The Markets January 16, 2020

Strategies for Including Private Equity in DC Plans

From an operating perspective, plans can use private investments in a multi-asset class investment vehicle.

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Results of a study by the Defined Contribution Alternatives Association (DCALTA), conducted in collaboration with the Institute for Private Capital (IPC), suggest that including private equity funds in defined contribution (DC) plan portfolios both improves performance and has diversification benefits that lower overall portfolio risk.

The researchers sought to understand the properties of a portfolio strategy that provides an investor exposure to more private funds early in the investment lifecycle but then shifts to increasingly lower-risk and more liquid assets over time. In particular, they simulate the impact of including private market funds into target-date funds (TDFs) that typically have a defined change in asset allocation over several decades.

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The analysis found average returns of the TDF portfolio are higher than for the all-public benchmark and the calibrated portfolio outperforms in 82% of the 1,000 simulations. The adjusted standard deviation falls considerably from 9.89% to 8.50%, suggesting that the diversification benefits from adding buyout funds remain substantial. This fall in risk drives the Sharpe ratio up for the calibrated portfolio so that in 100% of simulations, it is higher than for the all-public benchmark. “This is the first evidence we are aware of that an investor can invest their portfolios with private market funds and achieve substantial diversification benefits while at the same time manage dynamic allocation targets within reasonable bounds,” the paper says.

Plan sponsors in the U.S. may have concerns about including private investments in DC plan fund menus, notes Serge Boccassini, head of institutional global product and strategy at Northern Trust Asset Servicing in Chicago. There is a fear that as a fiduciary, plan sponsors worry whether they are making an appropriate decision to include investments that are not necessarily understood. There is concern about the cost of alternative assets and how that plays into participants’ savings accumulation. And, there are concerns about the illiquid nature of some private investments.

Speaking about the results of Northern Trust’s work supporting DC plans in Australia, Boccassini says, “The platforms and processes we use to evaluate [alternative investments] on a daily basis work.”

Including private equity in DC plans

Boccassini explains that when Northern Trust started to grow globally, one of the first places he went was Australia. He realized that the country is No. 1 or No. 2 in terms of leadership in DC plans, with its mandatory “Superannuation Guarantee” contributions program. “Many investments in those plans include assets in illiquid alternatives, such as private equity and real estate,” Boccassini says.

He adds that alternatives are incorporated in the balanced fund—the default fund for superannuation plans. These funds are the typical 60% equity/40% fixed income split, and on the equity side, between 2% and 15% is invested in alternatives. From a liquidity perspective, it works, because buys and sells needed are made with cash and liquid investments other than alternatives.

Boccassini has seen the inclusion of alternative assets result in better rates of return and a better response to challenges when the market slides.

In the U.S., when markets started to flatten and investors, including retirement plans, weren’t getting the same types of returns, many plans went back to a master trust strategy, or one in which multiple plans—defined benefit (DB) or DC—could be combined into one investment trust, and assets could be unitized, according to Boccassini. He explains that if a large plan sponsor has a DB plan with a global equity portfolio that invests in 50 stocks, with 20 in private equity, including venture capital and buyout funds, it can allow its DC plan to invest in that portfolio. For the DC plan, the global equity fund can represent 60% of the plan’s balanced fund. The global equity portfolio is investing both in marketable and nonmarketable securities. The liquidity challenge is addressed because the plan sponsor can sell portions of the fund not invested in illiquid assets when money needs to leave, Boccassini says.

As for the fiduciary concerns, DC plan sponsors can consider that DB plans have a deeper management philosophy and are more broadly based, he adds.

If a plan sponsor only has a DC plan, it would sit down with an asset manager or consultant to create a separately managed balanced fund or a target-date fund (TDF) with assets in private equity. Boccassini says there exists both the technology and processes to peg illiquid assets to the actual trading market through marketable assets and to peg to them to an index. The net asset value (NAV) can be calculated every day, using plus or minus cash flows and what happened in that particular industry.

“What we’re trying to do through research and participating in DCALTA is educate plan sponsors about value versus cost,” Boccassini says. “Some countries have put caps on fees in DC plans, and this limits the use of broad-based investments. The research shows that over time and net of fees, private investments in multi-asset class portfolios perform better, and their risk tolerance is more appropriate in down markets.”

He believes DC plans are missing huge opportunities in the U.S investment market because publicly tradeable securities have been on the decline since the 1980s, and private investments are on the increase. And, from an operating perspective, plans can use private investments in a multi-asset class investment vehicle.

One of the other challenges Boccassini notes is interpretation of the Employee Retirement Income Security Act (ERISA) about what investments can be included in a DC plan. He stresses that nothing in ERISA excludes alternative vehicles. “A number of plan sponsors include private equity or hedge funds in target maturity funds,” he notes.

Boccassini and others in DCALTA have sat down with the U.S. Senate Committee on Health, Education, Labor and Pensions (HELP) to discuss how plan sponsors in other markets are making investments in private equity easier and ways to expand U.S. regulations to include broader assets to alleviate plan sponsor concerns about fiduciary duty.

Compliance January 16, 2020

Will 2020 Deliver Union Pension Funding Solution?

The American Federation of Musicians and Employers' Pension Fund is just the latest union multiemployer pension to appeal to the Treasury Department for permission to cut benefits.

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In new commentary shared with PLANADVISER, Israel Goldowitz, partner with the Wagner Law Group, says the financial hardship faced by the American Federation of Musicians and Employers’ Pension Fund is characteristic of a broader problem.

As Goldowitz explains, the U.S. Treasury Department has received an application from the American Federation of Musicians and Employers’ Pension Fund to suspend benefits, based on authorities granted under the Multiemployer Pension Reform Act of 2014. The plan’s suspension application is the latest of more than 30 by similar union-run multiemployer plans.

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So far, Goldowitz says, the applications have mainly covered workers in transportation and the building trades. But upwards of 120 plans in a number of industries are considered “critical and declining,” he says, which means they are expected to run out of money within 20 years. Such plans, under the 2014 funding reforms, may suspend benefits if that would prevent outright insolvency.

According to a statement from the pension, more than 20,000 musicians could see benefit reductions under the plan. The vast majority face reductions ranging from 0% to 20%, while fewer than 1,000 could see reductions in the range of 20% to 40%. In cases like this, the Treasury must approve or deny the benefit reduction plan after conferring with the U.S. Department of Labor and the Pension Benefit Guaranty Corporation (PBGC)—for which Goldowitz once served as chief counsel. Once approved, the suspension proposal goes to the plan’s participants and beneficiaries for a vote.

While it might seem unlikely that pension beneficiaries would vote in favor of benefit cuts, in fact this has already happened across the U.S. Votes in favor of benefit reductions are cast based on a simple economic analysis: The guaranteed monthly benefit limit that will be paid out by the PBGC (which insures both union and single-employer corporate pensions) is about $36 per month per year of service, or about $13,000 annually with 30 years of service. This amount is far less than the PBGC single-employer guarantee of about $65,000, and it is often also far less than the level of the benefit to be paid after a proposed reduction. And unlike the single-employer guarantee, Goldowitz observes, the multiemployer guarantee is not adjusted for inflation.

“Worse, the PBGC’s multiemployer insurance fund is itself projected to become insolvent no later than 2026,” he warns. “At that point, there will be no backstop for plans that fail or for the 1.3 million people who depend on them. That includes 400,000 people in the Teamsters Central States plan alone.”

Goldowitz says it is no surprise that Congress has picked up on this challenge, given the political influence of unions. However, consensus on a solution remains elusive, even with the lobbying efforts of high-profile politicians and business leaders. Unlike the approach favored by Democrats in the House of Representatives, which would establish a government-backed loan program to assist troubled union pension, the Republican-favored approach in the Senate would permit the partition of such plans and would require accounting reforms.

“Either proposal would involve a cost to taxpayers, with interest groups citing various figures,” Goldowitz says. “Butch Lewis Act proponents [mainly Democrats] point out that retiree spending has a multiplier effect, as most retirement income is spent quickly on goods and services, keeping others at work and generating tax revenues. A compromise may be reached, but we can only speculate when that may happen or what a compromise would look like. These issues should be of concern to companies that participate in multiemployer defined benefit plans, to unions, and to retirees. They should also be of interest to those seeking to lend to or acquire such companies.”

To gauge public awareness and sentiment around multiemployer pension plans and their impending collapse, the Retirement Security Coalition recently commissioned a bipartisan poll among 2,700 likely voters in key states affected by the multiemployer pension crisis. According to the Coalition, the results clearly indicate voter recognition of the pension crisis, as well as the urgent need for Congressional action.

“The survey results show broad voter support for protecting retirees and Congress needing to make changes to multiemployer pension plans,” the Coalition reports. “Voters said overwhelmingly (92%) that protecting American retirees is essential to our economy. The survey found that three-quarters of voters recognize the urgency and need for Congress to take action. Voters support Congress taking action through a comprehensive (70%) ‘shared solution,’ including additional employer support, government assistance and additional retiree support.”

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