The pension industry is at a turning point, with the asset value of defined contribution plans growing, while defined benefit plans are shrinking.
“In a decade’s time, you will have a situation where DC will be almost $50 trillion in size, but DB will be $10 trillion in size and there will be big changes to long-term investing,” said Alex Veroude, chief investment officer for North America at Insight Investment, part of BNY Mellon Investment Management, when speaking at the Canadian Investment Review’s Global Investment Conference in September.
Once a DB plan is nearing the end of its life, it can’t make as long-term illiquid investments and it has a lower risk tolerance, which leads to a different investment management style – one that traditionally relies more on fixed income.
As fixed income portfolios grow in importance, it’s becoming more difficult to produce returns. Yields were already near historic lows when the coronavirus hit and now the pandemic has meant that rates will likely stay near-zero for numerous years and the stock of negative-yielding fixed income assets will increase too, Veroude said.
Against the challenging economic backdrop, many DB pension plans still require liquidity, reduced risk and growth. “They can’t afford to put all their money in zero per cent yielding stuff. And that’s a pretty tricky task that we’ve seen almost every pension plan struggle with.”
As such, plan sponsors are looking for good-quality cash flows that are useful to them and allow them to maintain liquidity, he said, noting that based on his experience, he is seeing pension plan sponsors take a strategic-credit approach that looks beyond traditional fixed income to other contractual assets with a high degree of cash flow certainty. “Most pension plans these days are looking for credit solutions, but ideally not too risky because they’re coming out of government bonds. And they want to stay as close to government bonds as possible.”
In a strategic-credit approach, investors combine all of their fixed income assets, including traditional global bonds and global alternative lending, in a single portfolio. They also focus on enhancing the yield of traditional bonds by moving away from a traditional benchmark and holding to maturity.
Ultimately, the goal is a best contractual cash flow approach that allows plan sponsors to calculate cash flows precisely, similar to the level of certainty they’d expect from an annuity payment. “What they’re doing is . . . [keeping] the risk of capital loss very low by focusing primarily on investment-grade type of risks, not necessarily investment-grade corporate bonds, but investment-grade type of risk, i.e., defaults are very rare and really shouldn’t happen at all.”