“I recently met with the governor of a large state,” recounts Kevin Vandolder. “He told me the state pension plan is built on the assumption of an 8% rate of return, which is typical for a public fund. The problem is, we see returns just north of 7% on a long-term basis. He asked me, ‘how are we going to get from that low-7% to an 8% return target?’ The answer is it won’t be easy.”

Vandolder is a principal at EnnisKnupp—one of the world’s largest institutional investment consulting firms, and one of the few that is truly independent, since they don’t sell their own funds or receive revenue from money managers. Pension plans call Vandolder when they need help figuring out how to meet their long-term promises to plan members. These days, the first step often involves coming to terms with how far off the mark they already are.

EnnisKnupp’s Toronto-based Managing Director, Rob Boston, breaks it down like this:

“At the end of 2007, Canadian pension funding was pretty much flush—assets were at about 96% of liabilities. Usually, at that high level of funding, plans can start to consider liability-driven investing, or LDI, which allows them to ‘lock-in’ by matching their assets and liabilities. So, in simplified terms, that means having cash on hand for the plan member retiring tomorrow, a 10-year bond for the member retiring in 10 years, a 30-year bond for the member retiring in 30 years, and so on. This dollar-for-dollar matching can bring portfolio risk way down.

“But by the end of 2008, pension funding in Canada was down to just 69%, and LDI had to be put on the back burner. By the end of 2009, I estimate Canadian pensions had bounced back to about 80% funding and U.S. plans were doing a bit better at 85%. But it’s still necessary to close that gap of 15% or so before LDI becomes a viable option again.”

Making up lost ground
There are other hurdles to reaching the “LDI nirvana” of a low-risk portfolio that can run virtually on autopilot and still meet all its liabilities. Even if market gains and new infusions of capital succeed in raising pension funding to previous levels, the longer-dated bonds needed for LDI strategies are in short supply and can be prohibitively expensive.

According to the experts at EnnisKnupp, part of the solution may lie with two of the asset classes that were hardest-hit by the financial crisis: private equity and real estate.

“Private equity is like wine,” says Vandolder. “Each year is a different vintage, except instead of putting grapes into a bottle, you’re putting capital into the market. The vintages of 2007 and 2008 were rather poor, but 2010 and 2011 look very exciting. Over the past three decades, periods of economic difficulty have led to very good vintages of private equity. Many folks who have commitments to private equity partners are hoping to get capital calls and see their money put to work this year.”

Private equity not only has the growth potential to help pension plans meet their return targets, it also can accommodate deal structures and underlying assets—such as infrastructure—that can generate the long-term yields required for LDI strategies.

Real estate is another place where pensions can find appealing assets with depressed prices and the potential for long-term yields. “We’re seeing clients where the publicly traded side of their portfolio has rebounded so much, they’re now underweight real estate for the first time in a long time,” says Boston.

“In these cases, we’re encouraging clients to rebalance their portfolios back to their policy weightings by investing in real estate where they have confidence. That may mean owning traditional hard assets, buying listed securities such as REITs, or even doing the appropriate due diligence to look at distressed assets with very attractive valuations.”

Of course, private equity and real estate have their own unique set of risks and constraints, such as limited liquidity. But Vandolder says fiduciaries need to shake off the “herd mentality” and focus on the opportunities that will help them reach their goals, without worrying about what others are doing.

Boston concurs: “It’s a human fault to always want to compare yourself to something or someone else—other plans, or other managers. That’s why you need someone to come in and help you look objectively at your situation, and how you can get funding back on track without adding too much volatility or risking too much.”

Our view
Pension plans are currently working on a five- to 10-year timetable to rebuild billions in savings on behalf of millions of North American workers. New economic realities call for new investment ideas, and we believe independent consultants like EnnisKnupp can help bring those ideas to the table.

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