The most revolutionary ideas in institutional investing come from new definitions of risk and how to manage it.
But the institutional universe remains dichotomous: Defined benefit plan sponsors, especially cash-strapped public pension plans, have become converts to risk factor-based investment and internal management at a much faster pace than those of defined contribution plans.
In fact, investment evolution within the defined contribution plan market is mostly incremental in comparison with the fervor that is shaking the foundation of defined benefit plan investment management from the concept of asset classes to governance.
Revolution in the defined benefit plan universe is centered on new definitions and categorizations of risk and ways of implementing that knowledge in investment practice.
With few exceptions, observers said the best minds in the 401(k) plan space are focused on refining and advancing existing approaches such as multimanager investment options, retirement income adequacy and financial wellness.
Defined benefit plan chief investment officers, on the other hand, are looking to employ more informed risk management to generate performance to meet assumed rates of return, more precisely diversify portfolios, protect their funds from drawdowns and become more nimble, opportunistic investors, sources said.
“Over the last 100 years pension fund management moved from asset allocation of set dollar amounts to looking at risk with a lower case “r,’” said Eugene Podkaminer, senior vice president in the capital markets research group of investment consultant Callan Associates Inc., San Francisco.
“The investment world gradually moved from risk as a concept in the ether to a mathematical proxy of risk with a capital “r,’” Mr. Podkaminer said, noting more recent manifestations of better understanding and application of investment risk include risk parity, portable alpha, smart beta, liability-driven investment, low-volatility and risk premiums.
Of those approaches, one of the latest is risk factor-based investing (Pensions & Investments, May 4, 2015).
Factor-based investing assumes risk premiums can be identified by a wide array of factors beyond simple equity market risk and then can be captured systematically through passive factor-based replication strategies or through portfolio construction based on a combination of risk factors.
Although some investors have progressed fairly far in converting their equity portfolios to a risk factor-based model, notably Pensions-kassernes Administration A/S, which manages $32 billion in Danish laborer pension assets, and the $9.3 billion Missouri State Employees’ Retirement System, the “factor revolution” still is in its early stages, said Roger Urwin, global head of investment content, who is based in the Reigate, England, office of investment consultant Towers Watson & Co.
“Over time, risk has begun to express itself in new ways and at this point on the continuum, investors need to become much more mindful of risk factors and return factors,” Mr. Urwin said.
A multidimensional approach to risk management and portfolio construction in the form of a model based on risk premiums is “a slow-moving train that is unstoppable and it will accelerate,” Mr. Urwin said, stressing that “if you look at the investment innovation curves of the past, they were always slow to pick up speed, but those with legs do pick up speed.”
“There will be a revolution over the next five years as every investor has to begin to simultaneously manage the financial consequences of their investment decisions, as well as the societal, environmental and stakeholder consequences,” Mr. Urwin added.
Another aspect of investment revolution running through the defined benefit plan community is the acknowledgement that to meet funding obligations, internal investment departments have to step up their game, investing in securities, sectors, regions and vehicles, often with partners, that staff and boards wouldn’t have considered a few years ago.
The accelerating pace needed to exploit the most lucrative opportunities exceeds the capacity of most boards of trustees and investment committees to meet often enough to approve these investments.
That timing mismatch has in turn has led to a significant upgrade in the number and capability of pension funds’ investment staff and an increase in the amount of assets managed internally, industry watchers said.
The investment division of the $25.9 billion Employees’ Retirement System of Texas, Austin, is a good example of how pension funds are profoundly altering investment operations to add capacity and competency.
“The easy money has already been made,” said Charles Thomas “Tom” Tull, chief investment officer. He noted that more stringent financial regulation, accounting developments, tax code changes and increased barriers to entry in the more opportunistic deal flow for both managers and smaller pension funds have and will continue to create an array of “opportunistic, problematic, profitable investments … in brand-new investment categories we’ve never invested in before.”
In order to invest in new areas such as litigation and receivables financing, energy loans and direct investment in self-storage properties, Mr. Tull said his investment team created a “no-holds-barred environment” that encourages creativity for internal teams on the lookout for deal flow wherever a profit can be made.
To accommodate the speed needed for investment in fleeting opportunities, Mr. Tull said: “The public pension plan environment is changing. We will see public plans become more like an investment shop with more internal management in order to compete for investments and meet funding requirements. Time will become the most critical factor in investment success. The institutions that will be successful will be those that are the most nimble. And the more money you have, the more ability you will have to win the best investment deals.”
About 63% of the Texas plan’s assets are managed internally and the governance model the board of trustees established is “essential” because it gives staff the discretion they need to make the best investment decisions, said Sharmila Chatterjee Kassan, chief of staff of the investment division.
By contrast, “the defined contribution plan market tends to be more evolutionary than revolutionary. Many of the best ideas today were around 20 years ago,” said Ross A. Bremen, partner and defined contribution strategist at investment consultant NEPC LLC, Boston.
There isn’t agreement among executives in the 401(k) plan market as to what investment ideas qualify as revolutionary vs. evolutionary, but Winfield Evens, director of investment strategy and solutions, based in Aon Hewitt’s Chicago office, was willing to take a stab at categorizing some.
In Mr. Evens’ evolutionary column for DC plans are:
- cost reduction;
- more structured, concise investment option lineups for a few edgier 401(k) sponsors offering an objective-based approach with four to eight “bread basket” funds that combine style-oriented options into a single fund, such as global equity; and
- “diversifying” asset classes such as hedge fund- or private equity-style funds that might “help a participant on the margin.”
In his revolutionary column, Mr. Evens placed:
na mindset change to a focus on retirement income adequacy from savings and participation rates;
npayout options that help participants make the right decisions beyond the “easy” accumulation stage; and
nfinancial wellness programs that help employees deal with all aspects of their financial lives so they can find a way to make any, or larger, contributions to a defined contribution plan.
“The question is, “who goes first?’” Mr. Evens said. “There are a few innovators who have made some of the revolutionary changes. Then, eventually, the early adopters will come. And finally, at some point in the future, the majority of 401(k) plans likely will follow.”
Defined contribution plan sponsors approach new investment ideas very slowly and with a great deal of trepidation, NEPC’s Mr. Bremen said.
Between litigation that over the years found 401(k) plan sponsors guilty of various transgressions — most recently the U.S. Supreme Court decision in Tibble et al. vs. Edison International (P&I, June 1) — and the vagueness of new regulations designed to improve transparency of educational processes, “when you roll all of that together, there’s a considerable amount of fear about adopting new investment approaches,” he said.
By way of example, when it comes to financial wellness programs, “only a handful of large plans have fully implemented the idea. This is a holistic approach which brings together all aspects of financial well-being,” said Sabrina Bailey, a Seattle-based principal and U.S. defined contribution plan leader of MercerLLC.
Among the outcomes of financial wellness programs are increased participation in the defined contribution plan, fewer 401(k) plan loans and higher participant satisfaction, Ms. Bailey said.
Los Alamos National Laboratory’s financial boot camp, however, exceeded the expectations of Michelle Autumn Ryan, investment program manager of the $1 billion 401(k) plan, and Jay Johnson, chief financial officer.
The government lab is run by a private company, Los Alamos National Security LLC, and all 7,000 employees work on the same rural Los Alamos County, New Mexico, campus.
There also is a $3.5 billion defined benefit plan that was closed to new hires in June 2006.
The idea for the financial wellness program stemmed from the successful introduction of a physical fitness program that attracted participation by 70% to 80% of employees.
Mr. Johnson attributed the success of the physical fitness program to the fact that the lab has “the highest per capita number of Ph.D.s in any workplace in the U.S. and they are very competitive.” But he added: “If you’re lying awake at night worrying about how you’re going to pay your bills, it affects your overall wellness.”
When it came to the financial boot camp, “we were sort of blown away by the response. We obviously had huge pent-up demand,” Ms. Ryan said, noting 3,000 employees attended the mid-November 2014 boot camp benefits fair and three days of financial courses.
Demand for some of the financial workshops was so high, the boot camp crew — composed of human resources, benefits and finance department employees — arranged for live streaming of the sessions.
The LANL boot camp outcomes were significantly positive, Ms. Ryan said. The average 401(k) plan deferral rate was 5% in the fourth quarter of 2013 and increased to an average of 7% in the last three months of 2014. About 8% of employees enrolled in the 401(k) plan for the first time with an average deferral rate of 10% and of existing participants, 41% increased their deferral by at least four percentage points.
More financial boot camps are planned on a biennial basis, Mr. Johnson said.
Sources did point to one more idea that is so revolutionary it hasn’t really started yet: the establishment of multiple-employer plans on the state and federal level for smaller public and private employers engaged in similar activities, said NEPC’s Mr. Bremen.
So far this year, state legislatures in Illinois and Washington approved basic retirement plans for individuals and employers with fewer than 100 workers.
But Mr. Bremen and Ms. Bailey both agreed the idea could work and work very well for small employers.
“There’s a huge divergence between what large and small 401(k) plans can obtain from vendors. The opportunities for small plans are far fewer. Many small companies joining together would give the (multiple-employer) DC plan significant buying power to get the bells and whistles usually reserved for bigger plans,” Mr. Bremen said.
Ms. Bailey said interest in these plans is rising in Washington and state capitals.
“The regulations have to be worked through, but if they are set up well, these plans could be really revolutionary in increasing the country’s retirement readiness,” Ms. Bailey said.
Source: Pensions & Investments