Prime Portfolio to Protect Pension Plan Funding

Pension plan funding, a perennial issue, was on the rebound as the recovery from the Great Recession took hold, but recent volatility in the financial markets compromised that improvement for many plans. A recent paper argues that one of the keys to buttressing a pension plan’s funding lies in its portfolio and optimizing growth and asset returns.

In “Revving Pension Plans’ Funding Engines,” Cambridge Associates’ Alex Pekker, Senior Investment Director; Barjdeep Kaur, Investment Director; and Alex Sawabini, Senior Investment Associate, write that it still is necessary “to generate meaningful asset returns, not just to close deficits, but also to fund pension risk transfers and offset ongoing plan administrative expenses.” They continue, “Given increased volatility in global equity markets, relatively high valuations in many market segments, and the late stages of the economic and credit cycles, optimizing the plan’s growth engine is more critical, and challenging, than ever.”

Such action, Pekker, Kaur and Sawabini write, is not just important for plans that are in obvious trouble — those that are underfunded and “soft-frozen.” They contend that it is critical to generate for such plans, but say that it is also important for plans that are well-funded and even those that are “hard-frozen.” Enhancing asset returns, they point out, will help offset Pension Benefit Guaranty Corporation premiums, actuarial fees, changes to mortality assumptions and other factors that may affect a plan.

Pekker, Kaur and Sawabini suggest that a strategy which can help with asset returns can include:

• striking a capital-efficient balance between liability-hedging assets and growth assets;
• a more granular allocation of assets;
• an appropriate amount of active manager risk; and
• the degree of illiquidity risk that can be assumed.

Pekker, Kaur and Sawabini call efficient capital allocation “paramount” in order for a portfolio to outperform a plan’s liabilities and also address interest rate risk. Such an approach, they say, can give make more capital available for use in pursuing growth.

And in asset allocation within portfolios, Pekker, Kaur and Sawabini say, plans should maximize potential excess returns relative to volatility of funded status, and evaluate anticipated returns as well as the opportunity for managers to add value. They add that it is important to consider the interaction between asset classes.
For those “willing to invest the required resources in portfolio implementation, a capital-efficient, risk-diversified portfolio can significantly outperform a traditional pension portfolio,” write Pekker, Kaur and Sawabini. And, they add, including alternatives can increase potential manager value-add “significantly.” They argue that global equities, private investments and hedge funds are “the growth engine of the pension strategy.”

Pekker, Kaur and Sawabini contend that one should “consider the full spectrum of growth strategies, evaluate the potential for active manager value-add, and engage the appropriate resources to construct portfolios tailored to their specific needs.” And, they add that “Although timely, setting the return generation lever is not a one-time exercise” — one should “reevaluate and recalibrate portfolios to ever-changing market conditions, plan circumstances and sponsor-specific dynamics” and that “a comprehensive and nuanced view of the returns lever is critical” to success.