Demographic change particularly affects defined benefit pension funds. Together with the prolonged period of low interest rates, it has already had a profound effect on their commitments and investment practices.
In the Netherlands, life expectancy at age 65 is now 18.8 years and 21.2 years respectively for men and women, compared to 14.0 and 16.4 years in 1980. The situation is almost identical in the United Kingdom: 18.8 years for men and 21.1 years for women in 2017-19.
Translated into asset liability management, securing two decades of solid income is a staggering task. In a rising rate scenario, liabilities will decrease but the value of fixed income portfolios will also decrease. In a scenario of weak growth and still low interest rates, attractive risk-adjusted returns remain rare.
What can we expect as pension funds continue to enter private markets and other areas of fixed income? Here are five (probable) outcomes:
• Commission budgets will increase with a new balance of alternative asset classes, at least in the short term (a controversial subject dealt with by my colleague Carlo Svaluto Moreolo in this issue). In previous decades, legions of product salespeople earned handsome commissions on retirement savings funds, both institutional and retail. In an era of low returns, an important goal of regulators and investors has been to shift the balance between cost (falling) and transparency (increasing).
In listed markets, a shift towards passive and quasi-passive investments over the past decade has caused panic, at least in some neighborhoods, about the future of active management. Yet its demise has been overstated from the perspective of multiple asset classes, and anecdotal evidence has long suggested that good institutional investors value both passive and active approaches.
In most private markets, be it mortgage loans for example or private equity, there is not yet a credible alternative to active management. Willis Towers Watson is studying a passive approach to private equity, but without a clear strategy at this time. As it stands, stakeholders should be comfortable with a reasonable balance of fees in private markets, which does not mean that they should overpay.
• Some investors will outbid: the competitive nature of many illiquid investment strategies (a tight supply pipeline) and the trade-off between the fixed cost of due diligence and the opportunity cost of a non-competitive bid means that forgoing to a portion of future income by overbidding can still be an attractive course of action. If this resets the price benchmark upward in a particular niche or asset class, then other investors may have to take it on the chin.
• More mature portfolios take on a green tint: equities are where the bulk of the ESG work has been done, especially given the ability of large investors (often together) to make board-level changes administration through their engagement and voting approaches. But many companies are decades away from achieving net zero carbon. Look at the portfolio’s carbon exposure through an LDI lens, however, and the picture changes. A tilt toward green assets from yield-generating private markets on the one hand – think renewables – and increasing green government bond issuance on the other hand means that a carbon neutral target may be more. close for mature retirement asset pools.
Pension funds will increasingly be able to use green government bonds in their LDI compartment in combination with a portfolio of illiquid alternatives in the yield section, with many underlying assets producing both cash flow and a measurable impact against the climate or other UN SDG targets.
• The form of outsourcing is changing and investment organizations designed to manage DB portfolios with positive cash flow appear less suited to their purpose. This could prompt a rethinking of housekeeping and, indeed, it could trigger a wave of outsourcing or consolidation among pension funds with smaller, less flexible investment teams more focused on liquid markets. It can be difficult, even for fairly large investors, to compete with very big international players like the Canadians.
• Limited turnover to equities: Longer and stable investment horizons as well as better and more granular risk modeling mean that mature pension funds may wish to take more exposure to equities if there is a shortage of viable return-generating assets – especially in the form of quality cash flows made up of stocks, some of which (not coincidentally) also score high on ESG measures.
Each of these developments would be significant in itself. Taken together, they will have profound implications for retirement asset pools.
Liam Kennedy, editor-in-chief