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Pension Plan Investments in Alternative Assets Pose Serious Risk to Taxpayers and Members

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Since the 1990s, public pension systems have seen diminishing returns from traditional workhorse investments like bonds and large-cap public equities. Because of this, public pension boards have increasingly relied on alternative investments to meet their funding goals each year. These alternatives, invested via limited private partnerships such as private equities, privately held debt, hedge funds, and other private assets outside of the traditional stocks and bonds investment strategy look tempting to struggling public pension systems because of their lucrative return potential. But lack of transparency and exposure to the possibility of unexpected losses upon liquidation of assets make these investments especially risky to taxpayers and retirees.

The below chart shows how interest in private equity assets has grown in the last 20 years.

From a pension board’s perspective, the justification for this shift is simple – they need higher returns. To pay for promised retirement benefits, pension plans rely on three sources of revenue: public employees contributing directly to the fund from their paycheck, employer contributions via taxpayer funding, and the investment returns generated from the market. When one source underperforms or under-contributes, the others need to pick up the slack or debt will be created.

When interest rates on 30-year Treasury bonds slipped below 7 percent in 1995, public pension systems floundered with their traditional investment strategies and leaned on their actuaries and investment consultants to help navigate complex alternative investment strategies. Actuarial firms monitor past experience, calculate the current health of the fund, and report on what funds can be assumed to receive in investment returns in the future. With these metrics the actuary calculates a pension plan’s assumed rate of return, which is a projection of what the plan’s investments will earn over time. If the plan falls short of this rate and does not make up for it by increasing contributions elsewhere, unfunded liabilities will increase.

As of August 2020, the weighted average assumed rate of return among state-managed public pension systems sat at 7.25 percent, while the average 20-year investment return for these plans was 6.3 percent. To make up for this underperformance and avoid increased taxpayer and member contribution requirements, pension boards sought out investment consultants who specialize in managing portfolios using alternative assets. This pivot intensified after the 2008 financial crisis as tax revenue and paychecks began to shrink.

The Challenge

When a public pension board is forced to rely on investment consultants to navigate complex investment instruments on a multi-billion-dollar scale, the valuation and return of those investments must be as transparent as possible to avoid a surprise increase in contributions or ballooning debt.

Supporters of private equity firms routinely point to median annualized returns for public pensions coming in at upwards of 13.7 percent over the last 10-year period. Public pension board investment consultants often highlight this point during private quarterly benchmark updates in order to sell their alternative asset investment strategy as the “highest performing asset class” for public pension funds across the country. But often the investment is in a limited partnership with a private equity firm operating as the general partner who buys and liquidates businesses. These liquidations, typically over 10 to 12 years, determine the true value of the investment. Until then actuaries use a value reported by the limited partner of these opaque assets to set funding policy and evaluate risk.

These investments are extremely sensitive to market conditions at the time of re-sale. If private equity firms hold onto assets until conditions improve, the plan will see zero realized return on that asset for an unknown amount of time. Because actuaries value public pension systems annually and pension boards base subsequent fiscal policies on those annual valuations it is even more important to assess what an accurate alternative asset assumed rates of return would be. Simply put, alternative asset returns are hard to predict, especially for public pension boards, because of their structure.

Even with full transparency, these alternative investments are the most challenging investments to value because they require assumptions about complex future cash flows and valuation multiples from future sales.

Such complexities expose public pension systems to the possibility of catastrophic unexpected losses upon liquidation—all with taxpayers and members ultimately responsible for the losses.

So, what can be done about lower traditional investment returns if alternative assets are too risky for pension plans to get involved with? Short of requiring contribution increases on members and taxpayers, do pension boards have any course of action? Should they limit alternative assets in their investment portfolio, or drop them entirely?

The Path Forward

Given the critical role investment returns play in a healthy and sustainable guaranteed-income pension system, plan members and the taxpaying public deserve a full and transparent accounting of assets.

If pension funds are to invest in alternative assets, all public pension stakeholders would benefit from more comprehensive reporting of alternative investment holdings. One example of such a report would be a private limited partner portfolio performance report that publicly discloses specific information regarding the private limited partner holdings of public pension systems for third-party monitoring and evaluation. Such a report could be as simple as a six-column table populated with the following data points per holding:

  1. Name of Each Investment Vehicle
  2. Date of Each Investment
  3. Amount of Capital Committed
  4. Amount of Capital Contributed
  5. Amount of Capital Distributed
  6. Internal Rate of Return (Annualized Return Estimate on Capital Invested)

Large industry leaders like the California State Teachers’ Retirement System (CalSTRS) currently provide such transparency, and states like Ohio and New Mexico, with the support of both budget watchdog groups and labor unions, are considering bipartisan legislation to implement similar reporting requirements.

In addition to these reporting metrics, Landmark Partners and the Public Employees Retirement Association of New Mexico recently developed a new data point to help better assess the true value of private equity and other alternative asset investments; it is called the Excess Value Method.

The Excess Value Method calculates, in dollar terms, the performance of managers of private limited partnerships above or below a comparable public investment benchmark, in addition to a multiple or a rate calculation used by some pension funds today. The current carried interest compensation formula, widely used by public pension funds, compensates private limited partners by their absolute return, completely removing any consideration of the risk associated with such an asset. It’s important to understand, in dollars, the performance of a private limited partner of a public pension fund by directly comparing the value gain to the fund in choosing a volatile and less transparent asset like a private equity investment over a public and highly transparent regulated asset like a mutual fund. In a nutshell, the Excess Value Method lets public pension stakeholders know if the juice was worth the squeeze.

Providing data that allows stakeholders to calculate a metric to compare costs against returns generated from those costs is clearly in the best interest of all public pension system stakeholders. There may be a legitimate need for these multi-billion-dollar public pension investment funds to leverage alternative assets to navigate the treacherous waters of global investing as safely as possible, but public pension benefits are paid from net returns, not gross returns or benchmark returns. Since increased investment costs reduce net returns, fees and expenses should be transparent, consistently monitored, and managers held accountable for the effectiveness of investments relative to the overall growth and resiliency of the public pension fund they are meant to support.



Source: https://reason.org/commentary/pension-plan-investments-in-alternative-assets-pose-serious-risk-to-taxpayers-and-members/


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