Private equity taps into defined contribution

Transcription

1 The institutional investor perspective on private equity, venture capital and infrastructure funds Q Private equity taps into defined contribution The phasing out of defined benefit pension plans finds private equity seeking new ways to tap into the swiftly expanding arena of defined contribution Published by Reprint from Limited Partner Q4-2013

2 FEATURE Private equity taps into defined contribution The phasing out of defined benefit pension plans finds private equity seeking new ways to tap into the swiftly expanding arena of defined contribution A recent estimate suggested that defined contribution (DC) plans, hold an estimated $3.5tn in assets. And while currently amounting to some 18 per cent of the $19.4tn US retirement market, this share looks set to grow as defined benefit (DB) plans continue to be phased out. Whereas in a DB plan the asset allocation does not affect the benefits promised to the participant, in a DC plan the asset allocation that specific participants choose directly affects their retirement pool. As a result assets are managed in a different way, with DC plan participants able to choose ready-packaged investment products depending on their risk preferences. Despite the evident appeal of gaining access to a growing capital source, historically, private equity has not proved wellsuited to such an off-the-shelf approach. Even with the in-built appeal of higher returns, with many pension plan sponsors proving familiar with alternative asset classes via their DB programmes, there remains a raft of operational and cultural challenges to navigate before private equity becomes a fully incorporated part of defined contribution plans. With its long time-horizon, pension fund capital via established DB plans has long been a considerable source of cash for private equity. However, this is likely to change with the DC plan or 401k as it is known after its US Internal Revenue code becoming the primary retirement choice of corporate America. Private equity needs to respond quickly to this shifting landscape according to Michael Riak, formerly director of savings and affiliate plans at US telecommunications group Verizon, and recently named principal and head of US defined contribution at private equity investor Pantheon. Having spearheaded Verizon s efforts to become the first nonfinancial plan sponsor to offer private real estate and absolutereturn investment options to DC plan participants, Riak is well aware the environment differs from the familiar pension plan landscape that many asset managers have become familiar with. One development he oversaw while at Verizon was the inclusion of custom target-date funds after the company froze its DB plan back in These funds offer a DB plan in miniature that can be tailored with specific targets and custom asset allocation, giving the ability to add types of asset classes that would not usually be found in a DC plan, such as private real estate and absolute return strategies. Riak explains, When you re investing a 401k, if it is a particularly sophisticated audience you can select your own fund. Target date funds are managed for you with a varying make-up depending on the date of your retirement. It makes it easier for participants, and depending on the time to retirement, this affects the proportion of certain assets in your portfolio. Target date Those plan sponsors with an existing private equity or alternativeassets exposure through an existing DB plan will be familiar with the benefits that private equity can bring, alongside its particular investment characteristics. Riak says, Private equity has added three to five per cent over public benchmarks over a 30-year time horizon. Plan sponsors that are invested in private equity know what it can do, and it is these people we are getting in front of. They will also have their own custom target date funds so they can do their own asset allocation and add private equity to it. From a fiduciary role, private equity makes sense as it can add alpha to the portfolio. To date, what has prevented DC plans from accessing the asset class is the fact that participants have come to expect a daily price on their portfolio, with the accompany high degree of liquidity two characteristics not traditionally found in private equity. With such in-built compatibility problems, it is unlikely that the DC industry is going to broadly adopt alternative assets off their own back, according to Stuart Odell, assistant treasurer of retirement investments at semiconductor chip-maker Intel, 14 Q4 2013

3 DEFINED CONTRIBUTION where he oversees both DB and DC structures. Where third parties can make this easier for these groups is by offering a sleeve of private equity exposure within these plans, he says. There is a definite place for a product that can make it more plug and play for a plan sponsor to add these assets to a defined contribution structure. It will not matter that they do not have the internal expertise to select underlying managers and monitor the capital calls that alternatives require. The alternative assets industry can push these plan sponsors by making it very turnkey for them. Buying off the shelf is the key to a wider adoption of these less familiar strategies. Those pension plan sponsors with a large existing allocation to alternatives offer the most promising entry point to private equity s inclusion in DC plans, says Riak. Pantheon is now looking to supply this sliver of private equity exposure to target-date plans, with allocations of between $50m and $100m for target-date funds. He adds, Plan sponsors we are approaching mainly comprise large plans, Fortune-500 companies that have DB plans of several hundreds of billions of dollars and have an existing alternatives and private-equity exposure through this. They will have what are known as Qualified Default Investment Options for people that do not want to make their own investment decisions and are defaulted into this single investment strategy. And once established within these funds, private equity exposure could vary from three per cent in conservativelyangled funds for people nearing retirement age, all the way to up to eight per cent for aggressive funds looking years into the future, Riak estimates Daily environment While a daily pricing model is a recognised feature of DC plans, Odell questions the suitability of this feature, particularly when investments are being made with a long-term horizon. He says, A basic question worth asking is, you have 25 years until your retire, why do you need to day-trade? Because it is a daily environment it severely limits the types of strategies and structures that can be made available, particularly when you are dealing with certain mutual funds that have very strict liquidity and leverage rules. To me, there is a disconnect between the marketing side of the 401k world, which is all about pushing products, trading and activity, and what is really in the participant s best interest, which is very long investment horizons. He adds, The 401k world 20 years ago saw record-keeping on a quarterly basis valuations were calculated quarterly and participants could only exchange in and out of these funds on that basis. As the industry evolved, people recognised they could get more of their products out to participants with features such as daily prices and daily trading. Today the industry is a daily environment. Silicon chip-maker Intel s defined contribution pension plan has led the way with the adoption of alternative assets strategies 15

4 FEATURE There is a definite place for a product that can make it more plug and play for a plan sponsor to add these assets into a defined contribution structure Odell has oversight on all of the US retirement plan investments for Intel, as well as either direct or indirect investment oversight for its non-us pension obligations. From his perspective, an exposure to alternatives is simply a necessary feature to pension fund investing. He says, It is relatively straightforward by increasing diversification in the portfolio we reduce volatility through asset classes that are not 100 per cent correlated with each other and reduce the overall risk. It takes away the reliance on purely equities, which historically has really been the only way that younger participants can get growth in their portfolio. There is a premium for illiquidity out there, and it is not insignificant. So if you can afford to take it, you should do so. If you are able to lock up your money for an extended period of time you can get paid quite well for that. Having embraced the 401k concept, Odell argues it is short-sighted for plan sponsors not to allow themselves access to the full suite of investment vehicles particularly those that specifically align with the investment horizon that so clearly reflects the outlook of their participants. Aside from the practical hurdles to incorporating alternative assets within defined contribution plans, there are also considerable cultural issues to address. He adds, Honestly, plan sponsors don t have to do it. They will often look at the risk and reward trade-off and ask themselves if it is worth it. Are you going to get a better outcome by doing this additional work? We believe this is the case, but there certainly isn t a requirement for a plan sponsor to think this way. Why bother For many groups, a certain level of retirement benefits are offered merely to attract and retain their workforce up to the minimum required level, and not be perceived to be below the market relative to their competitors. If others aren t seen to be offering certain features, there isn t necessarily a need for some Alternatives exposure still the exception With the launch of Intel s target-date funds back in 2004 where different assets were rolled up into a diversified portfolio and managed on behalf of participants the company embraced the use of alternatives in these funds, though this approach is still not particularly widespread in the DC industry. Stuart Odell, Intel s assistant treasurer of retirement investments explains, When 401k came out they where something of a novelty and employers often brought them in as a supplement to the traditional pension plan they offered to their participants. For example, they would often offer company stock as an investment option in the hope employees would invest their own capital, but they were definitely not a primary source of retirement income. Fast forward 30 years and defined benefit plans are on their way out as employers don t want to be saddled with an unknown liability going into the future. The 401ks, in particular, have become the primary retirement savings vehicle, and plan sponsors who have seen the benefit of diversification in their DB plans, including the use of alternative investments, are starting to ask what is preventing them from offering that same level of diversification to participants in their DC schemes.. Going through the 2008 crisis, a lot of plan sponsors saw that the traditional long-only stock/bond funds did not perform well. Essentially just two asset classes didn t necessarily protect and provide the diversification benefits that were necessary. A 60/40 stock/bond portfolio still has over 90 per cent of the risk coming from equities. However, the crisis has proven a catalyst for the reassessment of this asset mix. He adds, There has been a greater interest in providing better diversification across strategies to protect in all kinds of environment, not just a growth-orientated strategy. 16 Q4 2013

5 DEFINED CONTRIBUTION plan sponsors of the need for these assets over the long term, when their most recent reference point has been some unimpressive performance over the short term. He says, Some of it is very dependent on the environment you are in and the volatility that is being experienced in their portfolios. After the 2008 financial crisis there was a lot of scrutiny over custom target-date funds. Essentially there were all young participants, so were heavily weighted towards equities with a small portion of fixed income. Those funds often lost up to 30 per cent in a short period of time. People asked if diversification was really working, without asking whether this was indeed a diversified portfolio. For many pension plan sponsors, this environment proved an opportunity to take a step back from their programmes and enabled them to revaluate their options. Indeed, the pressure is off in the near term for these plan sponsors to refocus on their asset allocation, with long-term, return-producing assets such as private equity and other alternative assets potentially ready for more widespread inclusion. Riak says, It will take some time to bring private equity to the DC market. It is a new concept and we know other people are working on similar products. It is a long process and getting a plan sponsor to come on board takes a number of months. I come from one of these larger plan sponsors, and I am well aware that even once you have made a decision it can take time for this to be implemented. E ven if they don t have an allocation through their DB plan many of them will only have defined contribution. These can be very large and we believe they are still open to private equity and potentially adding it to their plans. The value of what private equity has brought to defined benefit plans and what it can potentially bring to their defined contribution plans is evident, we believe. They have a responsibility to take a look at the asset class, and we re very excited to take it to them. people to feel they need to add to their plan, Odell says. In addition, individuals may not also understand the benefit of alternatives in their portfolios, particularly as due to their long-term nature it will often take many years for them to see the tangible benefits of this diversification. For that reason, it requires a plan sponsor to take the initiative and diversify its offering, even if it requires work above and beyond what is required to remain competitive in the marketplace. He says, These are the headwinds facing plan sponsors. Again, they don t have to do this. Often a plan will be managed by non-investment professionals working off a menu of standard mutual funds. They are not in any position to build custom target dates or assess alternative portfolios; they are simply not equipped. They will need to seek out the resources to do so, but often will feel they don t need to bother. He points out that those groups that have so far taken on alternatives and custom structures tend to be those that come more from a dedicated asset management role, many of whom still have open DB plans. Rare thinking Many of these big industrial companies with large pension obligations continue to boast dedicated internal investment staff and will be comfortable managing often complex investment themes, which can then be applied within their defined contribution structures much as they have been doing with their DB existing plans. Odell adds, They get it; they understand the need for diversification into a range of asset classes. They also have the resources right at their fingertips to be able to leverage the work they do in the defined benefit side into their defined contribution plans. Consultants can also serve this role, and you could be a plan sponsor managing a 401k out of a human resources department, but with the right consultant there is no reason for you not to be able to develop custom products and use of alternatives. This thinking is rare, however. Ultimately, the benefit of such an approach is not really going to become apparent until that 30-year old employee is 65 and the 2040 target-date fund stacks up against a generic retirement product, he says. Step back As always, it comes down to the numbers and private equity s performance, like many other investment types in recent years, has not always been glowing. There is still nervousness around some of these asset classes, Odell says. It can be hard to persuade Michael Riak, principal and head of US defined contribution at private equity investor Pantheon 17

6 The above is a reprint from Limited Partner Magazine Q Limited Partners Magazine has provided Pantheon with the permission and authority to make this article available on Pantheon s website. The views and opinions expressed herein by Michael Riak are those of Michael Riak as of the date of the publication, and may change in response to changing circumstances and market conditions. Furthermore, market and investment views of third parties presented in this article do not necessarily reflect the views of Pantheon and Pantheon disclaims any responsibility to present its views on the subjects covered in statements by third parties. Under no circumstances should these views and opinions in this article be construed by any reader as investment, securities, legal, or tax advice. The information contained herein should not be deemed as a recommendation to purchase or sell any securities or investments. No representation or warranty, express or implied, is made or can be given with respect to the accuracy or completeness of the information in this article. In general, alternative investments such as private equity involve a high degree of risk, including potential loss of principal invested, are highly illiquid, and typically have higher fees than other investments. Information, opinions, or commentary concerning the financial markets, economic conditions, or other topical subject matter were prepared, written, or created prior to posting this article on this Site and do not reflect current, up-to-date, market or economic conditions. Pantheon disclaims any responsibility to update such information, opinions, or commentary. In addition, past performance is not necessarily indicative of future results. This article may include forward-looking statements. All projections, forecasts or related statements or expressions of opinion are forward-looking statements. Although Michael Riak believes that the expectations reflected in such forward-looking statements are reasonable, he can give no assurance that such expectations will prove to be correct, and such forward-looking statements should not be regarded as a guarantee, prediction or definitive statement of fact or probability.