Pension funds are restructuring for a new investment climate.
A State Street report, Pensions Funds DIY: A Hands-on Future for Asset Owners, reveals five key trends that are reshaping every aspect of how pension funds manage their investments and deliver long-term value to their members.
Getting hands-on with investment risk — Pension funds are re-evaluating their attitude toward risk as they seek to deliver value to their members in a difficult investment climate. Seventy-seven percent expect their institutions’ investment risk appetite to increase over the next three years.
The rise in risk appetite is driven by pension funds’ need to boost lacklustre returns. Interest rates have remained at historically low levels. Traditionally popular asset classes such as equities and fixed income may look pricey. Pension funds are making a major shift in allocations to less-familiar asset classes such as alternatives to drive growth and meet long-term liabilities.
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Big bets on alternatives — For pension funds, alternative investments have typically constituted a small part of the portfolio. This is changing. Pension funds are finding that a small allocation to alternatives is not sufficient to generate the required growth. This is forcing many of them to place bigger bets on alternatives.
Private equity emerges as a hot area for investment, with 60% of respondents anticipating increased allocations into this asset class. A significant proportion of pension funds also say they will invest more in direct loans (54%), real estate (46%) and infrastructure (39%).
Pension funds are also showing a greater appetite for hedge funds. Globally, 29% of pension funds that already invest in hedge funds will increase their allocation, while 25% will invest in this asset class for the first time.
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Do-it-yourself asset management — The trend toward the insourcing of asset management will accelerate over the next three years. Globally, 81% of pension funds say they intend to increase the proportion of their portfolio that is managed in-house.
Cost is a big driver for insourcing strategies. Asset owners also believe they can increase their oversight of assets by bringing them in-house. And pension funds with a focus on insourcing will have to acquire many of the capabilities of the specialist asset managers. The larger funds are already competing for top investment talent.
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The relationship with asset managers evolves — The relationship between the pension funds and their asset managers adds another layer of complexity to risk and performance management. Fifty-eight percent say it is a challenge to gain a complete picture of risk-adjusted performance, while 18% describe this as a major challenge. More than half (52%) of pension funds also find it difficult to ensure that their asset managers’ interests are aligned with their own. Cost is also an issue: 29% say it is a challenge to justify fees from their asset managers, although only 6% see it as a major challenge.
Pension funds will still pay a premium for managers with proven investment skills and ideas. Only the very largest and most sophisticated funds, for example, will have the skills to manage all aspects of today’s multi-asset class portfolios in-house. Pension funds need asset managers who can help them develop investment strategies that are compatible with their broader investment philosophy. For their part, asset managers must master the transition from product providers to becoming fully fledged “solution builders.”
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Fortifying governance — Several forces have combined to put a new focus on the governance model for pension funds. More than half of respondents in the survey view strengthening their overall governance as a high priority for the next three years.
The increased use of complex alternatives may also require pension funds to bring in more professional trustees or specialist advisors. Just under one-quarter of respondents agree that the increasing sophistication of their portfolios requires change in the composition of their trustees.
Read: Pension investing and plan governance
This report is based on a survey conducted by the Economist Intelligence Unit of 134 senior executives in the pension fund industry. Respondents from 15 countries participated, with the majority being drawn from Canada, the United States, the United Kingdom and Australia. Most respondents came from organizations that oversee both DB and DC funds.