To find out how plan sponsors are responding, CIO recently polled more than 100 institutional investors around the globe—85% of whom operate defined benefit pension plans—on their approach to two common strategies: liability-driven investing (LDI) and investing in alternative assets. To more fully understand what’s driving their thinking right now, our survey, commissioned by FactSet, also asked them which macroeconomic factors will have the biggest impact on institutional portfolios over the next 12 months. Finally, we asked how they’re approaching common risk management functions: in-house or using outside vendors or consultants.
LDI Strategies Are Popular, but Not Without ChallengesLDI strategies generally revolve, of course, around hedging a fund’s exposure to interest-rate risk and inflation risk using bonds, swaps, and other derivatives. By matching liabilities and assets, investors hope to stabilize, and over time shrink, their unfunded ratios. It’s the polar opposite of trying to grow your way to fully funded status by seeking to earn the highest possible returns on equities and other higher-risk assets.
Unfortunately, the low interest-rate environment that has prevailed since the 2008 financial crisis has made it difficult for some plan sponsors to embrace LDI investing—to reconcile themselves to the low returns available in the fixed-income markets, that is, while bypassing the bigger gains they have been seeing in the equity markets.
Still, a clear majority of the survey respondents—55%—say their institutions are employing LDI strategies today. Those doing so have allocated on average about 45% of their portfolios to those strategies.
Among the survey respondents who aren’t using LDI strategies, the most significant reason for not doing so—cited by 46% of respondents as “very important” and another 38% as “somewhat important”—is their plan’s funded status. The bigger the gap between a plan’s liabilities and its assets, the costlier it becomes, in terms of potentially lost return opportunities, for the plan to shift away from equities and into fixed-income.
Not surprisingly, the interest-rate environment is the second biggest inhibitor to embracing LDI strategies, cited as “very important” by 38% of survey respondents and “somewhat important” by 46%. The lower the general level of interest rates, the costlier it becomes, again, to match assets and liabilities.
Alternative Investments Are Widely EmbracedWhile many plan sponsors find LDI an important risk-management tool, most also find they need to generate alpha somewhere in their portfolio—especially in a low-rate environment like the one that’s prevailed for the past decade. To that end, and to further diversify risk, many plan sponsors have allocated significant portions of their portfolios to alternative asset classes where returns typically do not correlate highly with equity returns and may sometimes outpace them. The most common of these alternatives is real estate, with 82% of survey respondents reporting some allocation to the asset class. Within that group, three in 10 plan sponsors have allocated 30% or more to the asset class.
Private equity is the second most popular alternative—held by 73% of survey respondents—followed by hedge funds, infrastructure, and, lastly, venture capital (held by only 33% of survey respondents).