SFERS Board Cuts Rate of Return to 7.4% | Chief Investment Officer

The board of the $24.5 billion San Francisco Employees’ Retirement System (SFERS) has approved a small reduction to its expected rate of return to 7.4% from 7.5%, retaining the system’s status as having the most optimistic return projections of any public pension plan in California.

The return assumption comes as the pension system’s general investment consultant, NEPC, forecasts that the plan’s investment returns will see a lower 6.9% annualized investment return over the next five to seven years. On a 30-year basis, NEPC is more optimistic, predicting an annualized return of 8%.

A video stream of the board’s meeting on Nov. 14 and agenda material shows that the system’s actuary, Cheiron, recommended the system’s board take one of three options on the rate of return assumption: cutting it to 7%, 7.25%, or 7.4%.

A Cheiron analysis shows that the median return expectations of all California public pension plans over the next three decades was 7.2%, with four plans below 7%. The lowest plan had a 6.75% rate of return. Cheiron said while the San Francisco system has the highest projected rate of return in California, 7.5% was in line with the median national US average of 7.5%.

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The largest US pension plans, the $361.1 billion California Public Employees’ Retirement System (CalPERS) and the $320 billion California State Teachers’ Retirement System (CalSTRS), each have dropped their assumed rate of return to 7% from 7.5%.

Cheiron projects that the action taken by SFERS, cutting the rate of return by one-tenth of 1%, reduces the pension system funding level to 86% from 87% and increases the unfunded liability to $3.6 billion from $3.3 billion.

If the plan had cut its rate of return to 7.25%, the unfunded liability would have increased to $4.1 billion, an 85% funding level, and if it went down to 7%, the unfunded liability would have gone up to $4.9 billion, or an 82% funding level.

“Those are ugly numbers,” the system’s Executive Director Jay Huish told the board.

Huish said the mayor’s office had authorized him in meetings to tell the board that the city was comfortable with the reduction in the rate of return to 7.4%. Huish said he had briefed city officials on the rate of reduction cuts being considered. While the retirement system operates independently from the city, three of the seven members are appointed by the mayor, and a fourth member is appointed by the president of the board of supervisors.

Pension plan costs have a huge impact on the city of San Francisco.

Under the plan cutting the rate of return to 7.4%, the city’s cost per employee for pension benefits varies in different years over the next decade but is as much as 25% of salary per employee in 2021 to a low of 19.2% in 2024, shows a Cheiron analysis.

Each percentage point drop has an even greater impact. For example, if the rate of return had been cut to 7.25%, the city’s cost per employee over the next decade would have risen to a high of 26.1% in 2021 to a low of 21% in 2024, the Cheiron forecast shows.

If NEPC is right, and the pension system does not achieve its short-term return expectations, the system’s funding ratio would fall and SFERS might be forced to raise the contribution rate even higher. The Cheiron analysis does not examine the shortfall impacts on the pension plan’s unfunded liability if the annualized short-term rate of return falls below 7.4%

Cheiron data shows the pension plan has been unable to meet its return assumptions over the last 20 years. The actuarial firm said the annualized return for the pension system was 7.1% over that period compared to an expected assumed rate of return of 8.25%. Using a shorter five-year period, however, Cheiron noted that SFERS achieved on average a 9.4% return, higher than the expected rate of return. The pension plan has had a 7.5% expected rate of return since 2014, when it lowered the rate of return from 7.58%.

SFERS board member Joseph Driscoll, a fire captain, told the board that he favored the 7.4% rate of return before the unanimous vote approving it. He said public pension system critics, who have argued that a lower rate of return as practiced by corporate pension plans (often in the area of a 5% rate of return) were not realistic and that reduction would lead to a 40% to 45% contribution rate per employee for the city.

“We’re not going down that road,” Driscoll said, noting that “a realistic rate that is achievable is 7.4%.”

Tags: Cheiron analysis, rate of return, San Francisco

The more cautious approach to direct private equity investing at the second-largest US pension plan contrasts with a more aggressive approach by CalPERS, the biggest US plan.

Investment managers at the $220 billion California State Teachers’ Retirement System (CalSTRS), the second-largest retirement plan in the US, are embracing increased co-investments as a way to expand its private equity program and as an entry point into direct investing for the asset class.

A CalSTRS report that was presented to the investment committee on Nov. 7 contrasts how the West Sacramento-based teachers’ retirement system is going down a different road, at least initially, than its neighbor, the $361.1 billion California Public Employees’ Retirement System (CalPERS) in Sacramento.

The largest US retirement plan, CalPERS is proposing to invest $20 billion through two partnerships over the next decade in late-stage companies in the venture capital cycle as well as taking buy and hold stakes in established companies.

The CalSTRS report shows that system officials see co-investments, traditionally investments alongside private equity funds, as the best way to increase the size of its $18 billion private equity portfolio.

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Co-investments only account for a small part of the private equity portfolio at the retirement plan, around 5%, said a September report from the Meketa Investment Group, which serves as a CalSTRS consultant.

The November CalSTRS report did not indicate how large co-investments could become, but investment staff say in the document they believe it’s the way for CalSTRS to encourage more direct private equity investments.

“For the medium term (the next three or four years), staff believes that increasing the Private Equity’s co-investing activities presents the greatest opportunity for improving performance (and reducing total fees and incentives paid to outside parties) through engaging in direct investing,” the CaSTRS report said.

In co-investing, pension plans like CalSTRS are offered additional stakes in portfolio companies acquired by private equity firms. This is in addition to their investment as a limited partner in a co-mingled fund with a general partner. However, the management of the additional investment is controlled by the general partner, not the institutional investor.

CalSTRS investment officials didn’t rule out taking a great role in direct investments in the future, but the report shows that investment staff of the pension is aiming to take a more cautious approach than CalPERS.

“Staff also believes that increased co-investing provides the best means to prepare private equity to engage in more advanced forms of direct investing (e.g., co-leading deals, leading deals, etc.) in the future should that be desired,” the report said.

CalPERS officials also say they want to build their co-investment program in their $27.6 billion private equity program but much of their attention is focused on setting up two CalPERS-funded investment partnerships to invest in late-stage venture capital and buy and hold stakes in established companies.

Both pension plans have been dealing with the fact that they are unable to commit as much money as they want to new private equity funds after their existing funds end and capital is distributed back to the retirement plans.

Because private equity returns generally are beating the returns of other asset classes, the competition to be investors in private equity funds has become so heated that institutional investors can’t get all the commitments they want. CalSTRS’s overall private equity returns for the one-year period ending March 31 totaled 15.5%, the largest return of any asset class.

CalSTRS currently has 8.1% of its overall portfolio devoted to private equity, but its long-term target is 13%.

In the 12-month-period ending March 31, CalSTRS statistics show that funds ending their lifecycle distributed $5 billion, but CalSTRS was only able to commit $3.9 billion into new funds. CalSTRS made $390 million in co-investments in the six-month period ending June 30, compared to total commitments of $1.9 billion in co-mingled private equity funds.

The CalSTRS report details the appeal of co-investments.

“Often there are no fees and carried interest charges,” it said. “This arrangement is highly appealing to many institutional investors because, in theory and often practice, it results in higher performance for their overall private equity program as the co-investment portion of their portfolio is invested in high-quality investments but with much reduced (or often completely eliminated) fees and incentive charges.”

CalSTRS data shows that the pension system has been investing in co-investment partnerships since 1996. Performance data for the co-investments has been mostly favorable compared to the system’s overall private equity portfolio.

For the one-year period ending March 31, co-investments saw a net investment return of 27.3% compared to the 14.2% return of CalPERS’s private equity funds. For the three-year period, co-investments returned 14.3% annualized compared to 10.4% for private equity funds, and for the five-year period, co-investments returned 13.7% annualized while private equity funds returned 12%. For the 10-year period, co-investments averaged a return of 6.6%, while private equity funds returned 8.1%.

CalSTRS Chief Investment Officer Chris Ailman said earlier in the year that he favored increasing co-investments, and the system has hired AlpInvest Partners as a co-investment adviser to look for additional co-investment opportunities beyond what private equity general partners were offering the pension system.

The CalSTRS Investment Committee was scheduled to offer direction to Ailman and private equity director Margot Wirth at the Nov. 9 meeting on whether it was in agreement with the plan to increase co-investments, but the matter was taken off the agenda because of time limitations. It is expected to be moved to another investment committee agenda at some point next year.

The issue is not considered controversial and investment committee members are expected to go with the report’s recommendations.

The CalPERS Investment Committee, meanwhile, is scheduled to give approval to its version of direct investing, forming two investment partnerships with a general partner and CalPERS as the sole limited partner, sometime in the next few months.

Tags: CalPERS, CalSTRS, co-investments, late stage, VC, Venture Capital