The endowment model for investing suggests that long-term investors with access to illiquid investment opportunities, such as higher education institutions, should have relatively high allocations to alternative assets, which can help them earn greater returns.
Like endowments, defined benefit (DB) plans are also long-term investors, though many DB plans have different liquidity needs than higher education institutions. Still, sources say, DB plans can take some cues from the endowment playbook.
Adam Levine, investment director of Aberdeen Standard Investments’ Client Solutions Group, says DB plans are very focused on their goals. They aim to have a good funded status relative to liability and to ensure they have enough funds to pay all obligations promised. “DB plans are very much oriented to a specific outcome and what they want to achieve for the plan. They are not just focused on generating returns,” Levine says.
He adds that DB plans invest a lot in fixed income and fixed income that matches liability, and they use hedge ratios to manage changes in liabilities. Endowments tend to focus more on maximizing returns, Levine says, and they also concentrate on their spending policy and making sure assets are growing to fulfill spending obligations. He says endowments tend to be a bit more creative or bold, using non-standard strategies and alternative investments. Corporate DB plans tend to be more conservative in terms of investing in alternatives.
Dave Keil, partner of Aon’s Corporate Defined Benefit Solution Practice, says endowments and corporate DB plans have different goals, so it makes sense that they have different investment strategies. He explains that endowments have extremely long, sometimes infinite, time horizons and seek to earn a rate of return above inflation—the consumer price index (CPI) plus 4% or 5%. They might seek higher equity returns by investing in private assets.
DB plans, meanwhile, are not big users of private assets, Keil says. They have adopted interest rate hedging techniques, which usually means investing in a small or medium amount of long-duration bonds.
According to the “2020 NACUBO [National Association of College and University Business Officers]-TIAA Study of Endowments,” the average investment allocation for all institutions in the study as of June 30 was 20% in marketable alternatives, 14% in private equity (PE), 13% each in U.S. and non-U.S. equities, 12% in fixed income, 11% in real assets, 9% in private venture equity and 7% in global equities.
Levine says DB plans are so driven by fixed income that, in general, they will not perform as well as endowments during market upswings. Corporate DB plans are much more defensive, focused on managing funded status and interest rate risk for liabilities.
Keil says that 10 years ago, it was easier to make comparisons between the average endowment and the average pension plan. But now, pension plans have adopted different investment strategies, and frozen plans use different tactics than ongoing plans, so it’s harder to correlate the two since DB plans are not as homogenous as they used to be. Since the biggest driver of returns is interest rates for DB plans—because of liability-hedging strategies—DB plans likely outperformed endowments last year, he says.
“Over time, I would expect endowments to start to outperform pensions,” Keil says, “because the average pension plan should get more conservative over time. The average DB plan should be on a path to taking less risk to become fully funded, to either maintain low risk or to move obligations to an insurance company.”
Chris Moore, chief investment officer (CIO) for not-for-profit at Mercer, which includes endowments and foundations and not-for-profit health care entities, says at a broad level, the performance of endowments and DB plans is consistent with the biases of the different types of capital. Endowments have more diversification, but that also means they have a higher risk profile.
In the past year, DB plans performed similarly to endowments because long-duration fixed income did so well in 2020, he says. It performed as well as some equity allocations. But the risk of inflation is higher going forward, so investing in alternatives will be more of a benefit, he notes.
Levine says he’s seen a trend of DB plans investing more in alternatives, which will help with diversification. “The traditional 60/40 portfolio,” which is a portfolio that’s 60% in equities and 40% in bonds, “is exposed to downturns,” he says. “Endowments, in general, have been more spread out across return drivers.”
The Endowment Index calculated by Nasdaq OMX increased 4.43% (on a total return basis) for the quarter ended March 31, compared with a gain of 1.02% for the same period for a global 60/40 index.
Keil adds that endowments tend to use a host of alternative investments, including hedge funds and insurance-linked securities, and some DB plans take advantage of those asset classes as well. “Two reasons to use alternatives are to lower risk through better correlation and to improve returns through a higher return stream than regular markets,” he says. “For example, a DB plan might invest in core conservative real estate as a diversifier to bring volatility down, or it might add private equity investments that would bring in a higher rate of return.
“With what’s been happening with interest rates, the performance of long bonds has driven pension performance up,” Keil continues. “To the extent that turns around, DB plans can use different strategies.”
Keil also says private assets could help DB plans. “There is a subset of DB plans where incorporating private assets makes a lot of sense: plans that are ongoing or for which the funded status has long way to go.”
Keil says this came into additional focus recently with the passage of new funding relief in the American Rescue Plan Act (ARPA). “Corporate DB plans can now amortize their unfunded shortfalls over 15 years rather than seven,” he explains. “For a DB plan taking advantage of the funding relief, it makes sense to invest in private assets.”
Moore says DB plans can learn from endowments to look outside of traditional fixed income for low-risk return drivers. Endowments consider a low-risk hedge fund strategy as a replacement for fixed income. “Today, traditional fixed income is low-yielding with a tight spread environment, so there’s no real income in fixed income,” he says.
However, Moore says, there are meaningfully different end goals for ongoing versus closed DB plans, so their portfolio strategies should be different. “For closed plans, the investment horizon is to match liabilities, so low-risk hedge funds are not a good fit. This investment horizon typically means they should buy more fixed income,” he explains.