Even though pension funds are pretty well funded right now, the prospect of low bond yields lasting for years to come (even if not at today’s ultra-low rates) is a challenge that they need to be prepared for. Ignoring the problem could mean falling behind and struggling to keep funding ratios high, but risking principal while chasing yields with higher risk products could have the same result.
“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,” HewittEK in a recent white paper.
To balance the better risk profile and diversification benefits that alternatives can give with a pension fund’s liquidity requirements, HewittEK recommends determining your Extreme Illiquid Threshold (ExIT) allocation.
ExIT stress tests illiquid investments to find the highest reasonable allocation
To find ExIT allocations HewittEK first allocates part of a fund’s portfolio to different alternative assets including private equity, opportunistic real estate, hedge funds, and public equity and then runs a stress test on the portfolio’s assets taking expected contributions, benefit payments, and investor policy into account. Allocations are gradually increased until the maximum level that doesn’t violate plan targets (such as target return-seeking assets as the plan de-risks).
That maximum level is the ExIT allocation, which acts as an upper limit that the pension fund shouldn’t exceed so that it doesn’t risk falling below liquidity requirements even in times of stress.
ExIT allocation is a ceiling, not a recommendation
Even though HewittEK doesn’t actually recommend following the ExIT allocation, the company argues that it’s important for pension funds to know where the upper limit is. Pension funds, along with endowments and some other types of foundations, have an advantage over most individual investors and portfolio managers, their very long investment horizon. Investing in illiquid alternatives, whether it be hedge funds with their 2 – 3 year lockups, private equity, or opportunistic real estate, pension funds can look for deals in parts of the market that are inaccessible to most investors.
The danger is in taking the strategy too far and shooting yourself in the foot down the road. But by rigorously defining what ‘too far’ actually is, either with HewittEKs iterative ExIT method or some other process, those in favor of alternative investments will be able to clearly explain why their recommendations won’t interfere with the pension fund’s mission.