Private-Markets Investing in an Era of Higher Rates
Investors searching for yield flocked to private markets when interest rates were low and public equity valuations were high.
In the second episode of the podcast series 'Insight for OUTComes', Michelle Teng, Vice President and Co-Head of the Private Assets Research Program in PGIM’s Institutional Advisory & Solutions (IAS) group, spoke with guest host Julia Newbould, Managing Editor at Investment Magazine about how climate change and early release schemes can affect super funds and the global economy more broadly.
>> Hello and welcome. I'm Julia Newbould, managing editor at Connexus Financial, publisher of Investment Magazine and Top 1000funds. Today, it's my pleasure to be talking about how climate change and early release schemes can affect your super funds and the wider economy. There are many liquidity stresses on defined contribution funds, such as the common liquidity demands of private asset commitment pacing, rebalancing, in addition to specific liquidity requirements brought about by COVID, such as member switching, foreign exchange hedging, and early release schemes. Today, I'm joined by Michelle Teng. Michelle is vice president and co-head of the Private Assets Research Program in the Institutional Advisory and Solutions Group at PGIM, the global investment management business of Prudential Financial Incorporated. The Institutional Advisory and Solutions team conducts bespoke, quantitative client research that focuses on strategic asset allocation and portfolio and asset class analysis across both public and private markets. Michelle joined PGIM IAS group in 2018 after spending her first three years at Prudential with the Investment and Pension Solutions Group at Prudential Retirement. Michelle has recently written a paper on "Super Funds and Master Trusts in a World of Member Switching, Early Release Schemes, and Climate Calamities." Welcome, Michelle, and thank you for joining me today.
>> Hi, Julia. Thanks for having me.
>> Michelle, what is your focus at the moment?
>> So, Julia, in the past few months, I've been looking at asset allocations with illiquid private assets for defined contribution plans, such as super funds in Australia and master trusts in the UK. Previously, I used our asset allocation framework to help solve portfolio challenges for some other institutional investors, for example, some defined benefit plans and sovereign wealth funds. And recently, as DC-oriented plans have grown and have increasingly become the primary retirement savings vehicle, asset allocators are more and more drawn to incorporate these assets in their retirement funds to offer participants access to investment portfolios and risk-adjusted returns as provided by many defined benefit plans. And government are also encouraging plans to bolster retirement outcomes and support economic growth by investing in illiquid private assets, such as private equity and infrastructure. On the other hand, during the pandemic, you know, the Australian government, as well as the US government, announced an early release scheme that allows participants early access to these retirement assets. So one important aspect of my research is to look at how the liquidity landscape might change for these DC plans in light of the confluence of these two [inaudible], more illiquid assets and opportunities to gain early access [inaudible] assets. I was able to apply our framework to help solve some emerging liquidity challenges for the CIO's office DC plans and solve the challenges they may encounter while managing their portfolios.
>> So in this podcast today, we're going to look at the asset allocation in the context of liquidity risk. We look at the impact on asset allocation and the performance of some of those liquidity stresses which arose during COVID. So, Michelle, can you please begin by explaining why defined contribution funds more common in Australia and the UK are more likely to have portfolio liquidity management challenges than defined benefit funds?
>> Yes, Julia. So today, DC plans operate in dynamic and evolving market and regulatory environments. And changes in this environment, they prompt novel liquidity demandson the portfolios. Unlike the DB plans, this DC plans, such as the Australian super funds and UK master trusts may face liquidity management challenges arising from either participants' actions, such as the member switching, or government actions, such as the early release scheme.
>> So, what are the specific challenges that they face in relation to the DB funds, in relation to liquidity?
>> As I mentioned, these DC plans, they face some special liquidity challenges, for example, the member switching. In an adverse market environment, some of the members may move their assets from the risk-seeking fund to lower-risk fund or cash. And another one is the early release scheme that allows people to take their retirement assets out of the funds without penalty, for example, during the COVID-9 pandemic. And DB plans, they have their own liquidity management challenges. For example, for these plans, large liquidity demands may arise from corporate actions such as a PRP [inaudible] transaction. That may cause an immediate increase of the allocations to illiquid assets in these DB portfolios, as they may use some of the liquid assets to pay the premiums of these transactions.
>> So, Michelle, if we go back to the way DC funds are structured, what does it mean in the way that DC funds can choose to allocate assets?
>> For example, we mentioned that an early release scheme brings unexpected and large liquidity demands to these DC funds. And we know these early release schemes can be announced at different policy rates. And here we use the policy rate to represent the maximum amount a member can withdraw with short notice. And we know as the policy rate increases, a firm's expected maximum drawdown risk, which is an important liquidity risk measure, continues to increase. In the face of this ERS policy risk, a prudent ClO is unlikely to keep the asset allocations and change. So if the liquidity drawdown risk goes beyond a CIO's [inaudible] level, they may consider adjusting their asset allocations to reduce the level of risk in their portfolios.
>> So, Michelle, what are some of the ways that the super funds can reallocate to maintain their liquidity risk as it was before?
>> So generally, these CIOs would move some of the risk-seeking assets which tend to be less liquid to lower-risk assets and more liquid assets, for example, from private assets to stocks, or from stocks to bonds or cash.
>> And is this what we saw when the early release schemes were happening during the pandemic?
>> And what are some of the other issues that holding extra liquidity to plan for potential calamities can affect the overall performance of the fund?
>> So for the CIOs holding excess liquidity, it's likely to be costly in terms of expected [inaudible] performance. For many of the super funds, they are subject to the regulatory body, APRA's annual performance test. And a CIO cannot afford to respond to these heightened liquidity risks by simply becoming defensive with, say, a large allocation to cash and a small allocation to growth assets. And these CIOs, they need a tool to help them quantify the cost of adapting their portfolios, so these ERS risks will help them make more confident asset allocation decisions.
>> Yes. It's become a lot more complex, hasn't it? So can you explain how OASIS works to bring together portfolios' liquidity risks and performance?
>> Yes, Julia. So in the last episode, I discussed our asset allocation framework OASIS. I won't go into details today. But as a quick recap, so the challenge for the CIOs is to coordinate their top-down asset allocations with their bottom-up private asset investing activities. And in the meantime, they always have a number of liquidity demands they have to meet from time to time. And OASIS brings all these three portfolio management components together into an overall view of a trade-off between liquidity risk and expected performance. That way, OASIS can help the CIOs evaluate the portfolio's liquidity and performance and the different scenarios in a consistent way through what-if analysis. Let me just explain what I mean by what-if analysis here. So, in the context of super funds, we know the government may allow for different levels of early release, say 5%, 10%, or 20% of the overall assets. And we may use our framework to help them evaluate the cost of different levels of these early release schemes.
>> All right. So in the example of the Australian government allowing members to access their retirement funds early, it was unprecedented. But do you believe that this kind of early access has shown that governments are willing to make the funds available during catastrophes such as, you know, floods, drought, cyclones, etc?
>> The short answer is we don't know. But there is a possibility. So we know the Australian government unexpectedly announced an ERS during the COVID pandemic. And we know climate change potentially increases the volatility and magnitude of natural disasters. And insurance is costly and almost nowhere near adequate. More and more of the risk is on the individual's shoulder. So say if there is a widespread catastrophe, the government, they consider an ERS-like program for climate calamities relief. After all, what's the point of having a retirement plan if someone cannot rebuild their house now? So, this is not necessary -- Australian issue. In 2021, US legislation allowed for disaster distributions from retirement plans for calamities other than the COVID-19 pandemic.
>> Yeah. It's a very different world, isn't it? And everything has to change, you know. You can't sit back on the way that you did things before. It's very complex.
>> So it's a very different way of looking at the effects of climate change, what you just mentioned on, you know, on the way that we're structuring portfolios. So what does it mean for the asset allocation for a CIO who wants to be a good fiduciary?
>> Again, we try to bring liquidity risk to the forefront of our analysis and look at the implications of climate change from a portfolio liquidity risk perspective. And CIOs need to think ahead of time and understand what novel liquidity demands climate change may bring to their portfolios. Similar to an ERS during the COVID pandemic, climate calamities may prompt government to announce an ERS-like program, which is likely to create novel, large, and unexpected liquidity demands to the DC portfolios. And this may raise a CIO's concern for better liquidity management and more appropriate asset allocations today to be a good fiduciary
>> So when we're looking at the early release schemes, CIOs need to focus on more than just the money that they're losing through the withdrawals. Can you explain the broader implications?
>> Yes. So as we discussed, an early release scheme presents new liquidity challenges and affect the portfolio's liquidity risk over the long run and may compel the CIOs of his plans to adjust their asset allocations today. And these adjustments are not free. There are consequences for future expected portfolio performance. And this is a cost borne by all participants, including those who do not make an early release withdrawals or who did not switch their money out of the default fund during an adverse market environment. So our OASIS framework can help the CIOs quantify the hidden costs of these portfolio adjustments. And this may help the CIOs make more informed asset allocation decisions.
>> Yes, it's very important. Michelle, from your research, what's the greater impact that governments and policymakers need to consider before they look at allowing access to retirement funds early?
>> Yes. So certain people may think the COVID is behind us. But the impact of these novel liquidity demands goes far beyond the COVID pandemic. And this raises everyone's awareness of better liquidity management of the DC funds, including the CIOs, the participants, and the regulators. And APRA requires funds to maintain a robust liquidity management plan for each investment option. And they has called on fund to re-examine their liquidity management plans in light of the 2020 [inaudible]. And our framework helps examine the potential trade-off between the liberality of early access programs and the expected portfolio performance in the long term. That way, our research may help governments and policymakers identify portfolio allocation consequences and the costs of contemplative rule changes. And again, these costs will be borne by all participants.
>> Yeah. That's right. It's just got such broad implications once the government makes such decisions. You've been listening to Michelle Teng from PGIM today. Michelle, thank you so much for joining us and giving your insights on liquidity issues for defined contribution funds and obviously the need for better management of these funds.
>> Thank you, Julia. It's been my pleasure to be here with you today.
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