When Saskatchewan’s Public Employees Pension Plan’s board introduced alternatives to its investment lineup in 2020 with an aim to improve the defined contribution plan’s risk-adjusted returns through diversification, it wasn’t its first time at the rodeo.
The move came after 15 years of experience and comfort with alternatives through the PEPP’s defined benefit companion plan, the Municipal Employees’ Pension Plan, says Gary Hutch, executive director of investment services at the province’s Public Employee Benefits Agency, which oversees both the PEPP and the MEPP. After getting into alternatives with two infrastructure investments in 2007, the MEPP decided to expand its footprint, continually reinvesting in infrastructure and moving into private equity. Today, it has an active base of 100 or more funds and the PEPP is applying the lessons learned to a DC context.
“What we’ve seen [in the MEPP] is alternatives have done extremely well,” says Hutch. “In terms of the value-add compared to our expectations, it was considerably better than our expectations.”
PEPP members have exposure to alternatives through the plan’s funds, which range from aggressive to conservative in construction, as well as the plan’s take on a target-date fund. The alternatives portfolio contains a combination of infrastructure, real estate and liquid alternatives, while private equity falls under its equity portfolio. It also has a target allocation level that ranges from 22 per cent within the most aggressive portfolio to 17 per cent in the most conservative, though the plan hasn’t reached that level yet.
Both DB and DC plan sponsors are increasingly looking to alternative investments as the traditional 60-40 balanced portfolio faces significant strain this year.
Indeed, central banks have chased rapidly rising inflation with a series of severe interest rate hikes, depressing returns from both public equities and bonds. The S&P 500 index was down roughly 16 per cent on the year as of mid-September and, as of July, U.S. and European government bond markets were set to record their worst year in decades.
The unusual market conditions have made plain the value in diversifying into alternative assets, say investment consultants and money managers. According to BNY Mellon Corp.’s Canadian master trust universe of Canadian pension plans with more than $1 billion, private equity reported a positive median return in the second quarter of 2022 at 3.25 per cent, while real estate posted a median return of 4.37 per cent and hedge funds returned 1.32 per cent.
While allocations to alternatives are less common in Canadian pensions than in U.S. plans, they’re growing in popularity. According to RBC Investor & Treasury Services Inc.’s 2021 survey of DB plans, 73 per cent of respondents had alternatives in their plans or expected to add them in the near term, with real estate and infrastructure the most popular alternative assets.
But these asset classes can be more complex and come with risks such as liquidity and valuation challenges, as well as additional governance concerns.
In November 2021, the Financial Services Regulatory Authority of Ontario published a report that reviewed the risk management practices for alternative assets in six large Ontario public sector DB plans.
It found the illiquid nature of these investments — and the lack of available secondary markets — impacts their valuations and can make it far more challenging for pension plan sponsors to exit an investment if they need a cash infusion on short notice, in comparison to the public markets.
That illiquidity risk is the No. 1 concern for pension plan sponsors that are considering alternatives, but that’s been somewhat mitigated by the prevalence of open-ended funds, says Brendan George, partner at George & Bell Consulting Inc. These funds have no fixed term, typically pay out some sort of income stream and offer the ability for investors to flow in and out after a shorter lock-up period, usually of three to five years. In comparison, closed-end funds require investors to commit their funds for terms of typically 10 to 15 years.
But Kevin Little, principal at Eckler Ltd., points out open-ended funds aren’t necessarily as easy to get out of and can come with conditions and limitations on the post-lockup period. “Even when you get through, it’s subject to the manager’s discretion.”
In moments of macroeconomic stress that send investors running for the exits, managers have the ability to lock up the fund again, notes George. “An age-old issue is that every client in the fund wants their liquidity at the same time and it’s happened in the past — around 2008 to 2009, some funds were closed for a period of time; around [the coronavirus pandemic], there were some closures. You have to go in with your eyes wide open. There’s no guarantee of liquidity.”
However, he notes, while it’s easy for pension plan sponsors to access a wide range of open-ended funds in infrastructure and real estate, closed-ended arrangements dominate the private equity and private debt space — though that’s slowly starting to change. While these funds, in theory, offer a better return for the length of time investors lock up their dollars, “that hasn’t always been the case.”
The most common liquidity concern tends to be around being able to get out in a hurry, but some plan sponsors take issue with the fixed term of closed-ended funds, which eventually boomerang their money back to them. “Our clients don’t want their money back in 10 years’ time, they want it held for longer,” says George, noting these fund vehicles also present plan sponsors with the challenge of constantly maintaining their allocation at their target by continually having to reinvest in new vintages as older funds mature and pay out.
In addition, as pension plan sponsors evaluate open- or closed-ended funds, they need to make sure a fund’s structure truly aligns with their underlying investments, says John Wilson, founding principal, co-chief executive officer and managing partner at Ninepoint Partners. “Let’s just imagine you’re buying an asset that, for whatever reason, can’t be realized for five years. If that’s what the fund is buying and they’re offering you monthly liquidity, how is that going to happen? Is that reflected properly in the structure of the fund?”
Upon entering a fund, plan sponsors are expected to pay a fee on their committed allocation, notes Hutch, even if the full amount won’t flow into the fund immediately. And for funds that have a strategy to expand or grow an asset in some way, there will likely be initial depressed returns — called the J-curve — while the manager executes their strategy. “I think it’s more acute for a DC plan. You see the unit values every day and members are more aware than if you just see a funded status more periodically.”
The right alternatives allocation will depend on a plan sponsors’ investment time horizon and ongoing pension commitments, says Little. “We see clients hitting a threshold of 30 per cent, in that mid-sized range, where they might start to get concerned, but sometimes their concerns are a little bit too conservative — they’re not going to redeem 70 per cent of their portfolio at any given time.”
Again, Hutch says liquidity concerns are more acute in the DC space. The PEPP addressed this with equity, alternative and income-based mandates for each of its investment options, as well as relatively consistent exposure to alternatives across the options. “It’s almost like having a family of DB plans.”
It also has a wider minimum and maximum target weighting for each of its mandates. “When there’s a short-term movement in equities or fixed income, we’re not going to branch compliance as quickly,” he says. “We’re not buying and selling or rebalancing, these are much longer-term commitments. So we just give ourselves more margin for market volatility.”
Andrea Boctor, a partner and chair in the pensions and benefits group at Osler Hoskin and Harcourt LLP, notes the growing popularity of target-date funds in DC plans can also help to mitigate plan members’ liquidity risk, as alternatives become a much smaller part of a larger fund.
Alternative investments may also demand more from a governance perspective.
When the MEPP first entered alternatives, the fundraising cycles were “a little bit more forgiving,” says Hutch, but by the time the DB plan expanded into private equity, it was seeing those timelines speed up. It prompted the MEPP to establish a subcommittee to deal with private investments. The subcommittee, made up of three or four people from the MEPP’s oversight board, can meet virtually and move more quickly than the board to make individual fund decisions. It was a strategy the PEPP also adopted when it entered the alternatives space.
These investments are often set up as limited partnerships, which are far more complicated than an investment management agreement for equities and bonds, says George, suggesting plan sponsors would benefit from doing upfront legal due diligence.
Some alternative fund vehicles can be structured under a different regulatory regime or a different jurisdiction’s regime, says Boctor, and it’s important for plan sponsors to understand the nature of those rules and the vehicle itself.
Sometimes, it may be appropriate for tax purposes to put a blocker corporation in place to shield the rest of the pension plan from liability, she adds. In this structure, the plan would establish a wholly-owned subsidiary within the fund, which is considered a permissible investment under the Income Tax Act and a permitted investment schedule under the Pension Benefits Standards Act. If the plan’s investment is leveraged in a way that could require fund unit holders to put in cash, a blocker corporation can prevent that from bleeding back into the plan, she says.
The value question
Pension plan sponsors must also contend with the relative lack of transparency in the private markets, says Jeff Tripp, managing director and head of alternative investments at TD Asset Management Inc.
Private assets are valued on a monthly, quarterly or yearly basis, in comparison to the day-to-day, minute-to-minute gyrations of the public markets. “The view, [historically, was] that the value wasn’t as dynamic or quickly changing as you might see in public market instruments,” he says, noting best practice in the Canadian real estate market today is quarterly appraisals.
George believes valuation worries are a bit overblown as standards have started to materialize around frequency and the importance of independent, third-party valuations. “Nowadays, you would never invest in any private investment fund that isn’t at least annually externally and independently audited.”
The smoothing effect of less frequent valuations can offer the perception that private assets have lower volatility, says David Picton, president and chief executive officer of Picton Mahoney Asset Management. “[That] can be a feature for plans in times of stress in the public markets. The public markets are under pressure, but the timing difference and discretion from when mark-downs are taken in private assets looks to smooth out the return a bit more, even though, economically speaking, there really hasn’t been any benefit.”
Private equity, private debt, real estate and infrastructure are valuable components in a portfolio, he says, but they come with similar exposure to the macroeconomic factors that impact public markets, like rising interest rates and inflation, just on a delay. As such, they might not offer the diversification benefit expected by plan sponsors.
“Return diversifiers,” a basket of alternative assets that includes hedge fund-related strategies like long-short equity and credit strategies, arbitrage, market neutral and more, can help to mitigate that risk, says Picton, noting these strategies are less commonly employed in Canada than in the U.S. and other markets. But 2022 has made a strong case for their use.
Public equities and bonds have suffered significant stress this year, while private equity and debt have experienced milder downturns, he says, adding the equity market neutral strategy is up on the year.
As plan sponsors start to invest in alternatives, they won’t be able to ramp up to their full target allocation right away because it takes years of capital calls to make a full commitment to a fund, says Hutch.
According to the PEPP’s statement of investment policies and goals, the pension is targeting a 22 per cent alternatives allocation for its accelerated growth, growth, balanced and moderate funds and 17.5 per cent for its conservative fund, but is currently only at 17 per cent and 13.5 per cent, respectively. Deploying capital in the secondary market can be a good way to get the diversification benefits early, something that’s especially important for DC plan sponsors.
Knowing that its allocation will ramp up over the coming years, Hutch says the PEPP has had to be more thoughtful in how it communicates with members — particularly about fees, which will also increase commensurately.
“Alternatives, across the board, are more expensive . . . so we’re more deliberate in saying we expect an increase over the next five years,” he says, adding the fund pairs that with some good news for members. “They [hear] that with another message: that we expect better risk-adjusted returns in the long term.”
Kelsey Rolfe is a Toronto-based freelance writer.
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