A defined contribution plan sponsor’s strategic decisions around asset allocation are far more influential to the performance of the pension portfolio than security selection or timing investments.

“The strategic decision is very important in terms of long-term results and the long-term experience of your plan members,” said Chhad Aul, vice-president of portfolio management at Sun Life Global Investments at Benefits Canada’s 2019 Defined Contribution Investment Forum in Toronto on Sept. 27.

Expanding the diversity of assets that are available in DC plans is under-discussed, he added.

Read: Custom target-date funds growing in U.S.: survey

“For the past 10 years, having a very constrained, a very vanilla set of building blocks for your plan members’ portfolios has led to relatively decent outcomes — using a typical core set . . . Canadian cash, Canadian bonds and then equities essentially across the developed world.”

While this might have been enough to produce decent returns in the past, noted Aul, this isn’t likely to be the case going forward.

When plan sponsors are adding new assets to the mix, it’s key to consider their risk/return profiles, he said, and that has to be done with a forward-looking lens. A typical balanced fund might have a reasonable risk profile and a good return history, but returns look shabbier going forward.

Meanwhile, with defined benefit plans seeing a significant shift towards alternative assets, DC plans could boost performance by taking a similar approach, noted Aul.

Read: 2019 Top 40 Money Managers Report: Investment lessons for DC plans from their DB parents

“Have we constrained ourselves too much in the DC space? Of course, we have higher liquidity concerns, we have concerns around valuation on a more timely basis, but can we do a little bit more?”

In implementing alternative investments, plan sponsors can start by looking at what they add to the mix in terms of their risk/return profiles. Private assets, for example, introduce a liquidity risk. “This is where private asset classes get compensated a premium for being willing to take on that illiquid investment. If you invest in private equity or private fixed income, you cannot redeem that on a daily basis. So because you’re locking in for a longer term, you derive a higher return.”

Some alternative assets are sensitive to inflation, he noted, which gives them an added return driver.

As well, alternative forms of debt can provide additional returns because of their higher credit risk, said Aul, noting that, as debt becomes riskier, the return prospects have to be higher to compensate. “As you move up the credit spectrum, whether it’s investment grade, or down to lower credit where the company’s [debt] is higher yield, across the sovereign space into emerging market debt, then you’re getting paid a premium because you’re taking on some credit risk. But the research shows that you’re more than compensated for that risk if you select the right credits to be allocating to.”

Read: A look at the ‘big rock’ decisions for DC plan sponsors

Moving into a higher risk and lower return environment, it makes sense for DC plan sponsors to diversify into alternatives that improve the overall risk/return profile of the entire portfolio.

“Interest rates are exceptionally low. We expect them to continue to remain low. A lot of that has to do with lower inflation expectations, lower growth expectations. This is just the world that we’re living in. We can expect asset returns to be lower and we can expect them to be more volatile — all reasons why we should do more and more to get more out of our opportunity set.”

As one opportunity, Aul zeroed in on private fixed income. “The return premium is primarily the fact that these bonds are not liquid. You can’t go out into the public market and sell them the next day. So, because you’re locking in for the longer term, you would expect as the lender, as the investor, to receive an additional return for your investment.”

Read: North America still dominates Canadian DB plan alternative allocations

Notably, he demonstrated that a portfolio with a more diversified set of alternatives doesn’t fare much worse, if at all, in a major market downturn scenario, than a traditional portfolio. However, in average or better circumstances, alternatives can enhance portfolio performance relative to common asset classes like domestic stocks and bonds.

Regardless of how DC plan sponsors add or change their asset mix, it’s important to go back to the drawing board every once in a while and review the tools available, said Aul. Given the Canadian stock market’s heavy component of natural resources equities, for example, many plan managers have avoided making additional natural resources plays since a traditional portfolio will already have ample exposure. However, if a manager zeroed in on investments in renewable resources, which are less prominent in the Canadian market, or perhaps more rare natural resources, there could be reasons to diversify into them.

“It’s not just about what’s looking at the newest or sexiest asset class, but sometimes it’s about taking a fresh look at what you might have left out of the portfolio in the past.”

Read more coverage from the 2019 Defined Contribution Investment Forum.

Copyright © 2019 Transcontinental Media G.P. Originally published on benefitscanada.com

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