Corporate pension plan sponsors in the United States have become increasingly sophisticated in their approach to investment management. In their quest for performance, investor acceptance of new and innovative strategies has accelerated in the past few years. Complex investment strategies including structured products, hedge funds, private equity, 130/30, portable alpha and LDI, to name a few, have been implemented or are actively being considered by retirement plans.

The current investment climate and regulatory and legislative changes have altered the environment in which pension plan sponsors operate. Funding gaps in defined benefit (DB) plans have increased, and the passage of the U.S. Pension Protection Act of 2006 (PPA) and implementation of FAS 158 have made those shortfalls particularly onerous for the sponsoring companies.

“Much of the recent product innovation has been geared for defined benefit plans,” says John L. Krieg, CFA, director of investment product management at Northern Trust. “However, defined contribution (DC) plans are experiencing the lion’s share of growth. The challenge is to translate the product innovation and investment advances from the DB space to the DC universe for the benefit of plan sponsors and participants.”

Recent Defined Benefit Innovations

Following the lead of endowments and foundations, corporate pension funds have started to become more innovative and aggressive in their asset allocation policies.

In addition, pension plan sponsors possess a much more comprehensive understanding of risk, in terms of how it should be allocated and how investors should be compensated for it. Plan liabilities also have received more scrutiny as sponsors seek more relevant benchmarks against which to measure performance.

“The desire for enhanced performance and a growing awareness of the need to better manage assets to liabilities led corporate funds away from traditional investment strategies,” Krieg notes. “Initially, mandates expanded to include global strategies and alternatives. More recently, we have seen pension plans implement liability driven investing or incorporate derivatives and other synthetic strategies. In addition, alternative investments such as hedge funds and private equity have become somewhat more mainstream and next generation alternatives are now in the forefront for DB plans.”

Outside Forces Accelerate Changes

New legislation and regulatory mandates significantly increased the impact of a funding shortfall. “As FAS 158 requirements are phased in, plan sponsors will have to report a plan’s funded status in its financial statements. In addition, plan sponsors face potential penalties for non-compliance with the full-funding provisions of the PPA,” says Chris Carlson, managing director of strategic development at Northern Trust.

“Companies aren’t in the business of taking those types of risks,” Carlson adds. As a result, many companies decided to shift their employees from a DB plan into a DC plan. “It’s ironic that just as the industry was finding solutions to address DB funding problems, employees were being moved into retirement plan structures that currently don’t incorporate many of the recent investment innovations,” Carlson says.

Adding Sophistication

As the defined contribution plan becomes the prevalent choice for providing employee retirement benefits, it presents its own set of challenges. Consider asset allocation, for example. “Most DC plans, at least initially, offered investment options that were pretty straightforward — stock, bond and balanced mutual funds, much like DB plans years ago,” Krieg points out.

The defined contribution universe is quickly adapting to investment innovation and sophistication. In the past few years, DC plans have added international and emerging equity as investment options. Inflation hedging investments — such as commodities, global real estate and inflation-protection securities — as well as guaranteed income strategies also are gathering steam in the DC arena. “Other alternative strategies, such as hedge funds, however, don’t immediately fit into a DC plan, in part because of investor eligibility and the level of sophistication of most plan participants,” Krieg says. “Another problem is that DC accounts have to be portable and a fair number of alternative strategies are illiquid.”

As shown in the “Loan Exposure Relative to GDP” chart on page 15, developed market economies tend to have a much higher exposure to debt as a percentage of GDP. For example, the United States has the highest exposure, with loans making up 172% of its total GDP. Among the developed countries listed, Japan is lowest, with 92%. The U.K. and Germany are at 138% and 126%, respectively. Among the emerging markets shown, roughly half have a loan-to-GDP exposure of less than 50%. Only four of these emerging markets — Israel, China, Malaysia and Taiwan — exceed 100% in their loan-to-GDP exposure.

In another reflection of the maturity and stability of these nations, almost 80% of the countries in the S&P IFCG Global Composite Index, which represents emerging markets, were rated as investment grade as of May 31, 2008.

“The increasing number of developing countries that are rated as investment grade by the world’s major ratings agencies is a signal that investors’ perceptions about country-specific risk are improving,” Bright says.

The investment industry already has begun to address some of these challenges. For example, academic studies portray alternative beta as a meaningful component of hedge fund returns, opening up the possibility of hedge fund replication or passive hedge fund construction. These developments could alleviate some of the current difficulties of incorporating hedge funds into DC plans’ investment options.

“Will DC plans get to the same level of sophistication as DB plans? I think so, and in some ways they’re actually on an accelerated path,” Carlson observes. “First generation target-date funds covered the basics, using three, four, maybe five asset classes. During the past 24 months, though, they’ve become much more dynamic, with some target date glidepaths allocating to over 10 asset classes.”

“As the landscape continues to shift,” Krieg adds, “pension plan sponsors will need to remain innovative in order to provide retirement income security to plan participants.”

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