Seeking new sources of return
The first of its kind, the New Sources of Return Survey for 2005 undertaken by asset manager JP Morgan Asset Management, questioned 125 representatives of 120 of the largest US pension plans. Both corporate and public plans were included, as well as a few non-profit, Taft-Hartley, and other plans.
Differences in attitude between corporate and public plans were apparent throughout the survey. For example, while equities dominate the portfolios of both corporate and public plans, accounting for more than 60% of the asset allocation mix, they diverge on the types of alternatives deployed. “Corporate plans appear to be somewhat greater users of private equity and hedge funds, while public plans have a greater allocation to real estate – both public and private,” points out the report.
They also differ in their current funded status. More than half the survey participants classified their plans as less than 95% funded, “with corporate plans faring somewhat better than public plans.” The survey found that 42% of corporates, and 68% of public plans, are less than 95% funded; and 10% overall of the survey respondents acknowledged that maintaining funded status is a major concern.
Current benchmarks seem to suit: 93% of respondents said that they did not plan to change how they measure performance. Despite concerns about meeting target returns, 99% of plan sponsors still rely on market benchmarks, and 78% measure themselves against their peer group or their rivals.
The report concludes that this is “indicative of a period of change and exploration, one in which success metrics are a step behind the innovative solutions being explored”.
However, the study also notes that a significant number of plans - 44% of corporate plans, and 28% of public plans - are measuring themselves against pension liabilities; this, however, does not mean that they use duration extension strategies to effect asset/liability management – only 11% do so.
In general, though, plan sponsors are open to change: 82% are considering different asset classes or new investment strategies for a variety of reasons, the most commonly cited, by 73% of respondents, is to diversify risk. There is an interesting difference in motivations between the corporate and public funds here.
More public funds were concerned with diversifying risk and delivering higher returns, while the corporates, had the edge on wishing to hedge liabilities.
The report addresses the fact that this strong desire to diversify seems to contradict the stated concern with maximising returns: “Our interpretation is that recent experience has made investors keenly aware of the risks of being too dependent on concentrated traditional markets to consistently generate required returns. Investors are looking to diversity their sources of return – and their risk – in reaching their return destinations.”
In terms of new asset classes, those funds looking to diversify risk were most interested in private real estate, inflation protected instruments (TIPS) and emerging market equity.
Even here, there was a distinction between the corporates and public plans: more corporate plans were considering commodities, hedge funds, absolute return and tactical allocation, while public plans had higher hopes for emerging market equity, high yield, and REITs. The report “initially found these results surprising but believe that this interest on the part of public plans may represent planned diversification to areas where corporate plans may already be allocated”.
In addition, 65% of plan sponsors did say that they would consider change to deliver higher returns, and were looking at private equity, emerging markets equity and private real estate. Public funds were slightly more interested in public real estate, while the corporates were looking at commodities and long-only return strategies.
The plan sponsors questioned were also open to new investment strategies.
The report noted: “We see evidence in our findings that they have a level of confidence in active management and of experience and comfort with derivatives – the tools embedded in absolute return, alpha transport, and tactical allocation overlays. It remains to be seen to what extent these factors will support continued exploration and implementation of these potential investment solutions.” While the majority of plans were content with their current active/passive mix, those considering a change favoured a move towards more active management.
Derivatives have “gained a significant level of acceptance among plan sponsors” – 64% are currently using derivatives and another 16% are considering doing so. Far more corporates (70%) than public plans (54%) are using them, but it appears that the public plans will catch up, since 24% of public plan respondents stated that they are considering their use. Those not using derivatives were put off either by policy guidelines or by the perception that derivatives were an implicit form of leverage. Derivatives are mainly judged useful either for rebalancing or to hedge against interest rate risk.
In addition, more than half the plans were using or considering using absolute return strategies, “with a higher proportion of users among corporate vs public plans”, the study points out. Those plans not interested in absolute return strategies were put off by a need to do more research. This was the case for almost 40% of the public plans.
Only 28% of plans used absolute return benchmarks.
The group was fairly evenly divided on the issue of portable alpha strategies.
Around one-third of the corporate plans questioned have used portable alpha strategies, compared with only 15% of the public plans.
But the public plans are likely to catch up, as 37% say they are considering using such methods. The report points out that there is “a strong correlation” between those accounting for alpha and beta and those employing portable alpha strategies (72% of those separating alpha and beta already use or are considering using a portable alpha strategy).