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Pension Plans - A New Strategic Paradigm

With more than $23 trillion in assets under management, pension funds represent the largest asset class in the global financial marketplace. Managing this massive amount is the responsibility of pension plan sponsors who, supported by investment managers and other service providers, are charged with delivering results to plan participants within an ever-changing and ever-challenging economic environment.

The principal reason for the changing landscape of the pension arena has been the shifting economic and capital markets environment.

In relative terms, the last couple of decades have seen a significant amount of interest rate volatility. Because the present value of a pension fund's liabilities is partly-one could even say largely-a function of long-term interest rates, pension funds have frequently vacillated between overfunded and underfunded positions. If layered on top of that are the global capital markets environment, uncertain regulatory conditions and dislocations in the asset side of their portfolios, there has been created an almost perfect storm within which pension plan sponsors have operated over the last several years.

On the asset side of pension fund sponsors' business, several factors-including the tremendous financial crisis of 2007/2008-presented major challenges to pension plan sponsors: the relative underperformance of traditional long-only active managers; alternative investments, which in some cases did not fully deliver on what they were intended to do; and the breakdown of the correlation between different asset classes that were supposed to have added diversification to pension plan sponsors' portfolios in periods of high volatility.

This combination of market conditions is giving rise to a different paradigm in the way pension plan sponsors look to achieve their investment objectives. And as a result, their service providers-investment managers and other service providers alike-have had to, and will continue to, adapt their business model to accommodate this shifting paradigm.


Paradigmatic Change


For the better part of the last 10 years, pension plan sponsors and their consultants and advisers have been talking about separating the manufacture of their beta, which is their market returns, from their alpha, which is their ability to add value above an appropriate benchmark. In the new paradigm, pension plan sponsors will form a small handful of key strategic relationships with outside firms that they will depend on for their manufacture of alpha and beta, and the infrastructure necessary to facilitate that.

This shift will require a fundamental change in the working relationship between plan sponsors and their service providers-from a conventional buyer/vendor association to a strategic partnership.

That's not to say that sponsors will have only two or three or four fund managers. Certainly, there will be pension plan sponsors with dozens and dozens of relationships, and will be able to do so very successfully. However, there are others that may find greater value in managing a smaller, more strategic group of investments managers and other service providers. Importantly, this concentration of strategic relationships isn't about getting the best price. It's really about developing the strongest possible relationships with firms that understand the culture of a particular pension fund.

The new paradigm also includes fund sponsors being able to efficiently and cheaply get access to beta. The most fundamental way to accomplish that is through passive investment management by indexing portfolios in developed equity and fixed income markets around the world. In the new paradigm, plan sponsors have the ability to access beta returns through ETFs or other passive structures, and efficiently manufacturing beta exposure with derivatives.

Finally, in the new paradigm, plan sponsors may manufacture beta themselves, which does require some investment in technology to build or strengthen an infrastructure that may or may not exist in-house. Several market studies indicate that over the next three to five years, more plan sponsors may consider doing that, particularly the larger public pension plan sponsors-less so in the corporate pension plan space-and even in the endowment and foundation space.

For pension fund sponsors to attain alpha in this new paradigm, alternative investments will still play a meaningful part, but they won't be the whole story. It will be more about the way pension plan sponsors manage their business.

Of course, alpha generated from portfolio performance will continue to contribute to a fund's overall returns. Another factor is "organizational alpha." Citi recently sponsored a CREATE-Research study that indicated that investment managers with strong back- and middle-office infrastructures are correlated to those that tend to out-perform their benchmarks and create alpha. If that concept is transferred to the beneficial owners of the assets (i.e., the pension funds), it could be argued that organizational alpha will become critically important for pension funds, particularly those that manage their business relationships and their strategic partnerships in-house.


The Next Five Years