The 2021 financial year was an excellent year for public pensions. According According to funding data from Pew Charitable Trusts, a decade of rising pension contributions has been bolstered by the 2021 reopening rally. As a result, public pensions in all 50 states have seen their funded ratios exceed 80%, the highest level since before the Great Recession. By the end of fiscal year 2021, public pension plans had made the greatest strides in a century in bridging the gap between plan funding and liabilities.
While this data is positive, it may also indicate a high level of pension funding and stability. Pew’s forward projections suggest that pensions are more likely to struggle to meet their 7% return targets. Why? Stock market volatility, rising inflation and low fixed income yields all play a role, but so does fund governance. Rising contributions and a prolonged stock market rally have provided public pensions with significant cover in recent years. But choppy markets will make it harder for pensions to hide structural problems that have not been resolved, even if turnover numbers look better on paper.
Grope the bag
US public pension funds are a diverse cohort in size and scope, which can make them difficult to compare. However, the underlying structural issues are fairly consistent. Public pension funds have a fiduciary responsibility to manage the retirement benefits of millions of Americans. Internally, they are also tasked with managing the political realities of shifting legislative priorities, politicized advice and the public perception of pensioners themselves. This tends to result in public pension systems that resemble other government organizations: pension staff are underpaid compared to their private sector peers, and organizations run very small teams and often lack the expertise needed. As a result, US pension plans tend to face significant governance challenges compared to their counterparts around the world.
Several recent high-profile cases raise new questions about how these plans are governed, despite the fact that pension plan portfolios are doing better than they have in the past. In January, it was revealed that federal prosecutors were investigating the Washington DC Retirement Board, a pension fund that had been a model of good governance and is fully funded, putting it in an elite group. The investigation aims to determine whether investment management fees were misreported and how executive compensation is managed within the pension plan. If these expenses are not properly disclosed and accounted for, the funded status of the pension and municipal credit ratings could suffer.
Pennsylvania’s public school employee retirement system is also under scrutiny for potentially misreporting investment returns and fees in 2020. To date, the investigation has led to the early retirement of fund CIO Jim Grossman and executive director Glen Grell. In May, the CIO reported that the PSERS had retained the services of the Blank Rome law firm to help it determine whether to sue Aon, an investment consultant with whom the pension fund was working at the time. incorrect calculation of fees which led to the reporting problem.
Both of these cases raise questions about the ability of public pensions to internally manage the administrative requirements of complex investment portfolios or to effectively oversee relationships with external providers without additional support.
“Pensions are overseen by legislatures that are very often reluctant to allow the board to set compensation and headcount that would bring the kind of investment expertise you need in-house to replicate independence and success. that can be seen in the world’s peer organizations as in the Canadian model,” says Randall Miller at Funston Advisory Services, a governance and risk management consultancy that works with public pension funds.
The Canadian model allows an investment management firm run by a board of directors to operate separately from federal or provincial corporations. The board also operates separately from the investment team. This configuration has been recognized internationally as one that represents good governance and supports positive investment performance.
Reform at the margin
Making improvements to pension fund governance in the United States is a tall order, and achieving anything resembling the Canadian model seems unlikely. But there are already reforms on the sidelines that could bring US pension funds closer together. A February 2022 study by CEM Benchmarking, a pension data provider, titled “A Case For Scale” argues that larger pension fund portfolios tend to have better investment outcomes on both a gross and basis basis as well as better governance; it highlights the consolidation efforts currently underway worldwide.
“The breakdown of these results by assets under management begins to reveal the outperformance of larger funds. Small funds with less than $1 billion in assets under management generated 47 basis points of outperformance before costs, 36 basis points less than the 83 basis points of outperformance of funds with more than $10 billion dollars of assets under management. In fact, after accounting for costs, funds below $1 billion generated no value on average, while larger funds averaged 29 basis points of annual excess returns,” the report said. .
Larger portfolios can access better performing external investment funds and negotiate to improve investment conditions and reduce fees, and generally benefit from economies of scale. These results track with which Canadian funds cited as goals as they strive to expand investment portfolios through consolidation.
The state of Illinois is also currently pursuing this course as it attempts to correct its course after a long history of governance issues. But it hasn’t been easy. In his first budget speech after the approval of the consolidation plan, Governor JB Pritzker noted that it was the culmination of 70 years of attempts within the Statehouse. Two years after the plan began to be implemented, an Illinois Circuit Court judge dismissed a lawsuit to stop the consolidation, rejecting plaintiff’s claims that a law enacting the decision violated the state constitution.
Illinois continues its consolidation efforts. “The state is working diligently with all partners to achieve the goals of the legislation,” Jordan Abudayyeh, a spokesperson for Pritzker, told Bloomberg.
If the state fails to fill the gaps and build trust in the plan, it may have limited options for investing or improving governance in the future.
“If you look at reasonable expectations in the future, it will be very difficult to maintain current asset-liability funded ratios in public pensions without making significant changes,” says Keith Ambachtsheer, co-founder of CEM Benchmarking and CEO of KPA Advisory Services. Ambachtsheer is widely recognized as a global expert in institutional fund governance. “Pension schemes have had a good decade of strong investment returns, recently combined with higher liability discount rates. But these trends will eventually reverse, putting further downward pressure on capitalization ratios. If you combine that with boards that are unwilling to make structural changes to their business model, it’s a catch-22.
Challenges may be on the horizon. Data from Santa Monica, Calif.-based Wilshire Trust Universe Comparison Service, part of global advisory firm Wilshire Associates, shows that institutional assets posted a median return of all plans of -4, 94% for the first quarter of this year. Across all plan types, quarterly median gains ranged from -6.08 to -2.30% for large corporate funds (assets greater than $1 billion) and very large public funds (assets greater than $5 billion), respectively. All of the small median groups except the small public funds underperformed the multi-asset Wilshire Risk Parity Index – 12% Target Volatility. The index posted a loss of -5.02% for the first quarter.
Smaller funds, as well as funds that are unable to consolidate or are skeptical of reform, could look to the roadmap provided by the San Bernardino County Employees’ Retirement Association, an independent plan to defined benefits to multiple employers with over $14 billion in assets. SBCERA recorded an investment return of 33.3% for the 12 months ending June 30, 2021. The repo also ranked in the top 1% of public funds in the United States, with an investment return of 20 .6% for calendar year 2021, a record. year, of course, but the pension fund has also posted positive investment returns for eight of the past 10 years, according to its Complete annual financial report 2021.
SBCERA has taken steps to more clearly delineate its governance structure to enhance its independence and better utilize its limited resources. The SBCERA Board of Directors has largely delegated investment decisions to the SBCERA investment team while retaining authority over the investment managers it engages with and The pension fund credits this structure with its ability to make better investment decisions and improve oversight.
“We don’t take delegation of authority lightly,” said Donald Pierce, CIO at SBCERA. “We recognize the importance of effectively executing our fiduciary responsibility and honoring the long-term commitment our members rely on. We are committed to finding appropriate opportunities to achieve our ROI goals, regardless of the economic climate. »
Funston’s Miller notes that other pension plans are starting to make similar improvements to governance structures around margins, but it’s still a work in progress. “We’re seeing positive improvements – formalizing structures, creating guiding investment beliefs, that certainly helps. But you still have to address the basic fiduciary misalignment,” he says. administration with fiduciary responsibilities over billions of dollars in assets, but they lack the ability to exercise those responsibilities because they cannot hire adequate investment expertise or support technology and personnel. risk there.”
Tags: board governance, CEM Benchmarking, Funston Advisory Services, Governance, Illinois, Keith Ambachtsheer, KPA Advisory Services, public pensions, San Bernardino County Employees Retirement Association