Optimizing Private Market Allocations for Pension Cash Flow Management

Introduction

The landscape for defined benefit pension plans has evolved. While many plans are now closed and better funded — thanks in part to post-Covid inflationary periods and subsequent interest rate increases — plan sponsors now remain focused on ensuring stability and predictability of benefit payments. Traditional approaches, often reliant on bond portfolios, are increasingly tested by inflation risk, reinvestment risk, and the challenge of maintaining liquidity in a shifting interest rate environment. Many plans also face a mid-term funding strain, where projected benefit payments begin to exceed predictable income sources, requiring a more dynamic approach to asset allocation.

‍

This mid-term challenge is especially pronounced for plans closed to new entrants. Such plans are more mature, with a higher proportion of retirees relative to active workers and therefore lack ongoing contributions to smooth out cash flow needs. The question for plan sponsors becomes: How can they ensure sufficient liquidity during this critical mid-term period without sacrificing long-term returns or relying solely on increasingly expensive bond allocations?

‍

Our previous research explored the Private Fund Duration (PFD) framework — a set of metrics originally introduced by Rafael Castilla, Felicia David-Visser, and David Brophy in the Journal of Portfolio Management to decode the timing of capital calls and distributions across private market investments. By applying this framework to a dataset of over 7,000 funds spanning multiple decades, our analysis revealed how different private market strategies exhibit distinct cash flow patterns that can be strategically leveraged within investment portfolios. The empirical evidence demonstrated clear differences in timing characteristics across asset classes, vintages, and fund sizes — insights that can help investors better align private market cash flows with their specific needs, particularly for pension plan sponsors managing long-term liabilities.

‍

This article moves from insight to action. Building on these foundational concepts, we now apply the PFD framework within a practical optimization model for pension cash flow matching. We demonstrate how pension sponsors can structure private market allocations that enhance liquidity resilience, mitigate reinvestment risk, and optimize long-term funding. The goal is to translate theoretical insights into an actionable strategy that pension plans can implement today.

‍

‍

Traditional Bond-Centric Methods: Emerging Weaknesses

For plans closed to new entrants, meeting pension benefit payments over a multi-decade horizon requires balancing cost against return. Many sponsors adopt a cash flow matching approach, structuring assets to generate income aligned with projected benefit obligations. While effective for near-term liabilities through bond ladders or similar fixed-income solutions, this approach faces growing challenges in the mid-term window (years 5 to 15).

‍

As closed plans mature, their structural profile shifts dramatically. More participants retire while fewer active workers contribute, increasing cash flow needs precisely when natural asset replenishment slows or stops. This demographic reality creates a fundamental challenge that traditional fixed income strategies struggle to address efficiently.

‍

While bonds remain the foundation of many pension investment strategies, relying solely on fixed income to meet long-term obligations presents several key risks:

‍

• Inflation Risk: If pension benefits are indexed to inflation, unexpected spikes lead to immediate liability increases that nominal bonds may fail to offset — especially if real rates remain low.

• Capital Inefficiency: Locking up large allocations in fixed income may limit long-term growth and could undershoot return targets when inflation-indexed bonds are scarce or expensive.

• Reinvestment Risk: Bonds maturing in the near term must be reinvested — potentially at lower yields. This leaves the plan vulnerable to interest rate shifts and weakens the cash flow match over time.

‍

Compounding these challenges are longevity risk, whereby participants live longer than actuarial projections, and model risk, whereby flawed assumptions lead to significant asset-liability mismatches. Meanwhile, growing institutional demand for long-duration bonds has compressed yields and eroded liquidity premiums, further reducing the cost-effectiveness of pure bond-based matching strategies.

‍

‍

Bridging the Gap: The Strategic Role of Private Markets

Private market investments — such as infrastructure, real estate, and private debt — offer compelling alternatives to address the weaknesses of bond-centric approaches. Certain real assets provide revenue streams linked to inflation, helping hedge against this key risk factor. Meanwhile, private markets typically offer higher yield potential, enabling plans to meet necessary cash flows with a sufficient margin of safety.

‍

Most importantly, as revealed in our analysis of over 2,200 funds, private markets exhibit distinct and partially predictable cash flow patterns. By understanding these patterns through the Private Fund Duration (PFD) framework, pension sponsors can strategically time commitments to align distributions with projected liability peaks.

‍

However, effectively integrating private markets requires moving beyond simple allocation percentages to a more nuanced approach that considers:

‍

• Timing characteristics: Different private market strategies have distinct PFD profiles that can be matched to specific liability windows

• Complementary cash flows: When properly structured, private market distributions can fill gaps that bonds alone cannot efficiently cover

• Strategic layering: Rather than replacing bonds entirely, private markets can be selectively deployed to target specific liability challenges

‍

This approach transforms private market allocations from simple return enhancers to sophisticated cash flow management tools that complement traditional fixed income strategies.

‍

‍

Putting Theory into Practice: A Pension Cash Flow Matching Case Study

Key Assumptions and Constraints

To demonstrate how a PFD-based approach can enhance cash flow matching, we apply it to the baseline liability scenario described earlier. Our objective is to construct a portfolio that — when coupled with existing bonds — achieves net cash flow with a moderate surplus starting in year 5 (2030), effectively tackling the mid-term liability hump.

‍

1. Liability Profile

‍

• We use a baseline projection for a mature pension plan with 60% retirees and 40% active workers. This profile shows a characteristic mid-term funding peak around years 5 to 15, followed by a gradual decline as the plan naturally winds down.

• Practitioner Tip: Confirm these projections with your actuary. Even minor tweaks to mortality or inflation assumptions can alter the timing of benefit peaks.

‍

2. Investment Universe

‍

• The optimization includes five private market asset classes: Infrastructure, Private  Debt, Private Equity, Real Estate, and Venture Capital.

• Reasoning: Infrastructure  and private debt typically offer more predictable cash flow timing with moderate PFDy values, making them suitable for mid-term liability matching. Real estate provides inflation sensitivity with relatively early distributions, while private equity and venture capital contribute higher return potential despite their extended J-curves.

‍

3. PFD Metrics Integration

‍

Rather than treating private markets as a homogeneous asset class, we apply the empirically derived PFD metrics from our research to calibrate the timing characteristics of each strategy:

‍

• PFDx: Guides the timing of capital deployment to ensure liquidity for early commitments

• PFDy: Aligns break-even points with specific liability windows

• PFDz: Matches distribution patterns with peak funding needs

‍

These metrics allow for precise timing of commitments to ensure distributions materialize when needed most, rather than relying on general assumptions about private market behavior.

‍

4. Optimization Approach

‍

Our model uses a rolling commitment strategy from 2025 through 2040, with cash flows projected through 2045. The optimization seeks to:

‍

• Maintain a minimum cash flow buffer of €5 million annually from 2030 onward

• Respect reasonable allocation limits (e.g., Venture Capital <10%, Private Equity <25%)

• Leverage existing bond holdings for near-term liquidity (years 0 to 5)

• Minimize capital inefficiency by targeting distributions to coincide with liability peaks

‍

Implementation Strategy and Results

With these constraints in place, the optimization identifies a phased allocation strategy that balances short-term liquidity with long-term return potential. By systematically aligning private market commitments with projected liabilities, the model ensures that capital calls, distributions, and reinvestments remain synchronized with the plan’s funding needs.

‍

The chart below illustrates a phased allocation strategy, balancing short-term stability with long-term return potential.

‍

‍

Key takeaways for pension sponsors:

‍

• Emphasize Infrastructure & Private Debt Early: These asset classes provide more predictable PFD timing, ensuring early cash flow stabilization.

• Maintain Moderate Real Estate Allocations: While not as front-loaded as private debt, real estate offers inflation sensitivity and stable mid-term distributions.

• Limit Private Equity & Venture Capital to Growth Buckets: Given their extended PFD timelines, these should play a secondary role in liquidity-driven portfolios.

‍

These findings highlight that private markets should be deployed selectively — not as broad allocations, but as targeted investments aligned with specific cash flow objectives.

‍

The chart highlights:

‍

• Capital outlays for new private market investments (red)

• Pension liabilities falling due each year (orange)

• Distributions from private markets as capital is returned (blue)

• Net cash flow position (black line)

‍

Most importantly, the model shows that from year 5, distributions not only cover liabilities but also generate a surplus for subsequent commitments. This creates a self-sustaining cycle that reduces reliance on traditional bond allocations during the critical mid-term window.

‍

When consolidated into annual cash flows, the strategy demonstrates its effectiveness:

‍

‍

Scaling the Approach: From Concept to Practical Allocations

While our case study illustrated a deliberately extreme scenario — halting new bond allocations after year five — most pension plans operate under practical constraints such as regulatory caps on illiquid assets, governance mandates, and sponsor risk tolerance. Moreover, many sponsors find it prudent to preserve a minimum bond allocation for liquidity, rather than fully substituting bonds with private markets. Recognizing these realities, we used our in-house Strategic Asset Allocation (SAA) tool to assess two more moderate, albeit quite distinct, private market allocations — 5% and 25% — to demonstrate how incremental shifts in private market exposure can influence both return potential and cash flow resilience. This side-by-side analysis offers a clearer sense of how sponsors might balance the theoretical benefits of a high private market share with the practical demands of liquidity, risk management, and implement ability:

‍

1. Modest 5% Allocation

Adding a small private market sleeve to a bond-centric LDI portfolio generally does not outperform a standard 60/40 benchmark. Even though private markets may offer higher yields, a 5% slice won’t meaningfully affect total returns or risk metrics — any impact on mid-term liquidity is minimal.

‍

2. More Aggressive 25% Allocation

Moving an incremental 20% of the portfolio from bonds into private markets can substantially boost returns and reduce downside risk compared to both 60/40 and the 5% scenario. Enhanced distributions and lower correlation to public markets bolster mid-term liquidity without sacrificing near-term coverage. The key insight is not that private markets should replace bonds entirely, but that even moderate allocations — when structured with careful attention to PFD characteristics — can significantly improve a pension plan's resilience to mid-term funding challenges.

‍

‍

‍

Practical Implications and Final Thoughts

Moving Beyond Return Enhancement

Our findings reinforce a fundamental shift in pension investment strategy: private markets should no longer be viewed solely as return enhancers but as sophisticated liquidity management tools. By applying PFD-driven asset allocation, pension sponsors can reduce dependency on reinvestment risk, optimize mid-term cash flows without sacrificing long-term growth, and build more resilient portfolios that align capital deployment with liabilities.

‍

Balancing Scale and Impact

The analysis of different allocation levels reveals that while a modest 5% allocation to private markets offers limited portfolio impact, increasing to a 25% allocation can substantially improve both returns and mid-term liquidity coverage. This more substantial allocation helps address the critical funding "hump" that many mature pension plans face, while maintaining essential near-term stability through complementary bond holdings.

‍

Optimizing the Bond-Private Markets Partnership

Short-duration or high-grade bonds remain essential for covering near-term liabilities (years 0 to 5), providing the stable foundation from which more strategic private market allocations can operate. Private markets, when selected with appropriate PFD profiles, effectively address the challenging mid-term period (years 5 to 15), helping plans navigate inflation risks and potential reinvestment challenges.

‍

Our earlier research into timing patterns across private market investments provides quantitative insights that pension sponsors can incorporate into their own modeling frameworks. By understanding the diverse cash flow characteristics of different private market strategies, investors can create more tailored, liability-aware portfolios that bridge the gap between traditional LDI approaches and the dynamic nature of modern pension management.

‍

‍

‍

For more information related to the foundational paper upon which this paper was written, please reach out to us at info@klarphos.com.

‍

‍

‍

‍

^{Important Information‍}

^{This document is informative purposes only. It does not constitute research, investment advice nor solicitation to invest in any investment product or service that Klarphos offers or may offer in the future in any jurisdiction. The information contained herein is based on projections, estimates and/or other financial data and has been prepared internally by Klarphos. Opinions expressed therein are current opinions as of the date of this document only and are subject to change at any time without notice.No representations are made as to the accuracy of the observations, assumptions, and projections. No subscriptions to any Klarphos products are possible based solely on this document. Any investment decisions should be made in accordance with the legal documentation of a fund such as its offering memorandum.Klarphos is not entitled to provide any tax, regulatory or legal advice.Past performance is not indicative of future returns. There can be no assurance that the strategy objectives will be realized or that the strategy will not experience losses. Target returns are hypothetical and are neither guarantees nor predictions of future performance. There can be no assurance that the target returns will be achieved.‍}

^‍

‍