The last two decades have tested the resolve of many investors. During the Global Financial Crisis and the COVID-19 pandemic, traditional portfolios of stocks and bonds proved moderately resilient to market shocks. The Federal Reserve hiking cycle in 2022 exposed many vulnerabilities in these traditional portfolios, as high inflation drove correlations between stocks and bonds higher, reducing their diversification benefits. Many portfolios, once heavily reliant on equities and core fixed income, have found themselves overexposed to market swings and underprepared for liquidity needs. The current market environment could be described as anything but normal, and future shock events may continue to break the traditional fold.

Hedge funds provide meaningful diversification and downside protection, and, in many cases, still represent an important role in portfolios. However, their less liquid nature and higher fees have diminished their appeal, particularly for asset pools with ongoing cash outflow needs. For investors with near-term capital requirements, the delayed liquidity of hedge funds is a significant drawback. Capital typically takes three or more months to withdraw, which is impractical if rebalancing or if a portfolio outflow is needed at the end of the current month. As a result, investors are increasingly adding liquid diversifiers to their asset mix—strategies and assets that combine the diversification benefits of alternatives with the liquidity profile of public markets. Liquid diversifiers could represent a standalone allocation or in many cases be used in conjunction with traditional hedge fund portfolios.

So, what exactly are liquid diversifiers? In simple terms, these are assets or strategies that can be sold within a month or less, while offering returns that are uncorrelated with traditional equities, bonds, and alternatives such as hedge funds. Liquid diversifiers are not meant to replicate hedge funds strategies, but instead focus on market opportunities to complement institutional portfolios. There is a wide range of strategies that fit this description, but in general these can vary from:

• Traditional strategies: high-yield bonds, REITs, and inflation-sensitive assets.
• Niche strategies: insurance-linked securities (ILS), currency strategies, and structured liquid credit.

The goal is to build a portfolio that not only reduces reliance on equities and fixed income but also addresses specific risks—such as inflation spikes or credit events—that can lead to asset erosion and asset/liability mismatches.

Portfolio construction principles

Constructing a liquid diversifier portfolio requires both art and science, tailored to each pool’s risk tolerance, liquidity needs, and objectives. Key principles include:

• Beta Management: Most liquid diversifiers have a lower beta (0.0 to 0.3), similar to diversified hedge fund portfolios, which provides meaningful diversification from equity risk.
• Fixed Income Management: Traditional fixed income ranges from core (Agg) holdings for many institutional portfolios to longer duration holdings for defined benefit pension plans. Regardless of investor type, the focus is similar—high-quality, fixed-rate bonds. Liquid diversifiers, on the other hand, should focus on floating rates with relatively shorter duration and idiosyncratic credit risk.
• Inflation Sensitivity: Inflation risk remains a concern for asset allocators, as high inflationary environments increase correlations between equities and bonds, resulting in depressed assets in traditional equity and bond portfolios. Diversifying assets with inflation sensitivity—such as commodities or energy-related securities—can help protect portfolio values in these periods. They come at a cost, as these assets traditionally underperform other asset classes over time, so careful strategy selection and sizing is necessary.
• Manager Selection: Superior manager selection and dynamic asset allocation are critical to achieving the desired risk/return profile, particularly as many of the liquid diversifying assets are actively managed.

Combining these various objectives can lead to a robust strategy and fund mix, leading to valuable diversification benefits. An important consideration is to find managers and strategies that not only exhibit low correlation to traditional assets, but also each other—meaning positive returns come at different periods. When one strategy performance is down, another one’s may be up. In practice, these managers would be combined at varying weights, resulting in a diversified composite with favorable diversification relative to other asset classes in the portfolio.

As Figure 1 shows, the composite portfolio results in low correlation to other commonly used asset classes. Most notably, the composite allocation shows only a 0.3 correlation with global equity and near 0.0 correlation to fixed income. To compare, the HFRI Fund of Funds Index, a traditional diversifying asset, shows 0.8 and 0.3 correlations to global equity and fixed income, respectively. A lower correlation implies the liquid diversifier composite mix provided a more diversified return pattern relative to broad hedge funds. We would be remiss not to mention that an HFRI benchmark is non-investable and exhibits certain biases, such as survivorship.

Performance and risk

With clear diversification benefits intact, what can investors expect from a well-constructed liquid diversifier portfolio? Ideally, diversifier allocations would deliver returns between those of bonds and equities, with lower volatility and the potential to outperform traditional hedge fund indexes. Performance over the prior seven years shows something even more remarkable, as depicted by Figure 2.

The individual diversifying managers have varied performance in terms of both risk and return. In general, most have outperformed traditional fixed income assets, and many, the hedge fund composite. Most notably, the sample liquid diversifiers composite was able to outperform most every manager in terms of return efficiency (Sharpe ratio)—generating one of the highest risk-adjusted returns. We have also reflected the median performance from hedge funds we deem as institutional quality (Inst’l Hedge Funds) to provide a more appropriate indication of performance from funds that commonly make it into institutional portfolios. This aims to alleviate some biases from the HFRI Fund of Funds Index, which, as mentioned, is uninvestable.

The main reasons for liquid diversifier outperformance include:

• Low Correlation: Liquid diversifiers can reduce overall portfolio risk by providing returns that are less correlated with core asset classes.
• Downside Protection: In periods of equity or bond market stress, certain diversifiers (e.g., catastrophe bonds, currency strategies) have demonstrated resilience.
• High Yields: Many of these strategies are income-generating and hold yields much higher than traditional fixed income. This is typically achieved through securitization or through niche markets, such as asset-backed finance.
• Floating Rate Structure: The low duration nature of these assets helps diversify from traditional, fixed-rate fixed income, which provides superior returns, especially during inflationary environments.

It should come as no surprise that inclusion of diversification in the portfolio should result in improved risk and return metrics. One way to illustrate these benefits is to model the inclusion of diversifiers into a generic 60/40 portfolio (60% global equities and 40% core fixed income). Since diversifiers represent the intersection between these two asset classes, the diversified portfolio could be defined as 55/10/35 (with 10% now representing diversifiers). As illustrated in Figure 3, the addition of diversifiers not only improves risk metrics, but also the return profile.

Including liquid diversifiers in the portfolio reduced overall risk by 90 basis points, while also increasing returns. This analysis also supports the approach of using high-quality hedge funds and liquid diversifiers to achieve overall portfolio diversification, with hedge funds providing slightly higher returns for slightly higher risk. In practice, both allocations could be used to achieve the highest risk-adjusted allocation, as shown by the orange square. Of course, manager selection is as crucial as ever.

Implementation considerations

In today’s volatile and ever-changing investment environment, designing an investment strategy, monitoring its effectiveness, and altering it when appropriate is challenging. In addition, implementing a liquid diversifier strategy requires careful attention to benchmarking, fees, and operational considerations, such as:

• Benchmarking: Selecting an appropriate benchmark is challenging. Options include the HFRI index, beta approximations, or a blended approach tailored to the specific mix of diversifiers. The latter is typically used in practice, blending the benchmark of each diversifier manager.
• Fees: Most liquid diversifier strategies are actively managed, which tends to increase the management fees of the funds. Leveraging economies of scale and strong manager relationships can help reduce these fees. Regardless, the composite fees are generally lower than those of traditional hedge funds.
• Governance: Clear guidelines for manager selection, monitoring, and rebalancing are essential for success and need to be reflected in any Investment Policy Statement.

Conclusion

In a world where uncertainty is the only constant, investors with capital outflows can embrace new tools to achieve their goals. Liquid diversifiers offer a compelling solution—combining the diversification benefits of alternatives with the liquidity and transparency of public markets. By thoughtfully integrating these strategies, sponsors can build more resilient portfolios, better manage risk, and improve outcomes for beneficiaries. The future of investing is not just about weathering the next storm—it’s about building a portfolio that thrives in any environment.

The post Building Resilient Portfolios: Liquid Diversifiers for Today’s Institutional Challenges appeared first on Cambridge Associates.

Of the $12.2 trillion currently held in Defined Contribution plans, $8.7 trillion is invested in 401(k) plans, a figure poised to grow because of the recent introduction of regulations requiring automatic enrollment alongside a $500 increase in the maximum annual contribution limit. If current 401(k) participants were to allocate just 10% to private investment offerings, nearly $900 billion of fresh capital would be heading for the private markets. This capital would be on top of the surging activity in evergreen and semi-liquid funds, which have been busy accumulating individual investor assets in their own right. By some accounts, the evergreen and semi-liquid markets have already attracted several hundred billion dollars in assets and are also expected to grow at strong clips. A recent survey indicated more than half of all private capital flows are projected to come from individual investors within two years.

By comparison, the institutional private equity and venture capital market has been in a slump, driven by a prolonged distribution drought that has trapped capital, much of which was invested at excessive valuations in 2021–22 that has yet to be productively harvested. This lack of distributions, coupled with short-term underperformance against public markets, has translated into several years of reduced commitments to the private asset classes. With institutional investors essentially on the sidelines, individual investors are an attractive source of capital for managers able to access them through the 401(k) market.

Target date funds (TDFs)—a growing subset of 401(k) strategies that adjust asset allocations as plan participants approach an expected year of retirement—could serve as the best place for private markets capital, given their long time horizons. General partners (GPs) offering private markets exposure to 401(k) participants will face challenges, including providing TDF managers the ability to rebalance, redeem, and access daily valuation information on private investments, which is not easy due to the highly illiquid nature and reporting constructs of private markets. Although their professional management and pooled nature can allow for more effective implementation, TDFs are still subject to all the liquidity and valuation requirements of a broader 401(k) offering. GPs will also have the challenge of delivering historical private investment returns in a structure that could impede the very elements that helped to generate those returns, including the requirement to invest immediately, which can impact entry valuation discipline and therefore returns.

What’s an institutional investor to do? We advocate “following the money,” by observing where it is accumulating because that will be where the pricing and return pressure will be most intense and investing in tiers of the market that stand to benefit from this burgeoning supply. Thankfully, with thousands of GPs in which to invest, the opportunity set for institutional investors extends far beyond those GPs in hot pursuit of the individual investor. Many investors can pursue compelling private investments at any tier of the private economy across a wide range of strategies and styles. Additionally, the current fundraising lull will likely result in less intense competition for portfolio companies that are beyond the reach of private investment funds servicing 401(k) funds over the next few years, potentially creating better opportunities and, therefore, stronger returns for intrepid institutional investors.

The post Executive Order Opens the Gates to Private Markets appeared first on Cambridge Associates.

As almost 40 years pass, companies big and small start moving from the DB model toward the DC plan, shifting investment risk from employers to employees. With time, plan design improvements result in lower fees, simplified investment options, and risk management via target date funds. But where did it all lead? Are today’s employees as prepared for retirement as they should be, or is there a better way? A way that enables twenty-first century US companies to provide the benefits of DB plans while decreasing costs and managing risk? Our answer—yes. We believe “pension Shangri-La” is attainable for plans of all shapes and sizes through an approach that delivers high value employee benefits with low or no cost to the employer.

Enter the Hybrid Approach

For many organizations today, the transfer of DB liabilities is finally economically viable, as their plans’ funded status has improved. However, the conditions that are enabling plan termination are also paving the way for a redesign of retirement programs. Driven by the rise of cash balance (CB) plans, a new opportunity is emerging that can not only save costs, but also improve participant outcomes: the hybrid approach. The hybrid approach to retirement savings blends the options and strengths of the DC model with a CB-defined benefits strategy. Furthermore, today’s robust risk management tools, higher interest rates, and improved funded status have created ideal conditions for plan sponsors to explore this new, balanced solution.

Combining the Best of Both Models

With a hybrid framework to retirement savings, some, or all, of the employer contributions typically associated with a DC model are redirected to a CB structure. The CB account serves as the low-risk component of the employee’s retirement plan, offering a guaranteed cash pool that is protected from losses and grows based on prevailing interest rates. Meanwhile, the employee’s personal retirement savings continue to flow into the DC plan, where he or she can choose how to invest, potentially allowing for higher growth allocations than what might be available in standard target date funds. The combination creates a more comprehensive retirement program, even though the hybrid approach maintains higher equity allocations in the DC account (Figure 1).

The Benefits: Reducing Cost and Risk for Pension Plan Sponsors

Employers typically offer DC benefits via a matching contribution structure, such as 4% of eligible compensation. While this makes costs predictable for the employer, it also makes them more onerous. Shifting these contributions to a CB plan can significantly lower costs through long-term investment returns. The long-term net return of the capital markets can meaningfully decrease employer cost, while the CB nature of the plan is a lower-risk alternative to a traditional pension plan.

Furthermore, if DB plan assets perform well over time, the employer’s cost to provide retirement benefits could be de minimis. This is encapsulated in the concept of a “hurdle rate,” which is the investment return needed to fully cover the DB plan costs.

These costs primarily include:

• Benefit accruals (the amount a participant earns in benefits each year)
• Interest cost on liabilities (e.g., annual interest, such as on a mortgage)
• Associated plan expenses, such as administration, actuarial, audit, and legal

Established, overfunded DB plans have a head start in this scenario, as their assets are already greater than their liability. But a hybrid approach can renew the investment horizon for virtually any plan, allowing employers to tap all areas of opportunity as they seek to reap the gains of the capital markets while using modern risk management controls.

Figure 2 demonstrates how a plan sponsor can harness the power of capital markets to provide a high-value benefit at a low cost. The table illustrates the percentage of retirement benefit (i.e., Employer Match Amount in a DC plan) covered by investment returns for a hypothetical CB pension plan. It is based on funded status and uses an opportunistic allocation of 50% growth-oriented assets (e.g., equities and diversifiers) and 50% liability-hedging assets. For example, at 120% funded status and a benefit equivalent to a 4% match, investment returns could cover 100% of employer cost.

As a plan’s funded status improves, its capacity to cover the cost of future benefits increases and its administrative costs decrease. This is particularly significant for plan sponsors focused on the long-term health and costs of their benefits and investment programs. However, every plan sponsor has different goals and risk tolerance levels, and reaching for higher returns usually increases the chance of a downside event hurting the organization’s balance sheet or cash flow.

One way to evaluate such risk is to determine the likelihood of DB funds falling below 100% over a ten-year period. While a plan sponsor may want this risk to be as low as possible, they must weigh the likelihood of that risk against the hybrid program’s savings. Based on our previous 120% funded/4% match example, the DB plan has approximately a 21% risk of its funding dropping below 100%. (This is the risk of providing ten years of benefit accruals free of charge to the employer while letting the funded status decline below 100%.) By adjusting the asset allocation, contributions, and benefit levels, the appropriate balance can be achieved. For instance, a 130% funded plan with a more conservative asset allocation that is saving 50% on accruals can reduce their risk of dropping below 100% funded to 1%.

The main takeaway? A hybrid approach has the potential to significantly reduce the cost and risks of providing retirement benefits, especially at higher funded status levels. While Figure 2 details a single option, the exact combination of benefit levels and investment strategies should be tailored to each specific plan to achieve its unique objectives.

Helping Employees Retire With More Confidence

At first glance, a hybrid approach may appear to sacrifice employer returns. However, with certain tweaks to the way DC assets are invested, employees can realize similar total retirement savings while reducing risk, maintaining their opportunity to retire comfortably.

Given that a CB-defined benefit plan is the employee’s lowest risk option, the DC plan doesn’t need as much lower-risk fixed income, such as that found in a target date fund. If a portion of the plan’s fixed income is transitioned to equities, the DC plan can grow more quickly and generate additional returns, while still allowing the combination of CB + DC to be less risky than the stand-alone DC plan. Figure 3 depicts potential investment design under both constructs, showing how the CB component can become an integral part of the employees’ retirement program.

Additionally, the shift to a hybrid structure results in some interesting impacts on account balance and risk, as shown in Figure 4. While the combined account balance upon retirement is slightly less, the employee also assumes slightly less risk along the way. This is particularly important in the event of an unanticipated early retirement or unplanned withdrawals, such as those related to a company transfer.

Even though the account balances are similar, the hybrid approach could underperform the DC-only plan in a bull market. In this case, it is likely the CB plan will be exceptionally overfunded, which would allow the sponsor to increase the cash balance benefit and maintain a low cost to the business. In addition, a retirement program with a CB-defined benefit plan offers the option to take the benefit as an annuity—providing, by default, a solution to the retirement income issue that is such a hot topic today.

The final and potentially largest hybrid benefit to employees is downside protection. Because the CB plan cannot decrease in value, it provides diversification benefits. For example, during the rising rate environment of 2022, both equities and bond values fell, but the CB value would have increased, providing market diversification for participants nearing retirement.

Combining Tradition and Innovation to Benefit All

It is common knowledge that the average American has an underfunded retirement. What’s more, most lack knowledge or experience in the intricacies of capital markets. Many feel a growing anxiety about underfunded retirements, frequently deepened by their lack of investment savvy. In this environment, there may be a growing preference for the stability and predictability once offered by traditional pension plans.

A modernized, hybrid retirement plan preserves the capacity of employees to accumulate savings for retirement while reducing expenses for employers, representing an important shift in how benefit plans are structured. By switching to the hybrid approach we believe employers could save 50% or more, over time, on retirement costs through harnessing the capital markets and the bundling of accounts across all participants.

Although no single strategy can address all challenges related to saving for retirement, adopting a hybrid approach represents a significant initial step toward improving retirement savings outcomes—for employers and employees alike. So, when the future arrives, both parties will be less apt to look back with regret.

The post The Pension (Re)volution: How the Hybrid Approach is Reshaping Retirement Plans appeared first on Cambridge Associates.

Hear from Cambridge Associates’ private investment specialists on the valuable role these asset classes can play in a portfolio, as well as what investors should keep in mind as they approach the vast PI landscape.

Explore our collection of videos:

The post Video Series: Private Investing appeared first on Cambridge Associates.

This paper looks at the asset class in the context of current market conditions, specifically higher interest rates and the potential for increased volatility, combined with improved access to hedge fund strategies more generally. These factors could create a prime opportunity for liability investors—such as pensions, nuclear decommissioning trusts, and insurance companies—to explore their use. It also discusses the primary risks associated with hedge funds and presents four actionable guidelines for investors aiming to effectively incorporate these strategies into their portfolios. These include defining a clear role for hedge funds, ensuring thorough due diligence, maintaining diversification, and adopting a strategic approach.

Why Consider Hedge Funds Today?

While institutional hedge fund allocations have been reduced in recent years (Figure 1), current market conditions may help to bolster the asset class moving forward.

Higher Interest Rates

Although a “higher-for-longer” interest rate environment can have both positive and negative implications for investors, it tends to be a tailwind for hedge funds. Heightened interest rates and persistent inflation have pushed the short rebate ¹ into meaningfully positive territory for the first time since the GFC (Figure 2), a dynamic that directly benefits hedge fund managers that undertake short selling. While alpha generation remains paramount, the short rebate can function as a stabilizer against volatility for managers with high short exposure, such as long/short equity managers. Higher interest rates also mean increased returns on cash. This is an advantage for managers that have significant amounts of free capital, whether they are operating global macro strategies, relative value strategies, or other approaches involving derivatives.

Increased Volatility Potential

Although volatility has remained relatively low through the first half of 2024, the rapid emergence of generative artificial intelligence is likely to continue to impact volatility in various market sectors over the near term. Moreover, geopolitical uncertainty—including the war between Russia and Ukraine, ongoing conflicts in the Middle East, and US-China tensions—also has the potential to create elevated market turbulence.

What’s notable here is that hedge funds have traditionally thrived amid heightened volatility. This is because greater volatility results in greater dispersion of returns among individual securities and asset classes more broadly, often with projected highs soaring higher than expected and projected lows drawing lower.

As the market identifies winners and losers and companies compete for capital, more alpha opportunities become available to diligent hedge fund managers. Nimble asset managers can also look to capitalize as disparities between a company’s business fundamentals and security price become more defined, creating additional trading opportunities. It is also important to note that hedge fund allocations have the potential to offer portfolios protection from unexpected market headwinds, particularly those designed to be less correlated to traditional sources of return.

Improved Access

Investors allocating to hedge funds today have access to opportunities that they could only dream of a decade ago, partly due to increased openness and innovation within the industry. What’s more, regulatory changes have helped to improve hedge fund transparency. Lastly, technological advancements have helped make it easier to retrieve and analyze information about hedge funds in the pursuit of strategies that are best suited to specific portfolio needs.

Implementation: Four Actionable Guidelines

Even amid more favorable market conditions for hedge funds, investing success depends on effective portfolio implementation. Four important action steps will help institutional investors determine which strategies can complement their broader investment goals.

1. Clearly Define the Role of Hedge Funds in the Portfolio—and Adapt as Needed

Given the wide array of hedge fund strategies available, it is critical to first set clear goals and expectations around the role they will play in a portfolio and seek out managers that match this profile (see Case Study: Enhancing Pension Health with Hedge Funds). Traditionally, hedge funds have been positioned to generate returns between those of bonds and equities, with the expectation of sub-equity volatility.

However, allocations should be carefully customized to an investor’s specific needs and risk tolerance (Figure 3). Where some investors may be willing to take on more risk for more return potential, others many want a highly diversifying hedge fund portfolio that seeks to generate returns with low-to-no equity beta. By setting clear goals, investors can access managers that better align with their risk and return objectives. Regularly reviewing and adjusting hedge fund allocations can help ensure they continue to meet these goals.

2. Rigorously Evaluate Managers to Uncover Top-tier Partners

The hedge fund landscape presents substantial divergence in performance outcomes across managers. Working with top-tier managers is essential, as seemingly negligible differences among managers’ expertise and investment approaches can lead to materially different returns (Figure 4).

Historically, the hedge fund industry has been categorized by notable manager turnover due to the risks associated with the use of intricate financial products and balance sheet leverage. Navigating this universe and underwriting new funds demands a due diligence process that requires considerable time and resources. However, this effort is vital and will help investors uncover managers with high-quality investment processes, fund administration, and risk management.

To ensure thorough due diligence, investors should establish clear criteria for manager selection, including track record, investment strategy, risk management practices, and alignment of interests. A comprehensive quantitative analysis of historical performance, including metrics such as Sharpe ratio, alpha generation, and drawdown analysis, is crucial. Tools such as Monte Carlo simulations can be invaluable for stress-testing performance under various market conditions. Additionally, in-depth qualitative assessments through interviews and on-site visits can provide insights into the manager’s investment philosophy, team structure, and operational infrastructure. Engaging third-party service providers for background checks, legal reviews, and operational due diligence helps uncover hidden risks. Comparing potential managers against a peer group using industry benchmarks and databases offers a well-rounded view of their relative strengths and weaknesses.

Many leading hedge funds today are large and complex organizations whose proper evaluation requires significant industry experience. Investors must undertake comprehensive risk assessment to avoid blowups. With the rise of new trading platforms and the increasing commoditization of fundamental research, it becomes even more valuable for allocators to possess deep expertise and substantial global resources. This is necessary not only to proficiently underwrite funds, but to discern the sustainability of a manager’s competitive edge and identify top emerging talent. Understanding the nuances of the manager’s strategy, including their edge in the market, sources of alpha, and competitive advantages, is crucial. Assessing the robustness of the manager’s operational infrastructure, including compliance, reporting, and fund administration, is also essential. Collaborating with industry experts can provide valuable insights and validate findings.

Among the more than 8,000 hedge funds operating worldwide, Cambridge Associates believes that fewer than 2% merit investment consideration. Accessing these “high conviction” funds can be challenging but can improve as investors build relationships with fund managers. Most managers value their client relationships and are often willing to negotiate capacity. This underscores the importance of a proactive, informed approach that emphasizes strategic partnerships. We believe by actively networking within the industry, investors can build relationships with top managers and unlock exclusive opportunities. Being well prepared when negotiating terms and capacity can secure more favorable investment conditions. Additionally, demonstrating a long-term commitment fosters collaboration that can lead to superior investment prospects.

3. Use Hedge Funds to Optimize Diversification

In today’s investment environment, a thoughtfully diversified portfolio requires iterating beyond the traditional 60/40 split between equities and bonds. Investors should consider increasing allocations to alternative investments to provide valuable and differentiated sources of return, downside protection, and liquidity during times of market stress (see Case Study: Navigating Yield Uncertainty, Insurance Firm Turns to Hedge Funds).

While private equity and venture capital deserve consideration, they are highly illiquid, and cannot be used for regular rebalancing or ongoing cash needs. Hedge funds, however, offer a middle ground. They provide more liquidity than private asset classes and, given the wide array of available strategies, can offer the potential for robust returns in various market environments.

Executed effectively, hedge funds have the ability to play an all-weather role in a portfolio. For instance, in 2022, as equities and bonds suffered material losses, many hedge fund managers generated positive returns for the calendar year. Pensions with hedge fund allocations have tended to show more resiliency amid such market drawdowns (Figure 5).

Investors looking for greater consistency in down markets can consider absolute return-oriented funds, which aim to provide positive absolute returns regardless of backdrop. Those expecting inflated default rates following higher-for-longer interest rate conditions can consider credit-oriented funds that excel in identifying and profiting on struggling businesses and/or dislocated securities. Over the past 20-year period, hedge funds have provided moderate returns with lower volatility than equities, helping to balance risk and deliver diversification benefits in an ever-changing investment landscape (Figure 6).

4. Use a Strategic Mindset to Overcome Valid—But Not Insurmountable—Hedge Fund Challenges

Investors are right to be concerned about hedge fund fees, transparency, and liquidity, but a well-informed, strategic approach can help unlock their potential.

While the hedge fund industry is known for its “2 and 20” fees—2% management fee and 20% performance fee—investor costs and terms are often negotiable, particularly with scale. It is critical to ensure fees are reasonable relative to expected alpha and to only invest with managers offering compelling return potential net of all fees.

Similarly, investors should only invest with hedge funds that offer appropriate transparency. Transparency is central to assessing the strategies employed by the fund. Investors should demand clear, comprehensive reporting on holdings, risk metrics, and performance attribution so that they can make informed allocation decisions. Greater transparency not only aids in understanding a fund’s approach and alignment but fosters trust between investors and fund managers.

In terms of illiquidity, adopting strategies that reduce an investor’s readily available capital may be justified in some cases, as long as the overall portfolio maintains adequate liquidity levels. Investors should complement less-liquid strategies with those that provide quarterly, monthly, or more frequent liquidity options to ensure a capital reserve during stressful periods. For those with greater liquidity needs, building well-diversified hedge fund allocations offering full quarterly liquidity is advisable.

Conclusion

Economic conditions and financial markets are unpredictable. Despite 2023’s equity bull run and its continuation in early 2024, investor circumstances can always change. For pensions, insurance firms, and other liability-focused investors, being positioned to withstand volatility is a critical component of successful portfolio management. Despite the skeptics, hedge funds can offer an attractive option for enhancing portfolio diversification and returns, especially in an environment of interest rate uncertainty and elevated volatility.

However, understanding risk is the essence of informed decision making. Action items for investors include: clearly defining the role of hedge funds within the portfolio; seeking out the highest quality managers; maintaining diversification; and adopting a strategic mindset to navigate inherent challenges. By carefully pursuing these actions, liability investors can successfully leverage hedge funds to help achieve their investment objectives, ensuring a balanced approach to risk and return in an ever-changing investment landscape.

Index Disclosures

Bloomberg Aggregate Bond Index
The Bloomberg Aggregate Bond Index is a broad-based fixed income index used by bond traders and the managers of mutual funds and exchange-traded funds (ETFs) as a benchmark to measure their relative performance.

HFRI Fund of Funds Composite Index
Fund of Funds invest with multiple managers through funds or managed accounts. The strategy designs a diversified portfolio of managers with the objective of significantly lowering the risk (volatility) of investing with an individual manager. The Fund of Funds manager has discretion in choosing which strategies to invest in for the portfolio. A manager may allocate funds to numerous managers within a single strategy, or with numerous managers in multiple strategies. The minimum investment in a Fund of Funds may be lower than an investment in an individual hedge fund or managed account. The investor has the advantage of diversification among managers and styles with significantly less capital than investing with separate managers. PLEASE NOTE: The HFRI Fund of Funds Index is not included in the HFRI Fund Weighted Composite Index.

MSCI All Country World Index
The MSCI ACWI captures large- and mid-cap representation across 23 developed markets and 24 emerging markets countries. With 2,760 constituents, the index covers approximately 85% of the global investable equity opportunity set.

S&P 500 Index
The S&P 500 is a market capitalization–weighted stock market index that tracks the stock performance of about 500 of some of the largest US public companies.

Footnotes

1. The term “short rebate” refers to the interest income earned by investors that lend out securities for short selling.

The post A Liability Investors’ Guide to Reassessing Hedge Funds appeared first on Cambridge Associates.

Ultimately, overestimating liquidity risk and the denominator effect can prevent pensions from fully optimizing their portfolio’s return potential. This paper aims to help pension executives better understand how data can enable their effective use of PI. It also discusses how new investment policy approaches may help to take advantage of market opportunities and minimize the risk of portfolio stress when down markets occur.

Following the Data

It is no secret that investing in private markets can add considerable portfolio value. Investors that have allocated to these asset classes over the long term have tended to outperform investors holding only public asset classes. And investors that managed to allocate primarily to top quartile PI managers have tended to perform even better (Figure 1).

As pensions consider PI investments, data analysis based on historical returns for private markets can help them make more informed decisions. This analysis can yield insights about how PI allocations have previously behaved across different market environments.

For example, when a crisis scenario hits, private markets are expected to react. But in reality, the severity and duration of these market reactions are not instantaneous or uniform. In crisis conditions, private market asset values and cash flow generation can decrease—but contributions can also decrease—as asset managers have fewer investment opportunities. In the years immediately following a crisis, exit opportunities present themselves and PI-buying opportunities emerge, albeit typically with lower returns than a more normal market environment.

Figure 2 compares contributions and distributions from a sample private equity fund in hypothetical base-case, crisis, and boom environments. It shows how different market situations can impact the timing of capital calls by fund managers, as well as when capital is returned to investors. Contributions are deferred in crisis scenarios as managers typically wait until opportunities present themselves, while capital is often called quickly in boom scenarios. In both environments, it is typical for most capital commitments to be called by the manager over the total investment horizon. Conversely, distribution trends track nearly parallel for all three scenarios, echoing the returns of the public market. ²

Putting it all together, whenever a crisis ensues, public market portfolios are immediately affected, but the value of a PI portfolio lags because valuations occur less frequently. Furthermore, private markets will call and return capital more slowly. In order to fully understand and interpret the potential impact of PI investments on pension portfolios, this complex web of inputs and outputs requires careful analysis.

Modeling an Investment Portfolio

Liquidity is a key factor for pensions investing in the private market, but at what level does the lack of liquidity cause serious risks to the pension? Figure 3 paints a broad picture of liquidity risk as a function of net distributions. In this case, net distributions is the percentage of outflows required to pay benefit payments and expenses, minus contributions.

Using this simple framework is an effective way to consider the appropriate PI allocation for a pension. However, it’s important to note that because each pension’s risk and payment profile is unique, more detailed and bespoke modeling may be necessary. This is particularly true for those that intend to invest heavily in the PI market.

Modeling can also help to inform PI allocation dynamics over time. Figure 4 demonstrates a potential PI allocation path for a sample pension. In this example, the pension has a 25% target allocation to privates, is currently paying out 5% of assets per year in benefit payments, has benefit accruals equal to 1% of pension liabilities, and is currently above PI target by 5% due to recent market movements. ³

Here, it makes sense to start with a micro view of the assets to ascertain expectations under base-case, boom, and crisis scenarios to inform a more refined application that allows a broader range of randomness like a Monte Carlo simulation model. ⁴ The simulation model cannot be created without the scenario modeling.

In addition to forecasting potential PI portfolio dynamics, simulation modeling analyzes the non-PI portfolio, the liability plan profile, and broader capital market forecasts. The resulting “cone of doubt” in Figure 4 is based on 5,000 return simulations, with PI values informed by the three market scenarios discussed above. As in Figure 3, models such as this can provide a view to the potential liquidity risk inherent in the pension.

In this example, the model suggests an 81% probability that, in ten years, the PI allocation percentage will be less than where it is today. Furthermore, in the few future scenarios where the portfolio exceeds 35% in privates by 2029, there is a 71% likelihood that the proportion of PI in the portfolio will then decrease. These metrics suggest that the likelihood of a liquidity crisis is low—even in a stressed market environment—as is the risk that the portfolio will be overweight PI for a prolonged period. Thus, if an investor is willing to accept an elevated allocation to privates in the near term, then a decrease in private asset commitments, or a sale of private assets at a discount in the secondary market, is unnecessary.

Reconsidering PI Ranges

It is typical for pensions to express predefined thresholds for allocations within their investment policy statement (IPS). A well-constructed IPS dictates boundaries across all asset classes and informs decision making related to trading and rebalancing. However, in the case of a PI portfolio, there are few ways to remedy an overallocation in the near term. As Figure 4 shows, even in a simulation model where the IPS boundaries are breached, an overallocation to PI is unlikely to remain above the threshold for long—and unlikely to cause a lasting liquidity crunch. These scenario projections can help bolster confidence on the part of pension executives, demonstrating that there is enough liquidity in their portfolio and that their allocation is likely to return to their IPS range over time. While the above depicts a sample case, scenario modeling such as this can be customized to specific situations.

Governance and Target Ranges

The topic of IPS ranges brings up the question of what boundaries are necessary for pensions with PI allocations. In fact, it can be optimal to create two sets of boundaries. The first is a soft guideline that, when breached, flags that the allocation is above target and action may be necessary. A second set of boundaries can be used to demarcate the point at which immediate action is warranted. When setting these two boundary ranges, it is important to note that the larger the target of the private allocation, the broader the ranges should be. For example, a 5% boundary on a 10% allocation may be reasonable but is most likely insufficient for a 25% allocation.

What If?

When pensions find themselves in the middle of a market crisis, it can be difficult to stay rooted to analysis conducted during a calmer period. However, it is at this precise moment that a pension executive’s investment decisions can lead to the largest swings in PI value. For plans looking to sell in the secondary market to lower their illiquid allocation, the lost value is clear—their holdings will sell at a deep discount, locking in losses. However, for those interested in cutting commitments to new funds, outcome analysis depicts murkier results.

For example, what if decision makers overseeing the sample pension described earlier determine that the continued risk of the private allocation increasing is too high and move to cut their next three years of commitments by half? What amount of change can they expect in asset values? These questions can be answered using further simulation modeling, but the general outcome is that the pension has more surety of the liquidity profile at the expense of lower returns.

Looking back at Figure 1, a top quartile private equity performer may outperform the US equity market by ~15% per annum and—assuming a one-time, three-year decrease in commitments—the impact to the pension is a net decrease in assets of ~2%. ⁵

Model Outcomes

Scenario modeling of PI holdings can yield a crucial takeaway for pension executives: don’t fear the denominator effect. While the magnitude of this effect is conditional on a portfolio’s broader allocation strategy, analysis suggests that, overall, it is an uncommon and typically short-lived phenomenon. Pensions with an effective investment governance framework that build a PI portfolio tailored to their investment objectives can use modeling to strengthen their conviction in the ability of optimized PI allocations to deliver stronger portfolio returns without imposing too much additional risk. Pension executives can also use scenario modeling to better assess how to balance their pension’s liquidity requirements against PI growth opportunities as they work to meet their investment objectives over time.

Footnotes

1. The term “short rebate” refers to the interest income earned by investors that lend out securities for short selling.
2. This is a summary of broad private equity and does not detail any other private asset classes that have a shorter or longer investment horizon. Those separate private assets have a similar contribution/distribution profile.
3. For the sample simulation, a 60/40 portfolio consisting of asset class targets 25% equities; 10% hedge funds; 40% long government/credit; 10% private equity; 10% private credit; and 5% real estate. The PI portfolio is assumed to be mature and returning 25%–30% of capital committed, while continuing commitments to target the 25% target weight.
4. A Monte Carlo simulation model seeks to predict the probability of a variety of outcomes when the potential for random variables is present.
5. It is assumed that commitments decrease by ~2.7% of total assets and that the capital is drawn over six years and returned by year 13 with a total DPI of 2.6x.

The post Role Models: Pensions Can Use Data to Optimize PI Allocations appeared first on Cambridge Associates.

This paper addresses this challenge. It explains the historic role that PI allocations have had in generating strong returns for large investors with longer time horizons. Next, it lays out how target date funds (TDFs), which are professionally managed pools with long time horizons, can serve as the vehicle to provide exposure to PI, while simplifying the plan participant experience. Additionally, this paper explores how to incorporate a range of PI in a TDF glide path, optimize the ability of these funds to take on illiquidity, and maximize the probability of success. Lastly, it touches on keys to successful implementation of a value-generating PI program within a TDF structure. Expanding the asset class opportunity set to include PI can provide DC plan participants with exposure to the same higher return potential seen in the broader institutional investment world, and, if implemented effectively, can result in improved retirement outcomes.

Status Report: Where Are Institutions Allocating?

The investment behavior of institutional investors over the last several decades has been meaningfully different from that of DC plan participants, where diversification away from traditional stocks and bonds has been minimal. By contrast, institutions have steadily increased allocations to alternative assets—including PI, hedge funds, infrastructure, and real assets—which now represent more than 25% of total portfolio allocations on average.

The Use of Alternatives in Institutional Portfolios: First Movers

The first movers in building more diversified portfolios were endowments and foundations, which have been significant investors in the space since the 1990s. Many endowments, as reflected in Cambridge Associates’ own client experience, have had allocations to alternatives above 20% for more than two decades and today allocate well over one-third of their assets to these investments (Figure 1).

Many defined benefit plan sponsors have taken note of strong returns among endowments and foundations and followed suit with increased exposures to alternatives. Public plans have seen the largest increase, especially over the last 15 years (Figure 2).

Corporate plans, particularly underfunded plans that are seeking growth rather than de-risking into liability-driven investment strategies, have also raised their allocations. Family offices have made significant allocations as well, currently investing an average of 43% of their total investable assets in these strategies (Figure 3).

What do these investors all have in common? The longer time horizons and institutional scale needed to reap the rewards of alternatives. While DC plans (particularly TDFs) share these characteristics, they have remained a notable outlier in their allocation decisions thus far.

Better Returns Through PI

Institutional investors have increasingly incorporated PI—along with other alternatives—in search of higher returns, and the data show that they have been successful in that endeavor. This can be seen by looking at the performance of endowed institutions with similar investment objectives. Those with high allocations to PI have outperformed those with more liquid, traditional portfolios (Figure 4).

This is especially true for those who have invested in less liquid assets, such as private equity (PE), which has generally outperformed its public counterpart over the last several decades (Figure 5).

It is also worth noting that PI offers an expanded opportunity set for investors, given that the overall number of investable opportunities in the private and public spheres are moving in different directions. Between 1996 and 2019, for instance, the total number of publicly listed US companies decreased by 47%, while the number of private equity and venture capital (PE/VC) investment opportunities grew by 85%. ⁶

Private Investing: Why?
Participant Benefits
• Higher return potential relative to public markets
• Exposure to innovative, early stage, high-potential growth companies
• Access to larger opportunity set relative to contracting public company universe
• Greater diversification

Forward-looking modeling shows the potential benefits of including alternatives in a target date glide path. An allocation of 10% to PI—divided between PE and private credit—can result in approximately 3% of additional income replacement in retirement, which is comparable to increasing a savings rate by 1%. ⁷

As noted earlier, the institutions that have been most able to benefit from investing in PI are professionally managed pools with a longer time horizon. The question is—how can that approach be adapted for the benefit of DC plan participants? TDFs can help bridge this gap.

The Place for PI

We believe the best place to include PI in a DC plan is through a multi–asset class portfolio, such as a TDF, which can provide the necessary professional oversight. This supervision is key, as the complexity and range of outcomes from PI make them extremely challenging for participants to manage themselves. TDFs can provide plan participants access to more sophisticated investment strategies through an easy-to-use vehicle with professional oversight. In most TDFs composed of traditional assets, a manager oversees underlying asset class exposures, asset allocation changes, and rebalancing. Enabling a professional fiduciary to oversee the inclusion of private assets in a TDF is simply a logical extension of this framework.

Incorporating PI through a multi–asset class pool also means that a participant does not need to focus on liquidity management or overall risk. Plan sponsors can take comfort that they have selected a professional portfolio management team to oversee these investment options without burdening participants with the task of conducting complex due diligence and decision making.

Range of PI Categories

Private investments are often lumped together as a single group of strategies, but their effective use in portfolios requires a more nuanced understanding. The most successful implementation approaches are those that fully recognize how different PI types can serve DC plan portfolios in different ways. Most often, certain allocations are appropriate at distinct parts of the glide path, helping to address participant needs at the appropriate time(s). Figure 6 reviews some of the major PI categories available to DC plans.

Close consideration of the roles that each of these investment categories can play in a portfolio helps to inform how to include them in the TDF glide path. Plan sponsors may be able to make the largest impact on overall performance by replacing a portion of the portfolio’s public equities with PE/VC and secondaries, and by replacing a portion of the public fixed income portfolio with private credit. While real estate and infrastructure provide some diversification, investors generally will achieve more bang for their illiquidity buck through PE and private credit. Making these changes will allow plan sponsors to better optimize the performance impact of taking on illiquidity relative to available traditional assets. The breakdown of these strategies can change across the glide path to reflect the needs of participants at each point in their lives (Figure 7).

Answering the Liquidity Question

Today, the DC system operates in a daily valued—and mostly daily traded—context, which translates into a need for robust liquidity. Assets with less than daily pricing and liquidity are already included within DC plans (for example, private companies as part of a public equity portfolio, or lower quality parts of the fixed income market). However, including a meaningful allocation to significantly less liquid assets requires careful thought and oversight to ensure that the plan is able to meet participant needs. Overall, an allocation of roughly 10% to illiquid investments balances the need to maintain plan liquidity, while still providing sufficient exposure to PI to move the needle and help accomplish participant investment goals. When thinking about liquidity, it is important to remember that the remaining 90% of the portfolio is liquid and available for cash needs.

Combined with available liquidity from the remainder of the portfolio, there is often more liquidity available from PI than is generally assumed. A mature PI portfolio is typically cash-flow positive—distributions are higher than contributions, particularly for a portfolio that includes private credit. These distributions can be used to meet participant liquidity needs or may be reinvested in the portfolio, all while maintaining sufficient total liquidity.

In addition to ensuring sufficient day-to-day liquidity, it is also important to stress test a portfolio to confirm that liquidity will remain sufficient even during down markets. The hypothetical example illustrated in Figure 8 incorporates both capital market and cash-flow stresses and provides some context for a perfect storm, adverse liquidity event.

The Name of the Game Is Implementation

Ultimately, taking advantage of the growth opportunities and diversification benefits of PI in DC plans requires negotiating two challenges: (1) building a well-designed PI portfolio and (2) situating this portfolio effectively within a TDF structure.

Manager Selection Matters

Even more so than with traditional asset classes, how private investments are implemented can spell the difference between success and mediocrity. For example, private markets can provide outsized returns, but the dispersion between the best- and worst-performing managers in PI is much larger than it is for public assets (Figure 9). In other words, while the benefits of getting private market allocations right can be far greater than with traditional asset classes, the consequences of getting them wrong can be markedly detrimental. Thus, working with an expert that has proven capabilities to conduct thorough due diligence on fund managers should be a top priority.

Performance dispersion across managers is just one of many reasons why building a properly diversified portfolio requires significant expertise. Other variables, including time (vintage year), sub-strategy (such as growth, buyouts, and venture capital), and knowledge of underlying general partners (GPs) must also be closely considered. As mentioned, secondaries can also be used to help kick-start a program. This requires proficiency in modeling private exposure(s) over time—how much capital to commit and to which managers—to properly build toward future portfolio success. As liquidity and portfolio size change, this modeling needs to be revisited—and the commitment plan adjusted—to match the evolving portfolio dynamics.

A Pooled Approach

When incorporating PI in a TDF, getting the structure right is essential, as this allows returns generated by the allocation to meaningfully benefit participants. This can be achieved most effectively by creating several pooled funds—or sleeves—for each of the major asset types: PE/VC, secondaries, and private credit. Each sleeve can include a minimal amount of liquidity for purposes of capital calls and distributions, but the primary source of liquidity is derived at the TDF level, as opposed to seeking meaningful liquidity within the private sleeves. These can invest in individual private investments, allowing for appropriate management of each underlying strategy. This structure also allows for a daily valuation process at the private sleeve level, based on the aggregate exposure to underlying managers. Each vintage of the TDF series can invest in these underlying funds, like the structure used by most TDF funds to invest in traditional asset classes. The pooling of PI into sleeves, and the accompanying pooling of cash flows, allows each TDF vintage to individually manage its exposure to each PI asset class.

Private Investing: How?
Keys to Success
• Simplified participant experience through inclusion in TDFs
• Experienced professional investment management
• Diversification across asset categories, adjusted for participant life stages
• Expert manager and fund selection
• Asset class–specific pools, with liquidity management occurring at the total TDF level

It is important to remember that private investments are less liquid than traditional stocks and bonds—each TDF vintage will not be able to precisely rebalance to a specific target the way a portfolio of more traditional assets can. The portfolio management team can accommodate by adjusting the allocations to corresponding pools of public asset classes to maintain the portfolio’s desired risk exposures. To this end, ranges around allocation targets should be designed to provide sufficient flexibility to account for the nature of PI.

Right Mix, Bright Future

A growing number of organizations are considering the use of PI in their DC plans as they strive to offer an optimized line-up of investment strategies to their employees and work to ensure a secure financial future for their plan participants. For those who opt to include them, the most successful approach will be one that is informed by both the growth opportunities and risks associated with more illiquid asset classes. DC plan sponsors should consider building out their plan’s PI allocation options via a TDF structure, using a methodology that matches the efficiency and choice available to participants in the form of more traditional assets. While this approach can result in increased investment management complexity, working with an experienced partner can help. Moreover, PI returns have historically compensated plan sponsors for the additional complications and cost. Regardless of preferred vehicle, having a clear understanding of investment strategy options and how they relate to existing traditional assets is fundamental to success. Proper portfolio implementation, including identifying and investing with top GPs, is also necessary.

Today’s DC plan participants desire—and deserve—institutional-quality investment management, including the diverse selection, robust due diligence, and potential returns that this classification implies.

Footnotes

1. The term “short rebate” refers to the interest income earned by investors that lend out securities for short selling.
2. This is a summary of broad private equity and does not detail any other private asset classes that have a shorter or longer investment horizon. Those separate private assets have a similar contribution/distribution profile.
3. For the sample simulation, a 60/40 portfolio consisting of asset class targets 25% equities; 10% hedge funds; 40% long government/credit; 10% private equity; 10% private credit; and 5% real estate. The PI portfolio is assumed to be mature and returning 25%–30% of capital committed, while continuing commitments to target the 25% target weight.
4. A Monte Carlo simulation model seeks to predict the probability of a variety of outcomes when the potential for random variables is present.
5. It is assumed that commitments decrease by ~2.7% of total assets and that the capital is drawn over six years and returned by year 13 with a total DPI of 2.6x.
6. This compares the decrease in publicly listed companies from 1996 to 2019 against the increase in unrealized and partially realized institutional private investments from 1996 to 2020.
7. This is based upon Cambridge Associates’ Capital Market Assumptions projected over 60 years using a Latin Hypercube model with 5,000 iterations. We modeled the same participant profile, isolating the change in investment design using 10% of total assets in PE and credit compared to public equities and bonds. For purposes of this analysis, we used a sample 35-year-old participant contributing 11% to 19% to their retirement account, 1.3% to 4.3% real salary increases, and withdrawing 70% of their pre-retirement income at age 65, while offsetting for social security. This analysis compares the assets at retirement and how long those assets last in retirement under the two investment designs.

The post Better Alternative(s): Private Investments May Improve Outcomes for Defined Contribution Plan Participants appeared first on Cambridge Associates.

New Dynamics, Old Strategies?

Plan sponsors today are operating in the aftermath of one of the fastest rate hikes in history and a prolonged yield curve inversion. Discount rate increases, along with strong equity performance since the March 2020 COVID-19 bottom, have powered significant improvements in funded status (Figure 1). These factors have proven especially beneficial to plan sponsors with underfunded and underhedged plans, helping them catch up with those that have spent the past decade contributing to their plans and increasing their liability-hedging targets.

Most DB plans today also have much improved risk profiles. Funding relief regulations such as MAP21 ⁸ and ARPA ⁹ have stabilized the interest rates used for determining plan contributions and lengthened the time periods available to plans for addressing funding shortfalls (Figure 2). These measures have helped to make funding more predictable over the long term by using a moving average yield to determine funding requirements. As a result, pension plans have much lower contribution risk as compared to two decades ago. Even with the steep rise in discount rates devaluing some of the cost savings from these regulations, it is still important for plan sponsors to recognize that these changed dynamics are likely here to stay. What’s more, they may need to reconsider how they manage their plan to remain on track for long-term success.

Shifting Gears

Plan sponsors have four key levers to manage their pensions—asset returns, liability hedges, contribution policy, and benefit management (Figure 3). While these levers do not change over time, how they are operated should, as plan sponsors look to remain on track with plan goals and objectives. Whether a plan is recently closed, frozen, or open, the observations we share below are broadly applicable to ensuring its optimized management.

Growth Assets: Meeting New Goals Amid New Risks

Although many plans today are well funded and well hedged, growth assets remain a critical component of overall plan health, helping to offset administrative expenses, unfavorable demographic trends, actuarial assumption changes, and other unhedgeable aspects of liabilities. As later discussed in the benefits management section of this paper, a properly executed growth strategy can also increase a plan’s overall value to an enterprise by reducing the cost of retirement and other employee benefits and by funding other organizational priorities.

Even though many plans have been focused recently on investing in a higher interest rate environment, these allocations alone may not provide adequate diversification in the event of market volatility. This volatility could be driven by multiple variables, including additional interest rate changes, an economic recession, increased pressure in the banking sector, heightened geopolitical tensions, or any black swan event.

Private credit, high-yield fixed income, hedge funds, and real assets are all strategies with the potential to help enhance diversification, provide downside protection, and achieve superior returns. Of these strategies, private credit can be particularly advantageous. Higher yields, coupled with a floating rate structure, may prove beneficial in a rising rate environment, with some strategies providing risk mitigation due to senior standing in companies’ capital structure. As with any private asset class, however, conducting robust due diligence will help achieve superior returns and avoid strategies that appear favorable on the outside but may contain hidden risks on the inside, such as subpar lending standards, poor execution, and unfavorable deal flow.

As plan sponsors evaluate their growth-oriented options, they should validate their true liquidity needs. Doing so may enable them to unlock their portfolio’s full growth potential by using excess liquidity to take advantage of opportunities in higher return, generating private equity investments (Figure 4). A liquidity coverage ratio of 2x to 3x can help ensure a portfolio is positioned to tolerate periods of market stress.

The liquidity risk of private investments in a pension portfolio varies depending on its net cash flow. As net distributions increase, the optimal allocation to private investments decreases (Figure 5). Partnering with experts in the private investment space is crucial to understanding the implications of these cash flow dynamics. The days of investors shooting in the dark to build out private investment allocations are over, as data and technology improvements make it easier to analyze liquidity requirements in an asset/liability context.

Liability Hedging: Less May Be More

Many plan sponsors have been highly focused on increasing long-duration liability-hedging assets in recent years. However, it may be time to reconsider how to manage liability risk going forward, including the appropriate amount of capital committed to these strategies and the optimal mix of credit duration. As always, a plan’s liability-hedging strategy is informed by its funded status. It follows that improvements in funded status should inspire a revised approach to liability hedging. As plan sponsors consider their options in today’s investment landscape, they now have a better set of tools at their disposal.

For example, because the accounting discount rate for single-employer pension liabilities is based on the Aa yield curve, a portfolio of duration-matched bonds can provide a good hedge against interest rate volatility. The earlier use of a completion manager may also help to keep higher hedging ratios, while also freeing up capital to implement more effective credit risk management and achieve additional exposure to growth assets.

It’s important for plan sponsors to recognize that the old paradigm of devoting the vast majority of plan assets to liability hedging should evolve into a more balanced approach. In fact, with liability durations decreasing relative to many fixed income assets today, more hedging can be achieved with fewer dollars. Less commonly used investment strategies, such as intermediate credit, also can play a role here. They can offer multiple potential benefits, including increased yields, liability carry offset, and better credit curve exposure, which in turn can result in lower volatility and higher returns.

Plan sponsors should also evaluate the overall fit and relative importance of liability hedging for their plans. There is now diminishing marginal utility in hedging the “last-mile risk” in pension portfolios with more capital. In some cases, an excessive hedging effort may result in a lower returning liability-driven investment (LDI) program, which decreases the efficiency of not only the liability-hedging assets, but the entire portfolio. Instead, plans may pick up incremental yield by adding non-traditional instruments for hedging, such as private investment-grade credit, commercial mortgage loans, and securitized assets. This may help the liability-hedging portfolio keep pace with the higher interest cost on liabilities, while still reducing interest rate risk through completion or other Treasury strategies. Figure 6 depicts how allocating only 30% of the liability-hedging portfolio to more diverse hedging assets can result in 50 basis points of extra annual yield.

For plan sponsors whose main objective is controlling or minimizing contribution requirements, hedging liabilities may introduce additional risk. In this scenario, plans should consider blending total return investment approaches with specialized liability-hedging programs to achieve the optimal outcome. The recent rise in discount rates has also presented a new option—adjusting contribution requirements to be based on mark-to-market liabilities. This option allows a liability-hedging program to not only reduce accounting funded status risk, but also contribution risk.

Contributions: A New Paradigm

Even if plans should experience negative asset returns in the near term, they can afford to be less concerned about contribution volatility due to the favorable impact of regulatory changes on funding target ¹⁰ calculations. The significant funding relief options passed in the last decade have resulted in the adoption of higher interest rates for minimum required contribution calculations. For example, plans are allowed to discount liabilities using 25-year moving average rates, which are then bound by interest rate corridors. When higher discount rates are used, liabilities are lower, which leads to higher funded status and lower contribution requirements.

In addition, due to new shortfall smoothing rules, a decline in funded status will no longer result in exceedingly high mandatory contributions. This changed regulatory backdrop, coupled with revamped asset and liability management options, effectively lightens the load for plan sponsors, potentially freeing up corporate assets for other purposes, including critical enterprise goals.

Contribution risk should generally be considered separately from funded status risk, since the duration for liabilities used to determine contribution requirements is essentially zero. While the use of long-duration fixed income strategies is beneficial to hedge long-duration accounting liabilities, it has a countereffect for liabilities with zero duration. While this wasn’t much of an issue when interest rates were low, the disparity is presenting a bigger opportunity in today’s higher interest rate environment. Well-hedged plans can consider aligning accounting and funding target methodologies through the Full Yield Curve approach, which may not only reduce expected contribution requirements, but eliminate much of the contribution volatility risk.

Underhedged plans should be more cognizant of the difference and focus on controlling the risk that is most important for them—balance sheet or contribution volatility. Even under the stabilized interest rate approach, certain aspects of pension management, such as Pension Benefit Guaranty Corporation (PBGC) premiums, are sensitive to interest rate changes. The most risk-efficient plan portfolios often blend traditional investments with LDI strategies in accordance with plan sponsor objectives and circumstances.

Benefits Management: Reassessment Required

Multiple benefits management approaches are always available to plan sponsors. These include plan termination, hibernation, partial risk transfer, future benefit modification, maintaining an open plan, or even re-opening one. Each of these approaches carries direct and indirect costs and risks. A close consideration of the plan sponsor’s specific needs and goals will help determine the right way forward.

Many plan sponsors can evolve their DB plans from feeling like a burden to feeling like an asset, one that supports corporate goals and financial health. Thanks to effective benefit management—combined with more supportive plan regulations and tools for generating asset growth and managing liabilities and contributions—plan sponsors are able to extend the life of their DB plans. Well- and over-funded pensions can become a point of differentiation for these enterprises and a valuable tool in attracting and retaining talent for the organization. Surplus plan assets also can be used in other ways that are long-term value additive to an organization, including mergers & acquisitions activity and retiree medical benefits. As plan sponsors consider a DB plan restart, expansion, or extension, they are likely to find that DB plans come at a marginal cost compared to defined-contribution plans. In fact, the National Institute on Retirement Security estimated that a DB plan costs 27% less than an “ideal” defined-contribution plan—one with fees below the industry average delivering strong performance. ¹¹

Those sponsors closer to the termination side of the spectrum should consider how they can approach de-risking economically. For instance, many lean toward offering a lump sum payment option to plan participants; in this scenario, participants who receive a payment are no longer due a benefit from the plan. While this seems routine enough, it is important that payments be apportioned strategically so they result in less assets transferred than the liability. Generally, cost savings occur during declining interest rate environments that generate a lower lump sum payment relative to the market-to-market liability. However, this strategy can backfire in a rising rate environment and result in many plan sponsors having to contribute capital in order to terminate as lump sums become more expensive than buying annuities. Similar issues can occur for plans opting for pension risk transfers (PRTs) via lump sum windows.

Partial PRTs are commonly used with the idea of reducing plan size for purposes of PBGC premium savings. However, for most underfunded plans, this kind of transaction may actually negatively impact funded status and increase plan costs and PBGC premiums over the long term—even if the amount of assets transferred is less than the liability (or a gain to the plan). All sponsors should fully understand the implications of PRTs in terms of funded status, risk reduction, and future costs for their plan. For many plans, managing risk through asset allocation decisions is more effective.

Achieving a surplus position is never easy or risk free—and may be prohibited by many glidepath designs, especially those that aim to lock in funded status at a point just above 100% funded. For this reason, plan sponsors should reconsider the end stage of their glidepath, given the utility of a surplus and the potentially higher funded status needed to terminate without cost if a previous PRT has already been performed. Plan sponsors wishing to use surplus assets may find that increasing allocation to growth strategies could be advantageous as the plan moves higher in funded status, with the notion that the further away the plan is from becoming underfunded, the more risk a plan can take in pursuit of higher surplus.

Adaptability Is Key

Although pension plans today are experiencing much improved funded status relative to years past, the extent to which they take advantage of the opportunities made available by favorable improvements in funding and regulations will be a key determinant of their future health.

In all market conditions, the four levers that plan sponsors control as they seek to accomplish their objectives remain the same. However, an informed, adaptive approach to the operation of each will help ensure continued plan success over the near and long term. Plan sponsors are strategizing for growth and managing risk in in a significantly different investment environment. To accomplish their goals, it is imperative that these changes be taken into consideration. By taking a fresh look at their investment strategies and plan management, organizations have an opportunity to adapt, evolve, and reap significant benefits.

Footnotes

1. The term “short rebate” refers to the interest income earned by investors that lend out securities for short selling.
2. This is a summary of broad private equity and does not detail any other private asset classes that have a shorter or longer investment horizon. Those separate private assets have a similar contribution/distribution profile.
3. For the sample simulation, a 60/40 portfolio consisting of asset class targets 25% equities; 10% hedge funds; 40% long government/credit; 10% private equity; 10% private credit; and 5% real estate. The PI portfolio is assumed to be mature and returning 25%–30% of capital committed, while continuing commitments to target the 25% target weight.
4. A Monte Carlo simulation model seeks to predict the probability of a variety of outcomes when the potential for random variables is present.
5. It is assumed that commitments decrease by ~2.7% of total assets and that the capital is drawn over six years and returned by year 13 with a total DPI of 2.6x.
6. This compares the decrease in publicly listed companies from 1996 to 2019 against the increase in unrealized and partially realized institutional private investments from 1996 to 2020.
7. This is based upon Cambridge Associates’ Capital Market Assumptions projected over 60 years using a Latin Hypercube model with 5,000 iterations. We modeled the same participant profile, isolating the change in investment design using 10% of total assets in PE and credit compared to public equities and bonds. For purposes of this analysis, we used a sample 35-year-old participant contributing 11% to 19% to their retirement account, 1.3% to 4.3% real salary increases, and withdrawing 70% of their pre-retirement income at age 65, while offsetting for social security. This analysis compares the assets at retirement and how long those assets last in retirement under the two investment designs.
8. The Moving Ahead for Progress in the 21st Century Act of 2012, or MAP21, represents the first funding relief since the Pension Protection Act (PPA) of 2008.
9. The America Rescue Plan Act (ARPA) funding relief of 2021 significantly reduces funding requirements by introducing a floor on the interest rates used for discounting liabilities, and a longer amortization period (from seven years to 15 years).
10. The Funding Target methodology is used to determine the plan’s minimum required contributions under ERISA and the Pension Protection Act of 2006 (PPA).
11. See Dan Doonan and William B. Forina, “A Better Bang for the Buck 3.0,” National Institute on Retirement Security, January 2022.

The post A Changed Investment Landscape Is Providing Greater Opportunity for US Corporate Pensions appeared first on Cambridge Associates.