all pension sponsors need to spend some time or money on oversight of existing managers and searches for new managers as part of their fiduciary duties for plan members. But, pension sponsors should think about whether the time and money spent on these efforts can or should be reduced.  Plan sponsors should consider whether existing effort is worthwhile and whether this effort serves to crowd out time and attention on strategic, policy discussions.
  • Is your pension plan resilient enough?
    • For a typical pension plan, the answer is likely to be “no”. Typical pension plans should be able to handle volatility (and, while very difficult at the time, managed to handle the extreme negative returns in 2008) but would have a very difficult time handling a prolonged economic slowdown and a heightened pace of competition.  The single largest position in most pension plans is that those investments that are earning returns today will continue to be able to earn those returns (and hopefully more) in the future.
  • What is the practical limit on the use of illiquid assets?
    • Some pension plans have increased their use of illiquid assets to 30%, or more, of assets. There are no specific rules on how much illiquidity a going-concern pension plan can take on.  Any modelling of liquidity needs for a pension plan will show a very limited need (especially given that plans often invest in illiquid asset classes that regularly return capital).  Pension sponsors should challenge their thinking on the amount of illiquidity that they can handle because illiquid assets provide a premium for a given level of investment risk. [9]
  • Are asset allocation studies helpful?
    • First, asset allocation studies have some value in that they provide a construct for a discussion on a pension plan’s strategic asset mix and they help pension sponsors fulfill fiduciary responsibility to members. But, heavy reliance on asset allocation studies, as used by many plan sponsors today, can lead to suboptimal outcomes.

The desire to turn investment decisions into solvable math problems is attractive.  Making decisions using the resulting probability distributions from asset allocation studies is much easier than the alternative.  But, models provide a false level of precision.  Even more complicated models still provide a false level of precision.

Most asset allocation studies attempt to limit the influence of the model on decisions, through setting constraints on asset mixes in an optimization process (i.e., no more than 5% of assets can be invested in emerging market equities in any modeled portfolio) and through slightly departing from the modeled asset mix(es) when selecting a policy asset mix.  These actions implicitly accept that the model is (and must be) an imprecise approximation of the real world and only to be trusted to guide incremental decisions.

As a result, these studies are generally only helpful with making incremental decisions, often fairly infrequently.  Plan sponsors and their consultants should spend more time thinking about the stresses and shocks that their portfolios might face and the opportunities available.  A more frequent, more open minded discussion (not just an update of the existing model) on the asset mix would be a useful supplement to asset allocation studies as they generally occur today.

  • Do you consider your total portfolio enough?
    • Specialty investment managers (e.g., a domestic real estate investment manager) think about their returns relative to their benchmarks and other managers and they think about their business, but they do not think about pension sponsors’ overall portfolios. It is the responsibility of the pension sponsor, and their consultant, to think about their overall portfolio.  It may make sense, for example, for a real estate manager to offer a fund with leverage (through mortgages or debentures), because some of their customers will want leverage and levered real estate returns will generally present better (except in periods of poor performance).

From a pension sponsor’s perspective, if their real estate fund is borrowing money at a cost of 3.5% per year and the pension fund loans money through a bond fund at 2.5% per year, the total of the two transactions is a loss of 1% of the amount of loans [10].  Unless there is some aesthetic reason or unique circumstance to maintain a certain level of bonds, this sponsor should sell bonds and pay down its mortgages, to the extent possible, or if a lower leverage real estate fund is available, the sponsor should sell bonds and move the real estate investment to the lower leverage fund.

Similarly, where levered and unlevered funds are available from a manager, sponsors should seriously consider making a larger allocation to the unlevered fund than would be made to the levered fund, either funded by selling bonds or by efficient borrowing by the pension plan.

  • What is your pension plan’s investment advantages? Should you make more use of these advantages?
    • Pension plans have significant investment advantages in having size (or scale) and long-term certainty, particularly after the recent relaxation of solvency funding rules (and elimination of solvency funding rules in certain circumstances). Some asset classes, like infrastructure, real estate, private debt and private equity, make use of these advantages to provide improved returns relative to risk.  Other asset classes make limited use of these advantages, like public bonds, stocks and hedge funds.

 

Plan sponsors should actively consider their advantages and consider whether they could responsibly make better use of these advantages.

 

  • Should your pension plan consider (synthetic) borrowing?
    • Pension plans can synthetically borrow at around the Bank of Canada overnight rate through putting up assets as collateral in the repurchase agreement market. This relatively cheap borrowing rate, about 1.75% per year today, offers pension plans an opportunity that some of the largest pension plans in Canada already use.  Pension plans can borrow cheaply and invest in a portfolio of reliable investments to yield more than the cost of borrowing.  This strategy is used extensively by banks.  Other than the largest pension plans in Canada, very few pension plans make use of this strategy in spite of the existence of products for implementing this strategy cheaply for all sizes of pension plans.

Conclusion

Plan sponsors and pension investment consultants have evolved a fair amount over the past 20 years.  Even still, both could go further in breaking the habits of pension investing to allow sponsors to wrestle with interesting, consequential questions going forward.

Jeremy Bell  FCIA, CFA

Partner at George & Bell Consulting

 

[1] Persistent manager skill in many asset classes should be rare (if a manager has a “secret recipe” such that they can consistently add value after fees over time, they will eventually be replicated by others, decreasing added value opportunities for a given level of risk).

[2] There are other jumbo pension plans or jumbo public sector pension investment managers whose evolution and current state is reasonably described in this article.

[3] There was limited need to consider other asset classes: bonds provided decent returns, say 5-7% per year, roughly sufficient to fund a pension promise based on prevalent assumptions.

[4] Investment consultants were not prescient in predicting decreases in interest rates, but instead understood that pension liabilities are essentially negative long-term bonds – most apparent when a solvency test applies, but true regardless.  The best way to relieve the risk of a negative long-term bond is to buy a long-term bond.  Interestingly, investment managers were generally unsupportive of extending pension plans’ bond duration, and some managers fiercely objected.

[5] Ironically, these consulting firms insist on subjecting external managers to external, rigorous and ongoing scrutiny.

[6] What good is changing investment managers quickly when there is no evidence that the new highly-rated manager will perform any better than the now out-of-favour manager?  Equivalently, if a drug is not shown through evidence to have clinical benefits, why bother increasing the dosage?

[7] There are plenty of anecdotes that could claim to show evidence of this ability.  Anecdotes of added value from traditional asset class manager research are as compelling as a gambler’s anecdotes of winning bets as proof of gambling ability: not at all.

[8] Volatility is a shorthand for risk and is often used interchangeably.  This is reasonable for most, but not all, purposes.  For example: an investment with a certain annual return of 3% should not be considered less risky than an investment with an annual return that will alternate between 4% and 5%.  The second investment is more volatile but is certainly less risky by any reasonable standard.

[9] The entire banking system is built on the concept of taking liquid deposits and lending those assets on an illiquid basis.

[10] Putting this in a personal context: if you have a $100,000 mortgage at a 4% interest rate and you have $100,000 invested in bonds (say outside of a registered plan for simplicity) yielding 2.5%, you should sell the bonds and pay down your mortgage.  You still own the same house, but now you won’t be losing $1,500 per year from a peculiar financing decision (probably worse because you would likely pay tax on the bond return).


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