CIO Profile: In-Sourced, Fully Funded, Public, and American

The South Dakota Retirement System won’t be turning down the risk in its winning investment strategy, despite reaching 104% funding status.

(September 19, 2013) – The South Dakota Retirement System (SDRS) did something unusual among US public funds this month: It fully funded its liabilities.

As of June 30, the $9 billion retirement and health plan held 104% of the assets required to pay its current and future obligations.

The SDRS is not alone among US public plans in reaching full funding, as its top administrators are quick to point out, but it belongs to an exclusive group.

The nation’s 100 largest public funds were, on average, 75.1% funded in 2012, according to Milliman actuarial data. These plans assumed a median 8% annual rate of return, whereas the SDRS lowered its rate to 7.25% last year.   

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Investment staffers in South Dakota are free of some of the challenges plaguing other large systems. The state’s public employers, for example, have a strong record of paying their retirement bills in full and on time.

But the Midwestern fund didn’t reach this landmark by following the status quo. In many respects, its governance and investment style shares more in common with its neighbors to north—the Canadians—than with the typical US pension system.  

The SDRS handles plan administration, while the largely independent South Dakota Investment Council runs its assets. This division manages a total of $11.3 billion, including retirement assets, health and education trusts, and the state government’s cash flow accounts.

The investment council has taken its mandate to heart: It actively manages 65% to 70% of its assets in-house. Investment head Matt Clark leads a team of about 55, roughly half of which are finance professionals.  

“Managing assets in-house is a core part of our strategy,” he says during an interview with aiCIO. “And our staff tends to stay with us for the very long term.” Clark is a case in point: He has worked with the council since 1984. “We couldn’t have achieved all we’ve done if people left every five years.”

The council’s achievement for the 2013 fiscal year—a 19% return—largely propelled the SDRS’ funding ratio into triple digits. From 2003 through 2012, the investment team averaged 7.8% annualized gains, topping its 10-year benchmark by 120 basis points.

In the nearly three decades since Clark joined the South Dakota Investment Council, its assets under management have grown more than thirteen-fold. He acknowledges this latest landmark—full funding—as an accomplishment, but not a finish line.

“The asset values are calculated at market rates,” Clark cautions. “Things could go up or down a little bit depending on a few factors. And over the long term,” he adds, “market returns may be significantly better or worse than expected.”

For this reason, Clark says the council does not plan to dial back risk or change investment strategy in a meaningful way. 

“The 104% figure is largely based on actuaries’ prediction of what our returns will be in the future. I think that to assume we’ve already achieved them and change our strategy would be putting the cart before the horse,” he says.

SDRS and its investment council take the quality of its funded ratio seriously, paying as much attention to its inputs as its outputs.

For example, the fund reviews its assumed rate of return every five to seven years as a matter of course, according to Executive Director Robert Wylie.

Last year, this regular evaluation led the investment staff (aided by consultants) to pursue a “select and ultimate” strategy. For the next several years, based on internal market views, the assumed rate of return has been lowered to 7.25%. Following that, the long-term or “ultimate” rate of 7.5% will take over.

Expected returns are not the only dynamic feature of the SDRS’ funding ratio. Liabilities are also flexible, and can be dialed down as well as up depending on the health of the plan.

“When the retirement system was originally established, provisions were made in South Dakota state law that said if we drop below a certain funding status [80%], we have to make changes in benefits or contributions to rise back up,” Wylie says.

“It’s the opposite of what you see in some places, where benefits are constitutionally or statutorily guaranteed. Ours are flexible, by law,” he continues. “When we consider changes in our benefit structure which would raise liabilities, we have to be at least 120% funded.”

The SRDS’ ability to adjust benefits in a worst-case market scenario gives Clark and his team freedom to pursue growth past the 100% funding mark, Wylie points out. Here is perhaps the public fund equivalent of high cash-flow corporations that choose not to pursue LDI. Because if worst comes to worse, the company can afford top off the plan. Or, in this case, the plan could reduce its liabilities.

Of course, the fact that the South Dakota pension system can reduce its liabilities means it almost certainly won’t have to. By maintaining its investments in risk assets, the fund will likely continue its strong course of growth. And that, foremost, is how Clark sees his mandate.

“We’re responsible for the retirements of thousands of people in South Dakota,” he says. “It’s our responsibility to do the best we can with their life savings.”

UTC Introduces Risk Parity to DC Members

CIO Robin Diamonte has revealed the new core option will be provided by Bridgewater, AQR, and Invesco.

(September 19, 2013) – United Technologies Corporation is introducing a risk parity option for its defined contribution (DC) participants starting from next spring, aiCIO can reveal.

CIO Robin Diamonte said risk parity would be introduced in May 2014 as a core option in the savings menu line-up.

“Our investment board for the defined benefit (DB) plan has been familiar with risk parity for more than seven years. We’ve seen the returns through many different environments and it has performed as expected,” she said.

“We’re lucky that many members of our investment committee already understand and have experience with risk parity. There is some crossover between our DB and DC investment committee members – so when we wanted to discuss putting it in the DC plan, we didn’t have to go back to the drawing board and re-educate all committee members”.

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UTC’s DB fund already has an 8% exposure to risk parity, with Bridgewater, AQR, and First Quadrant as managers. But for the DC option, Invesco have replaced First Quadrant. Each of the three managers has been given an equal weighting.

On why Invesco had been chosen over First Quadrant for the DC operation, Diamonte said: “We wanted to build a diversified fund with two or more risk parity managers. Invesco has had a retail risk parity fund for a long time so they’re one of the few with a long track record in this space.

“They also don’t use any inflation-linked bonds in their portfolio. When we analysed the various combinations of the managers we like in this space, the combination of Invesco, Bridgewater and AQR gave us the ability to have a daily valued portfolio and a risk/return trade-off that was optimal for this option.”

Unlike other plan sponsors using the strategy in DC, UTC will not be applying risk parity to its target-date funds. Diamonte told aiCIO this was because the investment committee’s analysis had shown that simply using risk parity as a diversified beta in its target-date funds “didn’t add a great deal to the risk-adjusted returns, unless it was a substantial portion of the portfolio”.

And making it a substantial part of the portfolio is not an option due to the costs it would incur, at least for now.

“Our target-date funds have a fee of 9 basis points or less. If you add a diversifier, it has to add value on a risk- and cost-adjusted basis,” she explained.

A real asset option is also being introduced, through a partnership with State Street. The assets are attractive as they provide “a very different type of beta that is intended to provide an inflation hedge”, Diamonte said. The passive portfolio will have a static allocation to four different types of real assets – natural resources, commodities, REITS, and inflation-linked bonds.

Keeping the DC plan simple is also top of Diamonte’s wish-list, which means keeping the number of options down. In total, once the risk parity and real asset options have been introduced, there will be 10 options for plan participants to choose from.

“The investment philosophy behind our savings plan is for it to be simple, flexible, and low cost.  We want the design to have as few options as possible so we don’t overwhelm our participants but still incorporate all the various beta sources that would be used by a sophisticated investor,” Diamonte said.

“In other words, we wanted our participants to be able to create the best diversified portfolio that suits their unique needs.”

Related Content: The New Hybrid DC Plans in Corporate America and The Rise of Mega-Defined Contribution  

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