Investment Solutions For Smaller DB Plans
By: Julie Caron & Kurt Dreger
Smaller Defined Benefit pension plans have the same objectives and responsibilities as their larger counterparts. However, they face different challenges trying to diversify their assets, write Julie Caron and Kurt Dreger, of Industrial Alliance.
Most Defined Benefit pension plans face the same common challenge – ensuring there are sufficient assets to cover the pension promise. Typically, plan sponsors employ an investment policy to navigate the course of this challenge. Larger DB plans face this challenge by flexing their girth to increase returns and mitigate risk. These plan sponsors create sophisticated and complex investment policies. They are able to employ cost-effective techniques such as:
- private equity investing
- segregated investment accounts
- hedge funds commodity investment
- real estate investment
- hiring in-house investment managers
But what about the smaller DB plan? What options do they have to face the challenge of covering the pension promise? In this article, we explore investment solutions for these plans.
Let’s first define what a smaller DB plan is. Without attacking the many statistics available, we will peg $50 million as the threshold between a large DB plan and a small plan.
Small DB plans face different issues when it comes to finding the optimal investment solution for their assets. Given their size, these pension funds often cannot afford to have more than one investment management firm looking after their assets. While pension plans with assets under $50 million dollars have the same objectives and responsibilities as their larger counterparts, they face different challenges trying to diversify their considerable assets.
The One-manager Solution
It is very common to see smaller DB plans use one investment firm to manage all the asset classes in the plan. The greatest benefit of this solution is that the manager will tailor the management of the pension assets to the investment policy.
However, the entire asset portfolio will rely on one management team making the asset mix calls as well as the security selection for all the asset classes. Manager risk and investment style risk become very important. Since investment styles are cyclical, the portfolio’s style bias can be positive at some times and negative at others. Even though different investment styles (like value and growth) tend to produce similar returns over the long-term, different investment styles usually produce different portfolios which lead to different returns in the short-term.
The one-manager solution is the most common option employed by plan sponsors of smaller DB plans. However, the management of the assets will have a style bias and could experience volatility in the shortterm. These plan sponsors may consider mitigating this short-term risk by employing one or more investment managers with complementary styles.
The Pooled Balanced Fund Solution
Another common option available to smaller DB plans is to invest in a pooled balanced fund. This option is prevalent for plans with less than $10 million in assets. The advantages of this approach are that it is simple and inexpensive since it is invested in an existing pooled fund, instead of a segregated account.
In fact, investing in a pooled fund consists of buying units of the fund. The investment management fees are quite low since the fund already has an important asset base coming from other clients and the assets are pooled into one portfolio. Although this approach has considerable disadvantages, the most important is that the investment policy of a pooled fund might not fit the plan sponsor’s own investment policy and their particular risk tolerance and rate of return objectives. In some cases, the investment policies will be close enough that the simplicity and the low fees will offset this disadvantage. In other cases, however, the difference will be too important to bear the risk.
Another disadvantage is that the manager risk is not diversified with this approach. The management team is responsible for the tactical asset mix calls and also makes all the decisions regarding the different securities in the portfolio. Manager risk is defined as the risk of the manager being wrong in their market decisions, which happens even to the best managers. The plan sponsor will bear the impact of the manager’s investment style since it will not be diversified either. Since returns are highly influenced by the manager’s investment style, having only one manager usually increases volatility.
An option that is gaining some momentum and that answers some of the problems pension plans encounter by choosing only one balanced fund is to invest in a combination of balanced funds.
The advantage of this option is that a plan can diversify manager risk as well as investment style risk if they choose investment managers with different investment processes and styles.
Typically, plan sponsors will choose their balanced/diversified funds to have complementary styles. This option remains relatively inexpensive since the plan still invests in pooled funds.
One big disadvantage remains. The plan’s investment policy is still not considered since this approach is not customized so that the risk and return objectives are aligned.
The Multi-managed Portfolio Solution
Amulti-managed portfolio is one where each typical component of a pension asset portfolio is separately managed. For example, Fund A will be used to manage the Bond portfolio, Fund B will be used to manage the Canadian Equity portfolio, Fund C will be used for the International Equity component, and so on.
Multi-managed portfolios offer an interesting approach for smaller DB plans since they are composed of different managers, therefore diversifying manager risk.
They also offer the advantage of utilizing specialized managers in each asset class since a good bond manager might not be the best international equity manager. Separating the mandates can enhance returns.
These portfolios are usually constructed for style diversification in each asset class. So basically, this option offers a lot to the plan sponsor as it applies diversification by asset class, geography, manager, and investment style.
The downfall to this solution is that the multi-managed solution is a one-size-fitsall approach where the plan sponsor has no guidance with respect to the structure of the portfolio and the managers chosen for each asset class. It also does not solve the problem of having an investment policy suitable for the pension plan.
The multi-managed portfolio is an emerging solution for smaller DB plans. This momentum is due to interest from Canadian life insurance companies in DB plans. In the past 10 years, life insurance companies have spent millions of dollars improving their products and services for money purchase pension plans. These improvements include partnerships with money managers around the world to offer a broad spectrum of investment choices to money purchase pension plan members. It was a logical step to offer these investment funds to plan sponsors of DB plans.
Canadian life insurance companies have even taken this a step further by providing programs which can meet the unique needs of each sponsor. Industrial Alliance, for example, has a multi-managed portfolio solution called ‘Dynamic Asset Management’ which uses a combination of pooled funds to create separate accounts based on the investment policy for each client. Plan sponsors of smaller DB plans now have more investment solutions available thanks to new product offerings from Canadian life insurance companies. Some companies have unique products and services tailored for DB plans and allow plan sponsors access to a variety of investment funds managed by a number of different investment managers.
Plan sponsors should review these new products and services to determine if they can help mitigate risk and enhance returns.
Julie Caron is an institutional investment advisor and Kurt Dreger is a business development manager with Industrial Alliance Insurance and Financial Services Inc.
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