alternative investments for capital accumulation plans (cap)

Alternative Investments for Capital Accumulation Plans (CAP)

What Plan Sponsors Should Know

Bradley N. Rowe, CFA Principal

Start with the “Risk Free” Asset

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Government of Canada Bonds and Treasury Bills (Zero Coupon Yield Curve – Start of Year)

Data Source: Bank of Canada

‘W Y S I W Y G’

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Government of Canada (Mid to Long Term Bond Yield)

Bond Yield: 1982 was 14.3%



Data Source: CIA Report on Canadian Economic Statistics

‘W Y S I W Y G’

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Median Pension Fund Return

Average Return 1982-1996 was 13.2%

Average Return 1998-2012 was 6.4%


‘W Y S I W Y G’

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Government of Canada (Mid to Long Term Bond Yield) vs. Median Pension Fund Returns (15 year - plotted at Start of period)

Yield Fund Return


Bond Yield: 1982 was 14.3% Average Return 1982-1996 was 13.2%

Bond Yield: 1998 was 5.5% Average Return: 1998-2012 was 6.4%

Bond Yield: 2012 was 2.3% Average Return: 2012-2026 will be ??%

Asset Allocation – DB Plans (Canada)

Data Source: PIAC, Asset Mix Composites

Asset Class 2000 2003 2006 2009 2012

Fixed Income 37.5% 35.9% 31.1% 33.0% 30.7%

Equities 54.9% 52.2% 51.9% 43.9% 41.1%

Total “Traditional” 92.4% 88.1% 83.0% 76.9% 71.8%

Private Equity 1.5% 3.6% 3.5% 6.0% 7.5%

Real Estate 5.2% 6.7% 7.3% 8.9% 10.2%

Infrastructure Not Reported Not Reported 2.4% 3.8% 5.0%

Hedge Funds Not Reported Not Reported 2.3% 2.0% 1.7%

Other 0.9% 1.6% 1.5% 2.4% 3.8%

Total “Non-Traditional” 7.6% 11.9% 17.0% 23.1% 28.2%

Asset Allocation – DB vs. DC (Canada)

72%

28%

Asset Allocation – DB Plans December 31, 2012

"Traditional" Assets

"Non-Traditional" Assets

99%

1%

Asset Allocation – DC Plans December 31, 2012



Data Source: PIAC, Asset Mix Composites

Total assets reporting: $ 1,164,506 million Total assets reporting: $ 16,041 million

Asset Allocation – DB vs. DC (U.S.)

84%

16%

Asset Allocation – DB Plans December 31, 2011



92%

8%

Asset Allocation – DC Plans December 31, 2011



Data Source: Towers Watson

Does it Really Matter? (U.S.)

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Net Investment Performance Difference (DB less DC) Asset-Weighted Median Returns

DC Plans Outperform

DB Plans Outperform

Data Source: Towers Watson

Does it Really Matter?

• From 1995-2011, DB Plans outperformed DC Plans by an average of 0.76%

• From 2000 – 2011, DB Plans outperformed DC Plans by

an average of 1.10%

• From 2007 – 2011, DB Plans outperformed DC Plans by an average of 0.39% – DB Plan volatility was 1.5% lower

• Fees also play a role!

Key DB and CAP Differences

1. Investment Strategy

– Managing uncertainty

– Behavioural constraints

2. Structure and Resources

– Professional oversight

– Scale

– Flexibility

1. Investment Strategy

• DB Plan Sponsor

– Single Fund

– Relatively predictable liabilities and cash flow

– Potential for additional funding

– Liability immunization

– Dedicated staff and/or consultants to assist with investment choices

• CAP Sponsor

– Uncertain length of retirement and expense amounts

– Limited potential for additional funding

– Likely a need to continue to grow assets in retirement

– Investment choices left to the member – limited knowledge and/or interest

Spectrum of CAP Participants

• Investment offering must consider needs of all participants

– Defaulter: offer a suitable default option

– Passive Selector: offer structure and limited choice

– Active Selector: offer suitable range of options

Unwilling or unable to

make investment

choices

Defaulter

Able to make investment choices but

choose not to

Passive Selector

Make their own

investment choices

Active Selector

2. Structure and Resources

• DB Plan Sponsor – Dedicated staff and/or

external consultants to assist with oversight

– Centralized control

– Single investment policy with established objectives and goals

– Economies of scale • Broad opportunity set

– Flexibility in making changes to asset classes

• CAP Sponsor – Expectation of full liquidity

– Recordkeeping is predicated on the ability for participants to view daily account values

– Different objectives

– Daily pricing requirement

– Limited flexibility for changing investment options

• Participant notice required

Characteristics of Alternatives

• Relative to traditional fixed income, alternatives are expected to generate higher cash yields and deliver higher capital appreciation

• Relative to traditional equities, alternatives can serve two distinct roles: – Return enhancement – Risk diversification

• The choice of alternative as well as the source of the funding will depend on investor goals

Some Common Alternatives

Asset Class Role Relative

to Equities Liquidity

Need for Specialized Resources

Expected Returns vs.

Equities

Expected Volatility vs.

Equities

Expected Correlation to Equities

Private Equity Return

Enhancer Low - None Medium - High Higher Higher High

Real Estate Risk Diversifier Depends Low - Medium Slightly Lower Lower Low

Infrastructure Risk Diversifier Low - None Medium Similar Lower Low - None

Hedge Funds Risk Diversifier Lower Medium - High Depends Lower – Much

Lower Depends

Gaining Access to Alternatives

Asset Class DB Plans DC Plans

Private Equity Private Equity Limited Partnership Invest in public companies involved in

Private Equity deals

Real Estate

Private Equity Limited Partnership Real Estate Investment Trusts (REITS)

Direct Investments Comingled

Real Estate Investment Trusts (REITS) Pooled funds

Infrastructure Private Equity Limited Partnership

Direct Investments Comingled

Invest in public companies involved in Infrastructure

Hedge Funds Hedge Fund Limited Partnerships Mutual Funds using hedge fund-like

strategies

Typical Private Equity Cash Flow

1 2 3 4 5 6 7 8 9 10

Inve

sto

r C

ash

Flo

ws

Time

The “J” Curve

Distributions

Capital Calls

Cumulative Cash Flows

Investment Period

Harvest Period

Example: Infrastructure

• Refers to facilities and services essential for the economic productivity of society.

• Typically involve the movement of goods, people, water and energy.

Example: Infrastructure

Investment Characteristics

• Backbone of the global economy Essential Services

• High capital costs, regulation, advantageous locations, economies of scale Barriers to Entry

• Regulatory framework provides indexation mechanism Inflation Protection

• Demand has low sensitivity to price changes Low Demand Elasticity

• Long duration. Low reinvestment risk. Matches long duration obligations Long Life

• Long term contracts. Low maintenance requirements. “Take or Pay” commitments from customers Predictable Cash Flows

• Relative long term independence from financial markets Low Correlation to Other Assets

Issues for CAP Sponsors

• Investment Liquidity – The need for daily liquidity

• Member Education – Placing complex choices in the hands of

participants who may lack understanding

• Governance and oversight – Complex investments

Is There a Solution?

• Publically traded / listed options – REIT’s

• Companies that invest in direct real estate

– Listed infrastructure • Public companies that have exposure to infrastructure

– Private equity • Listed companies that invest in private equity deals

• Offers indirect exposure to the “direct”

investment, with higher volatility (i.e. the price of liquidity)


• Pre-built asset allocation funds

– Target Date funds

– Target Risk funds

• Member selects the “target” fund option and opts for an automatic rebalancing along the glide path through time

– Member choice limited / restricted

– Gain reasonable certainty around liquidity needs

– Liquidity managed by Plan sponsor

• Combination of liquid and illiquid options


• Unallocated CAP Plan – No participant investment choice – Single fund – Like a DB Plan without benefit guarantees – Liquidity managed by Plan sponsor

• Joint employee / employer sponsorship

– All participants earn the same total fund rate of return – Ease of administration and communication – Build “guarantees” around participants approaching

retirement • Risk sharing

– Legal implications?

Alternative Investments for Capital Accumulation Plans (CAP)

What Plan Sponsors Should Know

alternative investments for capital accumulation plans (cap)

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