Understanding How Much Alternative Assets Your Portfolio Can Handle Managing Liquidity Risk for Private Sector Defined Benefit Plans with De-risking Glide Paths September 2014 Risk. Reinsurance. Human Resources.
Key Points Many private sector defined benefit plans with de-risking glide paths can use alternative assets to improve their de-risking programs due to such assets return potential and diversification benefits. But it is critical to ensure that any illiquidity risk is tolerable. The specific level of illiquid assets a private pension plan can hold is highly customized to its circumstances, including cash outflows, cash inflows, asset allocation glide path and potential events like pension liability settlements. Investors considering alternative assets should perform multi-year stress-testing projections to understand their liquidity profile. For pension plan sponsors, this should be integrated with an assetliability analysis to incorporate both benefit payments and future contributions. Frozen plans are often able to invest in alternative assets such as core real estate and hedge funds, which generally have lock-ups of less than two or three years. Open and closed plans may be able to include meaningful allocations to longer-horizon investments such as private equity and opportunistic real estate. One of the biggest concerns about incorporating alternative investments in a portfolio is illiquidity, though the opportunity to invest in illiquid assets often translates into the very potential for higher returns and diversification that many investors seek. So understanding the liquidity characteristics of different types of alternative investments can help investors maintain their liquidity needs while maximizing the benefits from alternative assets. Unfortunately, simple rules of thumb are not often reliable ways to assess the risks and benefits of incorporating alternative assets. The amount of alternative assets an investor can hold tends to be highly individualized, as it is heavily dependent on factors such as: Contributions expected levels of contributions, and their sensitivity to different economic scenarios Benefit payments expected levels and sensitivities to different economic scenarios Investment policy level of risky assets, static asset allocation or dynamic investment policy that reduces risk as funded status changes Investor goals perpetual maintenance or intent to settle liabilities in the foreseeable future This paper uses a case study to illustrate how investors can use a combination of quantitative analysis and qualitative judgment to analyze liquidity risk from alternative assets for U.S. private pension plans on de-risking glide paths. Understanding How Much Alternative Assets Your Portfolio Can Handle Private Sector 1
Case Study Situation: This U.S. private pension plan is subject to the Pension Protection Act s rules for funding. It is open, with ongoing accruals, but is relatively mature. The illiquid assets the investor wants to consider are private equity (with an approximate 14-year horizon), opportunistic real estate (with an approximate nine-year horizon) and hedge funds (approximately one- to three-year lock-ups 1 ). To ensure its capacity for vintage year diversification, this investor will consider only strategies where commitments to private equity and real estate can be maintained for at least three years, preferably longer. Similarly, hedge funds will be entered into only to the extent that the investor expects to be able to maintain the positions for at least three years. The plan has a dynamic investment policy that de-risks from 65% return-seeking assets to 20% return-seeking assets as the funded status transitions from 85% to 120%. It currently has no alternative assets. The plan is currently 85% funded. It has approximately $2.5 billion in assets. The plan wants to identify the Extreme Illiquid Threshold Allocation ( ExIT Allocation ), which we define as the allocation holding the greatest amount of illiquid assets without violating the plan s target split between return-seeking and liability-hedging assets. This represents an extreme bookend for allocations to consider. Once the ExIT Allocation is known, the plan will then consider whether to invest in that portfolio or a different portfolio that is more liquid. To determine the ExIT Allocation, we used an iterative process of looking at various levels of each type of illiquid asset, until no additional commitments could be made without causing the alternative assets to exceed the target allocation to return-seeking assets in at least one of the economic scenarios. (The ExIT Allocation could be developed with a different constraint, such as alternative assets never exceeding half the total allocation to return-seeking assets. The decision of how to define the ExIT Allocation can be determined by the plan sponsor.) The following investment strategy does exactly that, maintaining the target allocation between returnseeking and liability-hedging assets at all times while also providing for the benefit payments from the plan: Private equity $200 million commitments in each of the next three years Opportunistic real estate $175 million commitments in each of the next three years Hedge funds $290 million deployment Public equity amount varies to achieve the target level of return-seeking assets in the glide path The figures that follow illustrate how the liquidity profile of the ExIT investment strategy will evolve in each of three economic scenarios. Figure 1 shows the Central 2 scenario, in which the glide path requires the plan to gradually increase its allocation to fixed income as the funded status improves. The exhibit shows 1 In practice, hedge funds have a wide variety of different liquidity characteristics. The assumptions in this paper are a simplification for illustrative purposes. 2 The Central scenario represents our base case assumptions for capital market returns. For example, public equities would return 7.5% in each year. Understanding How Much Alternative Assets Your Portfolio Can Handle Private Sector 2
that the alternative assets can be shifted to liquid as their lock-up period is over. In the case of private equity and opportunistic real estate, the net asset values increase steadily as commitments are drawn, and then decrease gradually as distributions occur. For hedge funds, the strategies are maintained for at least three years (though not a true lock-up, this time frame is used because it is the plan sponsor s horizon for reconsidering the asset allocation). The alternative assets never exceed the amount of returnseeking assets allowed by the policy, and thus there is no liquidity violation in this scenario. Figure 1 Scenario: Central Company XYZ 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 1-3 Year Lock-up 10+ Year Lock-up 5-10 Year Lock-up <1 Year Lock-up Risk-Reducing Assets In practice, the plan sponsor may consider whether to make additional commitments or maintain the hedge fund exposure beyond that in the figure above, as the figure focuses on lock-ups from illiquidity (and does not include additional future commitments that may be made by choice). Figure 2 is a simplified version of Figure 1, grouping all the alternative assets together so it is easier to see how the allocation to the total pool of alternative assets evolves over time. The remainder of this paper includes graphs similar in format to Figure 2. Understanding How Much Alternative Assets Your Portfolio Can Handle Private Sector 3
Figure 2 Scenario: Central Company XYZ 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 Illiquid Assets - in Policy Liquid Return-Seeking Assets Illiquid Assets - In Excess of Policy Safe Assets (Liquid) We will now do a similar analysis for the ExIT investment strategy under a more pessimistic economic scenario. In the Black Skies 3 scenario, the plan s glide path does not require de-risking for several years because the funded status declines significantly. As shown in Figure 3, while the illiquid assets increase to relatively large proportions of the total assets, there is still a lot of cushion because the high target allocation to return-seeking assets is maintained. 3 The Black Skies scenario represents a deep recession with no bounce-back. For example, public equities values would fall by about 50% over three years, and other assets returns would move in relation to their correlations with public equities. Understanding How Much Alternative Assets Your Portfolio Can Handle Private Sector 4
Figure 3 Scenario: Black Skies Company XYZ 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 Illiquid Assets - in Policy Liquid Return-Seeking Assets Illiquid Assets - In Excess of Policy Safe Assets (Liquid) It is important to note how the Black Skies scenario for plans on de-risking glide paths is different from most investors situations. While investors typically envision that liquidity stress occurs in extremely unfavorable economic environments, such as those of 2008, this is not the case for many de-risking U.S. defined benefit plans primarily because their glide paths would not require de-risking (e.g., selling alternatives) in a down market. In addition, the plan sponsors would be required to make large contributions to the plan after declines in funded status, injecting liquidity without selling assets. The Blue Skies 4 scenario shown in Figure 4 is the most challenging for this investor s liquidity profile, as the funded status increases quickly and the plan needs to reduce its allocation to return-seeking assets. The majority of the de-risking must occur by selling liquid return-seeking assets (public equities). There are two peaks at which the illiquid return-seeking assets will account for nearly all the plan s returnseeking assets: 2016 and 2018. The first peak is because of the assumption that the hedge fund allocation will be maintained for at least three years. The second peak is because the value of private equity is assumed to be at its highest in 2018. The plan will always be able to meet its benefit payment commitments without exceeding its policy s target allocation to return-seeking assets, so there is no violation of the liquidity requirements. 5 4 The Blue Skies scenario represents a strong, sustained market uptick. For example, public equities values would increase by about 20% annually for three years, and other assets returns would move in relation to their correlations with public equities. 5 A plan with higher liquidity needs would build those into the definition of the ExIT Allocation defined earlier, and incorporate that into a similar stress-testing process. Understanding How Much Alternative Assets Your Portfolio Can Handle Private Sector 5
Figure 4 Scenario: Blue Skies Company XYZ 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 Illiquid Assets - in Policy Liquid Return-Seeking Assets Illiquid Assets - In Excess of Policy Safe Assets (Liquid) Plan Sponsor s Decision We believe the ExIT Allocation is an important piece of information for making decisions, but we often do not recommend it as the actual allocation. In this case, the plan sponsor chose not to invest in the ExIT Allocation for four main reasons. 1. The Blue Skies scenario is not the most extreme scenario imaginable, so the sponsor wants a cushion for more extreme events. 2. The sponsor is uncomfortable with alternative assets ever comprising the entire allocation of returnseeking assets. 3. The sponsor currently has a more favorable outlook for opportunistic real estate than private equity. 4. The plan sponsor wants the freedom to be able to settle the liabilities via annuity purchase or lump sums in 10 years without too large of a sale in the secondary market if management later wants to do that. As a result, the plan sponsor selects the following strategy for illiquid assets: Private Equity Opportunistic Real Estate Strategy Selected $150 million commitment in each of the next three years $150 million commitment in each of the next three years Most Illiquid Strategy $200 million commitment in each of the next three years $175 million commitment in each of the next three years Hedge Funds $200 million $290 million Figure 5 shows how that strategy will evolve in the Blue Skies scenario. Understanding How Much Alternative Assets Your Portfolio Can Handle Private Sector 6
Figure 5 Scenario: Blue Skies Company XYZ 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 Illiquid Assets - in Policy Liquid Return-Seeking Assets Illiquid Assets - In Excess of Policy Safe Assets (Liquid) While this strategy does have some residual illiquid assets in 10 years, these comprise only 6% of the portfolio. The plan sponsor feels comfortable that the illiquid assets are not so large an amount that they would create a major obstacle to liability settlement, if desired (i.e., they would not be too painful to sell in the secondary market). With this allocation, the alternative assets are expected to peak at around 50% of the return-seeking assets in the Central scenario, and that figure would not exceed 80% in a Blue Skies scenario. The plan sponsor intends to monitor its liquidity profile annually, as the actual economic scenario occurs, and assess how the strategy should be adjusted along the way. If, for example, the economic environment is similar to the Central economic scenario, the plan sponsor would likely maintain its hedge fund allocation beyond 2016 and continue making commitments to private equity and real estate in the future. Understanding How Much Alternative Assets Your Portfolio Can Handle Private Sector 7
Commitments versus Target Percentage Allocations It is notable that the percentage allocations vary significantly across time and economic scenarios, ranging from under 10% to over 25%. Most investment policy statements are written to target certain percentage allocations. However, liquidity risk often occurs when actual allocations are different from the target level. Investors in illiquid assets do not decide on the percentage allocations; they decide on the commitment levels and the percentage allocations are a result of the combined effects of those commitment levels, the economic environment and other factors that may not be influenced by the investor. In the case of plans with de-risking glide paths, the desired percentage allocations to alternative assets can change across the glide path, both in absolute levels and as a fraction of the return-seeking assets. As a result, when we model liquidity risk for a particular investment strategy, we base it on commitment levels the unit of decision for investors and the actual percentage allocations that would occur in different economic scenarios, rather than target allocation percentages. The target allocations and ranges in an investment policy statement may be determined from the scenario analysis. Sales in the Secondary Market A potential consequence of having too many assets in alternatives is being forced to sell some at a discount in the secondary market. It is important to understand not only the likelihood of that event, but also how painful it might be. Figure 6 shows the annualized additional return needed from private equity to make up for the loss that would occur from a sale in the secondary market in the Blue Skies scenario. 6 Figure 6 Return Hurdle to Cover Loss from a Sale in the Secondary Market 5.0% 4.5% 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% Private Equity Blue Skies 5 6 7 8 9 10 11 12 Years Since Commitment As expected, longer horizons require lower return hurdles, both because there are more years invested in private equity and because the net asset value sold in the secondary market declines over time. Six years 6 There are many factors influencing discounts for sales in the secondary market. For this analysis, we assumed a 10% discount in the Blue Skies economic environment. Understanding How Much Alternative Assets Your Portfolio Can Handle Private Sector 8
from the date of the commitment, the annual return hurdle is under 2%, and it declines to under 1% eight years after the date of the commitment. Ten years after the commitment, the return hurdle is under 0.5%; that is, the one-time discount in the secondary market equates to a drag of 0.5% to 2% if spread throughout the investment period. We wouldn t recommend investing in private equity assets if the plan sponsor were confident it would liquidate them in six to 10 years (a common scenario for frozen plans). However, this plan sponsor is not confident it will liquidate these assets in this time frame it is just a possibility and the possibility would most likely become reality in a favorable economic environment for such transactions. A potential (but not certain) return drag of 0.5% to 2%, though not desirable, could be palatable when compared to the benefits of private equity; top quartile managers have historically been able to exceed this return threshold. 7 That is, a private defined benefit plan sponsor that is confident it will maintain the assets for at least six years may want to consider holding private equity it depends on the likelihood of needing to liquidate it in the secondary market, potential time until liquidation and returns expected until then. This conclusion is different from what we would recommend for investors that are most liquidity-stressed in Black Skies scenarios, so it is worth showing how influential the economic scenario is to the investor. In a Black Skies scenario, the secondary market would be much less forgiving, with a significantly greater discount for forced sales. Further, the distributions from private equity would be much slower, so the discount would be applied to a greater portion of the original investment. A similar analysis, but reflecting the longer horizon and higher discount for the Black Skies environment, is shown in Figure 7. 8 7 One reason to be more cautious about the attainability of the 0.5% 2.0% estimate is because the plan sponsor would be holding the private equity during the most difficult parts of the j-curve. 8 For this analysis, we assumed a 25% discount in the Black Skies economic environment. Although some observed discounts in 2008 were significantly higher, that was often because the appraised asset values hadn t been written down in tandem with the public equity market declines. We consider this discount a reasonable range for assets that are marked-to-market, and a higher discount would only strengthen our conclusions. Understanding How Much Alternative Assets Your Portfolio Can Handle Private Sector 9
Figure 7 Return Hurdle to Cover Loss from a Sale in the Secondary Market 5.0% 4.5% 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% Private Equity Black Skies 5 6 7 8 9 10 11 12 Years Since Commitment The one-time loss from a forced sale equates to an annualized return drag exceeding 5% for liquidations eight years and earlier, more than nullifying any of the return premium investors generally expect from this asset class. Even after 10 years, the annualized return drag would be over 3%. Such a drag on returns is more painful when it occurs in the Black Skies scenario, as it is correlated with other portfolio declines. In short, investors whose liquidity stresses occur in a Black Skies economic scenario should have a very strong aversion to the possibility of forced sales in the secondary market. In 2008, before derisking glide paths were prevalent, these types of scenarios were characteristic of the vast majority of liquidity events covered in the industry press. However, they represent a very different economic scenario and experience from the Blue Skies scenario; one that would cause liquidity stress for a de-risking pension plan. Understanding How Much Alternative Assets Your Portfolio Can Handle Private Sector 10
Summary of Key Factors That Drive Results Though the case study in this paper is intended to represent the broad range of issues that affect most U.S. private pension plans with de-risking glide paths, each plan has unique circumstances. The key factors that influence the ultimate results for a particular plan are: Factor De-risking glide path Benefit payments Contributions Future liability settlement Tolerance for breach of asset allocation targets Economic scenario when a sale in the secondary market is needed Impact Dynamic investment policies that adjust the allocation to return-seeking assets as funded status increases need to incorporate both current and future target allocations. The level of return-seeking assets when the plan is 100% 110% funded will strongly influence the ceiling on long-term illiquid assets with horizons of 5 to 10 years or more. (This means that fully frozen plans, which typically have glide paths ending with very low levels of return-seeking assets, may have little if any tolerance for investments with extremely long lock-ups.) The level of return-seeking assets in 2 to 3 years under a Blue Skies scenario will strongly influence the ceiling on more liquid alternatives, such as most hedge funds and core real estate. Higher levels of benefit payments or spending needs create a lower allowance for illiquid assets. Contributions inject liquidity and offset benefit payments, allowing greater allocations to illiquid assets. Many private pension plans want the option to settle their liabilities in the future, either with a lump-sum window or annuity purchase. That increases the need for liquidity, although the exact timing and amount is not usually known years in advance. Frozen pension plans that are likely to want to terminate may not be able to tolerate any assets with extremely long lock-ups. By their very nature, illiquid assets make rebalancing difficult. Investors who have broader ranges for asset allocation or are comfortable with short-term breaches of asset allocation targets can hold more alternatives. 9 Secondary market liquidations in a Blue Skies scenario are far less painful than those in a Black Skies scenario. All else being equal, investors who might need to sell alternatives in the secondary market in Blue Skies scenarios should be comfortable with higher allocations than those whose secondary market activities are triggered by Black Skies scenarios. 9 Another application of these types of liquidity projections is to help calibrate the size of ranges for different asset classes. Understanding How Much Alternative Assets Your Portfolio Can Handle Private Sector 11
Synthesizing Results: The Art and Science of Liquidity Analysis While this paper describes a very analytical approach to looking at liquidity, there is an art to interpreting the results and translating them into portfolio implications. Investors must thoughtfully consider which scenarios to analyze, and their likelihood not just the economic environments, but also scenarios for different levels of contributions, benefit payments and liability settlements. In addition, investors must think about how painful different liquidity events would be. For example, a slight breach of the desired asset allocation say, a liquidity event that causes an investor to hold 61% return-seeking assets instead of a target allocation of 60% is probably not as painful as a liquidity event in which an illiquid asset must be prematurely sold at a discount. The approach described in this paper is a stress-testing model for risk management, not a tool to provide an objective answer to how many alternative assets an investor can hold. Without understanding this information, it is difficult if not impossible for investors to make a complete case for (or against) high allocations to alternatives. This type of analysis will help investors consider many different scenarios and have confidence in the rationale for the amount of illiquidity in their portfolios. Understanding How Much Alternative Assets Your Portfolio Can Handle Private Sector 12
Contact Information Eric Friedman Associate Partner Aon Hewitt Investment Consulting, Inc. + 1.312.381.1319 eric.friedman@aonhewitt.com Understanding How Much Alternative Assets Your Portfolio Can Handle Private Sector 13
About Aon Hewitt Investment Consulting, Inc. Aon Hewitt Investment Consulting, Inc., an Aon plc company (NYSE:AON), is an SEC-registered investment adviser. We provide independent, innovative solutions to address the complex challenges of over 480 clients in North America with total client assets of approximately $1.7 trillion as of June 30, 2014. More than 270 investment consulting professionals in the U.S. advise institutional investors such as corporations, public organizations, union associations, health systems, endowments, and foundations with investments ranging from $3 million to $310 billion. About Aon Hewitt Aon Hewitt empowers organizations and individuals to secure a better future through innovative talent, retirement and health solutions. We advise, design and execute a wide range of solutions that enable clients to cultivate talent to drive organizational and personal performance and growth, navigate retirement risk while providing new levels of financial security, and redefine health solutions for greater choice, affordability and wellness. Aon Hewitt is the global leader in human resource solutions, with over 30,000 professionals in 90 countries serving more than 20,000 clients worldwide. For more information, please visit aonhewitt.com. Aon plc 2014. All rights reserved. Investment advice and consulting services provided by Aon Hewitt Investment Consulting, Inc. This document is intended for general information purposes only and should not be construed as advice or opinions on any specific facts or circumstances. The comments in this summary are based upon Aon Hewitt Investment Consulting s preliminary analysis of publicly available information. The content of this document is made available on an as is basis, without warranty of any kind. Aon Hewitt Investment Consulting disclaims any legal liability to any person or organization for loss or damage caused by or resulting from any reliance placed on that content. Aon Hewitt Investment Consulting reserves all rights to the content of this document. Understanding How Much Alternative Assets Your Portfolio Can Handle Private Sector 14