To say the past year has been eventful would likely be an understatement. Between vaccine rollouts, economies reopening, workforces adapting to remote work setups, discussions on climate change, political stalemates and strong returns from capital markets, almost everyone has experienced some form of disruption and change in their daily life as well as our wider society.
Even as we look to turn the corner to 2022, we believe this is not the time for plan sponsors and asset owners to become complacent. Consumer spending coupled with supply chain constraints, continued easy monetary policy accompanied by a surging stock market, has led to higher inflation in the current economic environment. At the same time, employers must tackle the challenge of "The Great Resignation," referring to the widespread changes to the modern labor force brought about by the COVID-19 pandemic. This "Great Resignation" may turn out to be one of the most pressing challenges that employers face this year as they scramble to adjust to the needs and demands of their workforce in a post-pandemic world.
Whether you have a defined benefit plan that’s frozen or manage a defined contribution plan that is evolving to being used as a lifetime savings account by your participants, in these rapidly changing times it has never been more important to manage towards your key objectives and purpose.
The objective may be to ensure you have the necessary assets to cover future pension payments or you may be focused on ensuring your workforce is financially secure and can retire successfully. In light of these challenges, we have compiled the following list of key considerations and areas of focus that we believe will aid retirement plan sponsors and asset owners in tackling the investment challenges they may be facing.
01
Irrespective of the nature of your investment pool, a key necessity will be to translate your objectives to a return goal.
Many defined benefit plans have seen the funded status of their plans rise substantially over the past year. For those that have, the next step is to consider the end-game objective for their plans. For frozen plans, this would traditionally involve either hibernating the plan in a low risk holding pattern or terminating the plan completely.
However, there is a third option that is starting to become attractive for a number of plan sponsors looking for more upside potential. By running the plan in a well-hedged, moderate surplus return target state, these plan sponsors can address the needs of multiple stakeholders.
Regardless of where you find your funded status, or what your end-game objectives are, our key piece of advice is to make sure you understand what your return needs are relative to your desired objective. For example, we have seen some plans de-risk too quickly with a capital allocation glidepath, leaving the plan with insufficient returns necessary to reach their goals.
Hurdle rates and the need for returns isn’t unique to defined benefit plan sponsors. The return needs of defined contribution participants should be expressed in real returns, or returns in excess of Consumer Price Index, and as we discuss further in this paper, inflation is an ever-increasing risk. Investment menus should be reviewed to make sure they’re effective in achieving those long-term real return needs in order to provide participants with resiliency of cash flows and increased purchasing power.
02
We believe that investors require an expanded return-seeking opportunity set in order to make portfolios more resilient in the face of an inflationary environment. Specifically, the uncertain policy environment associated with stimulus being withdrawn, corresponding rate rises and inflation risk will require traditional portfolios of equities and investment grade credit to be scrutinized under these scenarios.
For defined benefit plans, the increasing volatility of rates are expected to impact both the liability and asset side of the balance sheet equation, with credit and Treasury bonds expected to perform poorly due to rising inflation risk premia and secularly low starting yields. This makes the understanding of how your existing portfolio will respond to different inflation scenarios critical, along with identifying new sources of income that are typically more resilient to inflation.
For defined contribution plans, the limited asset representation in menu structures today beyond equities and traditional core plus bonds poses a big risk. In order to better support their employees’ retirement income needs, we believe that sponsors need to consider expanding their asset categories and leveraging multi-manager structures where both geographic and style diversity will play a bigger role. Geographic diversity is expected to benefit portfolios given policy success will likely vary by region.
Private assets, particularly private loans with floating rate coupons as well as real assets which have a natural inflationary component, may become more relevant tools to assisting plans in weathering future inflationary pressures. Further, we believe private assets provide a fertile ground for climate solutions, which are expected to benefit from structural tailwinds.
03
One of the key developments of the COVID-19 pandemic has been the expansion and extension of funding relief via American Rescue Plan Act (ARPA) for defined benefit plans. For many plans, this has either substantially reduced or even eliminated the required cash contributions the plans would have otherwise needed to make over the next few years.
This development has provided plan sponsors with increased flexibility in pursuing their objectives, as the potential for higher contributions has been reduced. For some plan sponsors, this could allow for a more aggressive investment strategy that can ignore some of the bumps in the road that might have previously triggered a cash contribution. Alternatively, plan sponsors that are looking to take on less risk might be content with a longer time horizon on their path to achieving their goal.
Regardless of your objectives, we believe that the introduction of ARPA has made it a necessity for plan sponsors to review their investment strategy in order to make sure that you aren’t missing out on new opportunities, particularly in private assets, which may have been otherwise underutilized.
04
We continue to challenge the traditional ways of thinking about asset allocation and its connection to risk.
In our recent paper "LDI and the percentage fixed income question" we shared our belief that the percentage allocation to bonds is actually a very poor indicator of investment risk. A lower allocation to fixed income does not necessarily equal higher risk. We believe it isn’t the amount of bonds that matter but rather the focus on the type of risks and objectives you are managing towards.
This type of thinking can help free defined benefit plan sponsors from the historic bias to a particular allocation of return-seeking/growth assets and liability hedging assets, and instead allow you to pursue the return needs that correspond to your specific objectives while at the same time maintaining your desired risk level.
The growth needs of defined contribution plans have historically yielded significant equity representation with allocations of seemingly diverse equity options; however the actual equity risk and exposure end up being managed poorly within the still-commonly-used "style box" approach. We believe that investment style box labels both greatly oversimplify investment manager approaches into ‘value’ and ‘growth’ and overwhelm defined contribution participants who often struggle to understand how to use their fund options. We believe the use of multi-manager solutions within equity and beyond can provide participants a greater breadth of investment exposures, which can result in greater opportunity for stable wealth accumulation and income generation. Further, expanding exposures within the core menu and Qualified Default Investment Alternative (QDIA) glidepath can potentially generate a significant long-term income differential for participants.
05
When it comes to narrowness within capital markets, where a significant amount of returns are driven by a handful of companies or positions, don’t be a "taker," especially when it comes to passive capitalization-weighted indices. Instead, define your risk and consider providing capital that seeks to generate returns and make money for you, your plans and your participants.
We believe that plan sponsors should consider active management and more high-conviction portfolios that can add value. This aligns with investment professionals’ best ideas given their conviction in underlying corporate or asset fundamentals. The individual manager volatility can be offset with a multi-manager structure, with monitoring relative to objectives and/or a benchmark occurring at the aggregate or total structure level.
More specifically, sponsors should consider extending their high-conviction investment strategies beyond equities and into other potential return generative ideas (e.g. credit and real assets). Don’t lend where it’s crowded. Instead, evaluate where you lend and aim to reduce corporate lending risk, given overlap with your equity portfolio.
06
We believe sponsors should consider integrating desired investment themes into their investment program, which may contribute to longer-term beneficial growth and/or provide differentiated return streams. At the same time, evaluate whether those themes address or hedge emerging risks, and generate long-term sustainable benefits (to the asset portfolio). Once those themes have been identified, consider which asset categories provide the most attractive or efficient access to that desired exposure(s) while being careful not to define a theme as an asset category.
For example, given the recent Department of Labor proposed ruling on integration of Environmental Social and Governance factors within fiduciary investment processes, consider investment beliefs on climate stewardship and the energy transition (which underpins climate transition). Opportunities for risk management and/or return generation may emerge across a broad spectrum of potential solutions and asset categories.
An area of focus that investors will likely need to embed within their programs is management of climate risk and its potential impact on asset returns. Having a more explicit focus on climate risk throughout your portfolio could lead to alpha opportunities and/or more sustainable cash flows.
07
We have observed a strong shift from plan sponsors simply talking about diversity towards actually acting on it, with even more plan sponsors seeking to lay out action plans of their own. Similarly, the topic of diversity, equity and inclusion (DEI) has never been more top-of-mind for the asset management industry. Our approach to DEI has been outlined in our 2020 paper "Diversity in the asset management industry," and centers on measuring diversity and understanding both where you’re starting from and where you’re going.
This type of evaluation requires a holistic assessment that goes beyond simply looking at ownership. We believe that ownership is an easily attainable metric that fails to integrate diversity across different functions within an organization. We believe that the only way to have more diverse-owned investment firms is to first have diverse investment leaders and teams. By measuring diversity across these three levels, we believe the resulting evaluation helps provide a more robust and relevant picture of diversity.
“The analysis supports our beliefs; investment teams with diversity tend to generate better returns.”
Chris Redmond
Head of Manager Research
This is further backed by our research, which shows that investment teams that are more diverse result in greater investment returns. This highlights the importance of understanding and evaluating diversity at the investment team level.
Once you have obtained a clear picture of what diversity looks like and means for you today, you can then move forward in crafting a longer-term action plan for your retirement plans. We believe a crucial aspect of such a plan would be encouraging investment managers to incorporate greater data transparency and action on their part. By engaging with existing managers and identifying new opportunities to add, we believe that plans can make even greater progress. For DC Plans, let's not forget about participant implications. Read more about it here.
The last couple of years have created numerous challenges which can make some plan sponsors lose sight of their objectives. Regardless of these challenges, plan sponsors still need to earn strong risk adjusted returns in order to fulfill the purpose of their retirement plans and investment programs. We believe understanding different levers and areas of consideration will help plan sponsors better navigate these complex economic conditions in the near-term and long-term.
1 Willis Towers Watson. Diversity in asset management. 2019.
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