Exclusive Coverage: CIOs Assess How Pension Fund Investors Can Be Successful After COVID-19
Strong governance, flexibility over benefit structures, clever investment strategies, and maintaining savvy relations with investment trustees are among the best practices that can help pension funds do well in the post-pandemic era.
A panel of four allocators and consultants discussed solutions in CIO’s virtual conference “Inside the Minds of CIOs.” Speakers included pension investment chiefs from Maryland and New Mexico, as well as leaders from Backstop Solutions and Insight Investment.
Public pensions face any number of challenges to deliver good returns. Navigating board bureaucracy and funding liabilities has always been tough. But the pandemic has worsened pressures on chief investment officers, who have to deliver high return targets in a low interest rate environment, while local governments are strapped and are less able to increase plan contributions.
Introducing flexibility to benefit payment structures is one way to make retirement systems more resilient during times of fiscal trouble, said Dominic Garcia, CIO of the New Mexico Public Employees Retirement Association (PERA), a $16.4 billion plan. It is about 70% funded.
The retirement system now has created two benefit payment structures. It kept its promised statutory benefit costing 5.5% to 6%, but it changed its cost of living adjustment benefit (COLA) to a variable rate, from a fixed one. The changes were approved last year by the state legislature.
Instead of the fixed 2% COLA payment all current retirees received in the past, members will now get payouts fluctuating between 0.5% and 3%, based on a new “profit-share” model that ties benefit payments to investment performance and funding ratio. Garcia said the change is “kind of a relief valve” for the plan, which can make COLA payments based on shifts in the economy.
“Our assumed return is about 7.25%,” Garcia said. “But now, just to pay for that promised benefit, it only costs us 5.5% to 6%. So if we get the 5.5% to 6% going forward, we maintain our sustainability. That’s a big, big change for us.”
The benefit change structure was modeled after similar plan designs in South Dakota and Wisconsin. Still, Garcia acknowledged that implementing the same benefit design structure is politically difficult to replicate in many pension funds across the country. “Half of our participants are already retired,” he said.
Investors should also review and employ separate alpha and beta strategies for their portfolio, the New Mexico PERA CIO said. Cash will remain a weight on investor portfolios, as it pays very little. Investors scrutinizing their beta should consider using leverage to diversify their assets, which would result in better returns than un-levered portfolios, he indicated.
They should also embrace alpha, including hedge funds and private equity funds, to generate returns in excess of the market’s, he suggested. For example, consider investing a basket of futures for the S&P 500 to match the market, but any extra could be put toward a hedge fund portfolio to produce alpha. The beauty of this structure, Garcia said, is that investors are only paying fees on the excess returns.
“When we talk about best practices and portfolio management, it’s really trying to separate an optimized alpha and beta separately both in public and private markets and then putting them back together,” Garcia said.
More public pension funds are also using increased leverage, noted Insight Investment US Head of LDI Portfolio Management Shivin Kwatra. As cash flow becomes negative, public pension funds are reviewing their liquidity to see if they have enough to pay benefits.
Making full contributions is key to the longevity of public pension plans, said Andrew Palmer, chief investment officer at the Maryland State Retirement and Pension System (SPRS), a $54.8 billion fund.
The investment chief graphed the funded status over the past two decades of more robust public pension funds and others. Despite all the plans starting the century fully funded, a leading group of public pension funds that met their actuarially required contributions maintained their status over time. These include North Carolina, Tennessee, Wisconsin, and South Dakota.
Meanwhile, plans in Maryland, New Mexico, Minnesota, Massachusetts, and the public school plan in Pennsylvania that did not do the same saw their funded status fall to just about 70%.
Of course, full funding is just one piece of the puzzle, albeit a significant one, Palmer said. Other plans that maintained their contributions still managed to lose ground after sustaining large losses during downturns. What’s just as important, the CIO said, is risk-controlled investments and a conservative approach to benefits and actuarial practice.
Maintaining strong governance is also important for plan sustainability, Garcia said. Part of that comes from employing investment trustees who have a high level of financial experience. Attracting and retaining good talent also remains a challenge for pension funds. Palmer said being in the Baltimore-Washington area has helped the fund retain good talent.
All of this requires better communication with stakeholders in a public pension fund and a more streamlined processes, said Backstop Solutions Group CEO Clint Coghill.
He pointed out that investors waste nearly one-third of their time on administrative tasks that could be better spent on investments, according to a joint study last year from Backstop and Mercer.
“The job of a CIO today is harder than it’s ever been,” Coghill said, because of the number of investing instruments.
For investors who are looking elsewhere for clever ideas, there are innovative ways for public plans to tap public assets. The panelists said if getting benefit design changes or increases in contributions is too much of a lift for a pensions system, there is a third way—asset transfers.
Transferring public assets to public pension systems is a helpful strategy for local municipalities. This can improve their credit situations, improve budgets, and reduce their unfunded liability share through the exchange. And it can help boost returns for pension systems. Examples include water treatment plants and state lotteries.
Another method is to dedicate a revenue stream from an organization’s own return-generating assets to a plan. Insight Investment’s Kwatra said the practice is more commonplace in the corporate sector. For example, AT&T transferred preferred shares and tapped its wireless business to aid its pension system about a decade ago.
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