Following an asset-liability matching study in early 2018, the Toronto Transit Commission Pension Fund Society is expanding its allocation to less liquid investments.

The jointly sponsored pension plan, which has about $6.5 billion in assets under management, is comprised of 37 per cent fixed income, 44 per cent equities and 19 per cent real assets, such as real estate and infrastructure.

While the TTC plan regularly reviews its asset allocation, it hasn’t experienced any major shifts over the years, says Sean Hewitt, chief executive officer of the TTC plan, noting the asset-liability matching study largely confirmed the plan’s traditional approach with some minor modifications. “What we’ll be doing over time is continuing to reduce our allocation to traditional fixed income investments in favour of nontraditional fixed income, as well as alternative asset classes such as infrastructure.”

Setting targets

The study aimed to develop a better understanding of the TTC’s capacity for illiquid investments. “As part of this, we developed what we call a liquidity budget, which targets, both in regular capital markets and then in periods of capital market stress, what our capacity is to withstand illiquid-type approaches,” says Hewitt. “What we found . . . given the composition of our current asset mix, our contribution regime and the plan demographics, we have considerable room and budget to move away from traditional fixed income approaches into more sophisticated credit strategies, including private debt.”

The liquidity budget helps the plan build a systematic approach to understanding its capacity for illiquid investments while recognizing the risks to the plan, he says. “[For example], if the plan has very large cash outflows, and you have an asset base that isn’t readily marketable . . . then that can pose some issues. And that’s what we would call an asset-liability mismatch, in a sense.

Understanding that dynamic and that capacity for illiquidity is important because, if you have a good view as to what your capacity is, then you can take advantage of that without exposing yourself to risks in a downside event.”

Despite more room for alternatives, Hewitt says the plan doesn’t have hard targets for when it will move into more real assets. “In our investment policy, we build ourselves flexibility to take our time and approach.

As an example, the longterm target for private equity is quite a bit higher than what we’re at currently. And we will certainly make investments as opportunities arise, but we also don’t want to be forced into making asset allocation decisions . . . in a challenging market environment.”

Looking at illiquidity

A liquidity budget is derived through a cashflow modelling exercise where a plan looks closely at what’s coming in compared to what’s going out, says Janet Rabovsky, partner at Ellement. “Do I have enough to cover my expenses through my contributions plus my pension payments or do I need to disturb some of my assets to get money for that?”

In addition to a liquidity budgeting exercise, pension plans should consider their governance budgets and administrative constraints, she says, noting some examples include looking at how often the pension committee meets, the skill level of committee members and whether the plan’s reporting structure can accommodate quarterly lagged returns.

If a plan has good governance in place and can stomach the return pattern, it would be worth becoming more illiquid, though not in all cases, says Rabovsky. “Sometimes it’s just too complex and people shouldn’t do what they don’t understand.”

When considering illiquidity, plan design also matters, says Dave Makarchuk, strategic growth leader for Mercer’s wealth business in Canada. “For plans that are very close to winding up, for plans that just can’t withstand any volatility at all and need a lot of certainty, I would still be cautious,” he says. On the other hand, for open DB or DC plans, as well as plans that intend to run for at least three more years, he says there are good arguments for exploring more illiquid investments.

Plans should also review their investments and the corresponding agreements with managers to understand their “days to cash,” meaning a best guess of how quickly these assets can be turned into cash if necessary, says Makarchuk.

He also recommends testing out different scenarios to determine how much liquidity is needed in comparison to how much a plan currently has. “The stress scenarios are challenging, because we haven’t had a liquidity stress since, really, 2008/09. And when it happens again it will probably look different.”

Benjamin Abramov, director at LaSalle Investment Management, says it’s key to consider not only the cash requirements for liabilities, but also the cash needed for currency hedges, uncalled capital for private funds or portfolio rebalancing.

However, he also notes most plans have more than enough liquidity. “My experience of looking at a lot of pension plans is that most tend to hug liquidity more than they need to and have more of their budget to spend.”

End in sight

Once a plan determines it has the capacity to become more illiquid, it’s important to understand the end goal, says Rabovsky. For example, does it need income or is it looking for capital appreciation?

It should also understand its tolerance for the J-curve, where a return is back-ended and doesn’t pay income from the very beginning, she notes. “Can you afford to take no returns from that for a couple of years for the sake of outsized returns years down the road?”

It’s key to consider objectives, agrees Abramov. “Real assets tend to be still attractive, especially for pension plans that have a lower return threshold and are looking for more diversification,” he says, noting infrastructure, real estate and hedge funds generally offer the most diversification, while private equity offers the most alpha.

However, though private equity and venture capital may be attractive for alpha seekers, they don’t have a strong diversification benefit, he adds. When entering illiquid investments, another critical consideration is manager selection, says Rabovsky.

“These are somewhat like marriages. It’s really hard to get out of them, and could be quite expensive and costly. And so, doing the proper analysis to find the right partners is really important because if you’re not happy longer term, you may not be able to get out of these things.”