How pension plan sponsors can use demographic-focused investing

Over the last 40 years, the demographics of pension plan membership have changed drastically, said Michael Augustine, managing director and head of asset-liability management at TD Asset Management, during a webinar hosted by the investment manager earlier this month.

Forty years ago, when rates were a lot higher, pension plan demographics were quite different. For every one retired member in a pension plan receiving benefits, there were eight active members making contributions. Pension plans were in full accumulation mode and [they were] cash flow rich and the focus was clearly on growth. Then, over the next 20 years, something happened.”

Read: Shifting demographics key catalyst to changing pension plan design

In the 2000s, the ratio of retirees to active members changed to 3:1, then 2:1 in the 2010s and 1:1 in the 2020s. As such, pension plans are reaching an inflection point where benefits paid out are much richer than the investment being generated, making them cash-flow negative.

The situation is a perfect storm with low interest rates, a greater requirement for cash flows and a need for asset growth to close funded status deficits, noted Augustine.

He pointed to demographic-focused investing as a solution. “DFI begins with an analysis of a plan’s purpose or objective by demographic cohort. Now, for retired members, the objective is to generate sufficient cash flows to meet pensioner payments, but [to] do so at a reasonable cost. The time horizon is shorter and, as a result, the tolerance for risk is generally lower. The recommended approach is cash-flow generation over the appropriate horizon.”

For active members, the objective is generally to grow the asset portfolio at a rate that meets or exceeds the growth of the underlying actuarial liabilities within an acceptable risk level, he said. “Now, taking advantage of the longer time horizon and generally larger risk budget, DFI emphasizes a variable payout asset that is expected to outperform over the long term.”

Read: Options for small plans to invest like the big pension funds

In demographic-focused investing, it’s critical to ensure proper correlation between the asset-classes and the underlying liabilities, said Augustine.

Referring to a case study of a closed pension plan balanced between retirees and active members, he said that generating adequate cash flows at a reasonable cost for retirees would include private commercial mortgages, investment grade private debt, corporate bonds and provincial government bonds.

For active members, the objective is growth, he added, which could involve investing in variable-return assets while being mindful of their liability correlations. “Public equities can generate dividends, while offering the potential for capital appreciation. At the same time, they exhibit a degree of interest rate and credit correlation to the plan’s underlying liabilities. We also like infrastructure. The long-duration nature of the projects in a typical infrastructure strategy can be a particularly good fit for long-active liabilities. They provide the potential for capital appreciation and also a degree of inflation protection.”

Further, Augustine noted real estate is a good fit in a demographic-focused investment strategy. “From a cash-flow perspective, rental payments can be tied to changes to [the consumer price index]. That creates a nice hedge to inflation. At the same time, increasing property values can provide capital appreciation over the long term.”

Read: Pension funds with hefty real estate allocations on the rise: survey

Institutional investors can also use a bond overlay to free up capital to invest in growth assets to maintain a degree of correlation with underlying liabilities, he added.

A key for pension plan sponsors interested in using a demographic-focused investment approach is “right risking,” said Augustine, noting this involves setting the right balance between cash flows and growing assets.

“And obviously . . . demographics are the starting point. However, other factors such as plan status, funded position and a plan sponsor’s investment beliefs, all help to determine and shape a sponsor’s risk appetite and that determines the fit or the balance, if you will.”