Tackling the 65-per-cent-funded status of the Maryland State Retirement and Pension System has resulted in the bold political move to boost employee contributions while a long-term plan to increase allocations to private markets is part of a push to hit the system’s 7.75-per-cent-return target.

The system is more than 10 per cent below the average funded level of US public pension funds and both state politicians and the system’s board have put in place programs that aim to have the system reach 80-per-cent funding by 2023.

Sam Riley speaks with the Maryland State Retirement Agency (MSRA) chief investment officer Dr Melissa Moye about how the $37.7-billion fund plans to make its return target and start the long climb back to full funding.

Moye was appointed permanently to the position of chief investment officer midway through last year. She had been acting in an interim capacity since October 2010 after previous CIO Mansco Perry III left to head up the endowment fund of Macalester College in Saint Paul, Minnesota.

After a nation-wide search for a candidate, the system’s board decided to stick with Moye on the back of a 20-per-cent return last financial year.

Moye has inherited a long-term asset allocation from the board that has set a course to increase the fund’s exposure to private markets in an effort to further diversify the portfolio and decrease its overall volatility (see figure).

 

A state apart

But in a move that sets itself apart from many other states, Maryland Governor Martin O’Malley agreed to stick with the defined-benefit structure of the system when designing a reform program to address funding levels.

While other states such as California are considering hybrid defined contribution/benefit systems, O’Malley and the state’s legislature passed reforms last year that seek to share the burden of providing for public pensions.

At 65-per-cent funded, the Maryland system lags behind the average funding levels of its peers by more than 10 per cent.

A National Conference on Public Employee Retirement Systems (NCPERS) study released in mid-2011 found that US public pension funds were, on average, 75.7-per-cent funded.

While state politicians have maintained the defined benefit system, this has been balanced by an increase to employer contributions from 5 to 7 per cent and cutting back on cost-of-living increases when calculating benefits.

The system manages benefits for approximately 350,000 public employees.

According to the National Association of State Retirement Administrators, Maryland state and local governments contributed 2.79 per cent of the total state budget in 2009 compared to a national average of 3 per cent.

Investments also form a vital part of the plan to return the system to full funding in the long term.

Before the financial crisis the MSRA board decided to significantly increase its exposure to private equity, ultimately to 10 per cent of the total fund as a long-term target.

The current allocation to private equity is 4 per cent.

The decision to move more into private markets came before the fund experienced a more than 20 per cent loss in the 2009 financial year. This loss resulted in funding levels dropping from 78.62 per cent to 65.02 per cent.

The board has expressed a desire to limit the volatility of the portfolio through increased diversification into private markets, real return assets, property and hedge funds.

This increased allocation to private markets is to come predominately from the public equity portfolio, which currently accounts for 47 per cent of the overall portfolio.

Moye says the board plans to reduce its exposure to public equity to 36 per cent of overall fund.

The private markets push also reflects advice from MSRA investment consultant Hewitt EnnisKnupp, which identified the fund’s then 2-per-cent-private-equity allocation as underweight relative to other public pension funds.

“In terms of private equity, we were really under-allocated relative to our peers, at roughly 2 per cent of our total plan, and what we are seeing is that, in fact, there is potential for return in private equity, as a balanced part of the portfolio,” Moye says.

Hewitt EnnisKnupp is also a consultant to the Teachers Retirement System of Texas, which has been one of the most aggressive of the public pension funds in allocating more to alternative assets.

In a February 2011 study, Wilshire Associates found that US public pension funds had an average allocation to private equity of 8.8 per cent.

The public equity portfolio is constructed to limit home-country bias.

“We keep the portfolio balanced to the MSCI All Country World index, so in other words it is really a global allocation,” she says.

This typically sees the funds split 44-per-cent US equities to 56-per-cent international.

SRA has a team of 20 investment and accounting staff but all of the system’s assets are externally managed.

The board has committed to a gradual transition to private markets. Capital that is currently unallocated to private equity is temporarily allocated to public equity.

 

Opportunities in diversity

The diversification push also includes an increased allocation to real estate and credit/debt to 10 per cent of the fund respectively.

Distressed debt opportunities offer attractive opportunities at this stage of the market cycle, Moye says.

“The credit/debt push came after the global financial crisis as it made sense to provide credit as a way of getting equity-like returns with lower risk,” she says.

“We see private markets as part of the overall opportunity set for institutional investors.”

Moye says that the board has also looked to position the portfolio to deal with what it sees as a long-term risk of inflation.

Subsequently, it has increased target allocations to the real-return asset class. This asset bucket is currently 10 per cent of the portfolio and includes real assets such as timberland, infrastructure, Treasury Inflation Protected Securities (TIPS), global inflation-linked bonds, commodities and energy, and energy-related assets.

According to Moye, the fixed-income and real-return assets currently make up 30 per cent of the portfolio. The board has set a target allocation of real returns and fixed income combined at 25 per cent of the total fund once real estate reaches its 10 per cent target from its current level of just over 5 per cent.

 

Inflation, commingling and outsourcing

“Most investors are concerned about inflation in the longer term and over time we will move more assets to inflation-protected type of assets, and real assets like timber and infrastructure that have capacity to increase returns with inflation,” she says.

MSRA assumes a 3 per cent rate of inflation in its actuarial assumptions and its investment team is planning for potentially higher inflation in the next decade.

The fund has decided to wind up its direct investment program in property, preferring commingled funds as a way of increasing the diversity of its holdings.

In December the investment division of the Maryland State Retirement Agency, SRA, closed its 20-year direct-equity real-estate program, selling its last three Maryland properties.

At the time Moye said that commingled funds offered greater diversification across property types and geography.

The fund has also gone for a new consultant for its absolute-returns portfolio, appointing Albourne America at the start of this year.

Absolute returns are capped at 15 per cent of the portfolio and currently make up around 9 per cent of total assets. Albourne will look at the portfolio construction as well as due diligence of managers, and ongoing operational due diligence.

The absolute returns portfolio achieved an 8.54-per-cent return last year, beating its benchmark.

The push into private markets comes as the fund has also maintained its assumed rate of return of 7.75 per cent.

The National Association of State Retirement Administrators (NASRA) found last year that 56 of the 126 state pension plans it surveyed had an assumed rate of return of 8 per cent.

The NASRA research also found that all of these plans’ return assumptions fell within a range of 7 to 8.5 per cent.

While the largest US public pension fund, CalPERS, has decided to cut its assumed rate from 7.75 per cent to 7.5 per cent, Moye says that the system’s long-term performance shows it can achieve its current return target.

“It [the rate of return] is in the range of what can be expected, given the asset allocation that we have. We receive an annual evaluation from both our general consultant and our actuary,” she says.

Moye points to the long-term performance of the system, saying it has achieved average returns of 5.65 per cent over the past 10 years, 7.64 per cent over 20 years and 8.55 per cent over 25 years.

Last year Wilshire Associates forecast a median return of 6.5 per cent for public pension funds in the long-term.

Along with its core mandates, the system has an innovative small-manager program, named Terra Maria.

The program grew out of an emerging manager program and targets smaller managers with under $10 billion in assets under management.

The system currently allocates $3.3 billion, or 8.8 per cent, of total assets to the program, as of June 30 last year.

The Terra Maria program was originally started in 2008 for public market managers., In 2010 it was decided to expand the program to include private managers.

The program returned 29.6 per cent for the last fiscal year, compared to the custom benchmark’s 30.1 per cent.

In public markets it has seven “program managers, who are effectively an extension of the investment team, as they are responsible for sourcing managers, due diligence and monitoring”.

Final manager selection and termination rests with the chief investment officer.

Figure 1: Asset allocation (June 30, 2011)

Return to top

Three funds find effective ways to get better value from staff, co-investment and private markets.

The Danish ATP, Australian Sunsuper and the Teachers Retirement System of Texas are among the funds looking at innovative ways to extract value and interact with the managers of their private equity allocations.

Institutional investors are increasingly seeking new ways to extract value from their private equity holdings, including forays into emerging markets, direct investing and innovative investment vehicles.

One fund that has taken an innovative approach to accessing the asset class is Denmark’s ATP, which utilises an innovative incentive structure that attempts to deal with some of the pitfalls of fund-of-funds models.

The problem of fees-on-top-of-fees, where investors are paying fees to both underlying managers and the fund-of-funds manager, has been a common criticism of these types of vehicles.

In 2000 the fund took the view that it should expand its private market program and decided to launch ATP Private Equity Partners (PEP).

“If ATP had invested their entire private equity program with external fund-of-funds managers, you could say that their returns would have been impacted by another layer of fees. As we are managing our business in a very cost-effective way, this is not the case,” ATP PEP managing partner, Torben Vangstrup says.

“If they had committed to a fund-of-fund manager, they would have had to pay annual management fees in the range of 0.25 to 0.8 per cent and that will have an impact if they do so for 10 or 15 years.”

 

Staff incentive schemes

ATP PEP manages four funds for ATP, and has €7 billion under management. Funds are typically €1 billion to €1.5 billion in size. ATP has targeted a 7-per-cent allocation to private equity and currently has 5.5 per cent of its overall portfolio allocated to the asset class.

The key difference between ATP PEP and typical in-house private-equity team or a fund-of-funds manager can be found in the incentive scheme offered to staff, according to managing partner Torben Vangstrup.

“We wanted a program in place so we could incentivise people for doing a great job, but also to give us an opportunity to attract and retain the right people,” Vangstrup says.

“The incentive structure we have put in place is very much like what you see in those funds where we invest. In general, many pension funds do not want or have the capability for this type of incentive system.”

A key problem for funds looking to build out internal-asset teams is the retention of talented staff. Pension funds, which must strictly control costs, often cannot compete with the generous bonuses paid by private-equity firms in the private sector.

ATP requires all partners at ATP PEP to invest their own funds in any investment the pension fund makes.

Under the carry program, when all the capital drawn down has been returned to ATP, including an 8-to-10-per-cent-hurdle rate, further distributions are shared between ATP PEP, other general partners and ATP.

“But this split is not even close to the typical 80/20 carry split in the private-equity industry,” Vangstrup says.

While it is voluntary for non-partner staff to invest in the scheme, the entire team currently participates. Its first fund has achieved an internal rate of return net of fees of 15.8 per cent since inception.

“The beauty of the system is that you will only be rewarded if and when you have been able to create excess returns for investors,” he says.

One key difference to other private equity managers is that you will not see ATP PEP partners walking away with headline-grabbing bonuses. Total remuneration from the carry program is capped.

“If you look at a traditional buyout fund there is no limit in terms of how much they can get, when they have a homerun they can get extremely rich from such a carry system,’ he says.

“We can’t, because we are part of a pension fund, we can get rich but we can’t get very rich because the carry program is capped.”

 

Co-investment can count

Since inception the fund has also looked to invest up to 10 per cent of any of its four funds in co-investment opportunities.

In a study released this month, research firm Preqin finds the appetite for co-investment opportunities was strongest among investors with sizeable allocations to private equity, with 66 per cent of LPs with allocations of more than $250 million looking to pursue such opportunities.

“Co-investments are where we invest directly into companies, typically with one of our existing buyout-fund managers, and that has been something we have been doing very successfully since our first fund,” Vangstrup says.

Preqin’s study reveals that 61 per cent of LPs it interviewed would use allocations to co-invest from their existing private-equity-fund allocation, with about the same proportion doing so on an opportunistic basis.

More than half of investors listed better returns and lower fees as the reason for seeking out co-investment opportunities.

Co-investments form part of the $19.8-billion Australian superannuation fund SunSuper’s private equity strategy, which includes using the secondary market and going directly into funds.

SunSuper chief investment officer, David Hartley, says the lower fees are an attractive aspect of this form of investment.

“The J curve, which is often put forward as a feature of this type of asset class, you actually find it’s a lot less significant when you buy secondaries or go into co-investments. In a lot of cases you can do co-investments at zero fee,” he says.

The fund invests 7 per cent of its balanced fund into what it describes as private capital, which includes equity as well as debt opportunities.

Large managers such as Apollo Global Management have looked at various private-equity strategies being more attractive during different market cycles.

In a recent presentation to the Teachers Retirement System of Texas (TRS), Apollo co-founder Leon Black told trustees that distressed debt, rather than buyout opportunities, represented a compelling opportunity in this current market environment.

It is a view shared by Hartley, who has upped its allocation to private debt recently.

“We are heading to 15 to 30 per cent of the portfolio in debt and the rest is in equity-type investments. But if the situation continues where we think we can get better returns versus risk for debt, that will increase over time, but we don’t necessarily expect that this will always be the case,” Hartley says.

SunSuper has achieved a net internal rate of return of 10 per cent above the listed market alternative since the inception of its private equity program in 1995. It aims for 5 per cent above the MSCI World index.

Both SunSuper and ATP have diversified their private-equity holdings beyond their domestic markets.

Emerging markets now make up 10 per cent of ATP PEP’s fourth fund, while SunSuper has a 7 per cent allocation to Asia.

 

Private markets pay, too

Cambridge Associates Australian managing director Eugene Snyman says that private markets are an increasingly popular way for investors to play the growth story in emerging markets.

While public markets in emerging markets can be dominated by large companies in the finance, mining and energy sectors, private investment gives exposure to fast growing consumer-based and technology sectors, Snyman says.

“The return enhancement is what draws investments to private equity but it is that additional diversification that also draws them to the asset class,” he says.

“That is true for the Indian and Chinese market where a lot of our clients have been wanting to gain exposure to the growing middle class. But if you are just playing the public-market exposure to those markets, the cap-weight exposure you are going to get puts you into the largest companies that are ultimately selling to the US and European consumers.”

Ralph Jaeger, managing director at Siguler Guff’s Boston office, says that as investors have looked at their private-equity holdings since the global financial crisis, they have found that emerging markets have been one of the strongest portfolio performers.

“When it comes to the risk profile in emerging markets, there is a misconception. There is less – significantly less – volatility in emerging-market private equity than in emerging-market public markets,’ he says.

“Emerging-market private equity has also significantly outperformed emerging-market public markets since around 2003. What we also see is that it has been very resilient from a performance point of view in the global financial crisis [when] compared to emerging-market public equities.”

Cambridge Associates research shows that since 2006, emerging-market private equity and venture capital has an annual compounded premium of 1000 basis points.

Emerging-market private equity and venture capital is also consistently approximately half that of the MSCI EM index volatility, Cambridge finds.

 

In a harsh capital-raising climate, ATP Private Equity Partners and TRS have different startegies on how to drive hard bargains on private equity fees.

Institutional investors are gaining concessions on private equity management fees, with a near-record number of funds on the road seeking funds resulting in a shift in bargaining power to limited partners.

The head of Danish fund ATP’s private equity arm ATP Private Equity Partners (ATP PEP), Torben Vangstrup, says that it has seen management fees drop to as low as 1.5 per cent for bigger players and remain as high as 2.5 per cent for smaller venture capital managers.

“We are in a situation today where the private equity market is not as hot as it was a few years ago,” he says.

“So we do have more opportunities to impact the terms and conditions under which we are going into these partnerships. Having said that, it is about finding a fair balance between the general partners (GPs) and limited partners (LPs). In my mind what is important is that GPs are not going to get rich from management fees, but only from outperformance.”

ATP allocated 5.5 per cent of its overall portfolio to private equity, with ATP PEP managing €7.5 billion in four funds, which range from €1 billion to €1.5 billion in size.

Vangstrup says that ATP PEP aims for an optimal uniform allocation of $65 million to each of the underlying managers, with 10 per cent of the fund kept for co-investment opportunities.

 

Better access at lower cost in Texas

Along with driving a hard bargain, large institutional investors are concentrating their allocations to managers to achieve cost benefits and better access to quality managers.

The $107-billion Teacher Retirement System of Texas (TRS) has been a high-profile case of where providing steady capital to a manager has given them both better access at lower cost than the general market.

There allocation of $6 billion to two managers, Kohlberg, Kravis Roberts (KKR) and Apollo Global Management, was on terms considerably better than the market, according to TRS chief investment officer Britt Harris.

The announcement of these ‘strategic partnerships’ were followed closely by the New jersey Division of Investment, which manages New Jersey’s $66-billion-public-pension fund, saying in December it would provide $1.8 billion to Blackstone to invest in private equity and other investments.

While big investors such as TRS have been able to gain better terms and conditions by using top-performing managers, smaller players have also seen the benefits of consolidating managers.

One fund that has looked to increase the concentration of its managers is Australian fund, SunSuper.

The $19.8-billion-superannuation fund allocates around 7 per cent of its balanced fund to private equity, and currently has committed capital to 20 private-equity managers.

“Over time we have been getting more consolidation of managers, we have identified the managers we think are worthwhile continuing with and some we are not quite as enamoured by,” Hartley says.

“We think we get a better deal on fees, terms and access when we compensate managers.”

 

Fundraiser jam

The better terms and conditions come amid a backdrop of record numbers of funds on the road trying to raise capital in many markets.

Alternative asset-research firm Preqin says that in February this year there was a ‘log jam’ of funds seeking capital, with more than 1800 private equity fundraising vehicles in the market.

This amounts to effectively three years of stock in the market, seeking an aggregate of $777.5 billion in investor capital.

The tough fundraising market has seen investors bear down on the traditional 2-per-cent management fee and the structure of the ‘carry’ part of the fee structure, which sees the general partner take 20 per cent of returns generated.

Steven Kaplan, professor of entrepreneurship and finance at the University of Chicago’s Booth School of Business, says the bargaining power has shifted to investors, with the management-fee component of private equity arrangements coming under particular scrutiny.

“There is definitely pressure from limited partners on management fees but less pressure on the carried interest where there is alignment, but there is definitely pressure on management fees,” Kaplan says.

“That is likely to continue for the next couple of years because of the huge amount of fundraising in 2006 and 2007. Those funds are coming back to market and there is less money now than there was then. While there is excess demand from the GPs for private equity, the LPs have some bargaining power.”

In addition to a focusing on fees, most managers are now required to make a hurdle rate, typically set at 8 to 10 per cent, Vangstrup says.

However, according to Preqin, management fees still remain a bone of contention for investors, with a survey of last year showing half of investors saying it was an area where alignment of interests could be improved.

In a study of fees that analysed 2400 funds over the past 20 years, Preqin showed that the mean-management fee for larger funds had only fallen marginally to 1.71 per cent, despite the recent fundraising conditions.

Cambridge Associates’ chairman and chief executive officer Sandy Urie says that managers with strong track records are still in high demand and don’t need to discount.

She notes that Cambridge predicted fees would come down after the 2008 financial crisis, but was surprised at how resilient management fees have been overall.

“For the good providers, there is a long line of capital [to which they] would love to have access,” Urie says.

It is a view shared by Cambridge managing director for Australia, Eugene Snyman, who warned that investors must think carefully about managers who are discounting to raise capital.

“Where we have seen some changes on the edges are that managers that have really struggled in a tough fundraising environment and have had to present themselves in a different way,’ Snyman says.

“But this asset class is all about manager selection and you don’t want the median of the asset class. So for managers who are struggling to raise capital and are looking to get more attractive from the fee point of view, due diligence has to be very solid to buy at the end of the day.”

A study comparing the performance of equal-, value-, and price-weighted portfolios of stocks in the major US equity indices over the last four decades has won a prestigious award.

Raman Uppal, Member of EDHEC-Risk Institute and Professor of Finance at EDHEC Business School, along with co-authors Grigory Vilkov and Yuliya Plyakha, both of Goethe University in Frankfurt, has been awarded first prize at the SPIVA Awards for the paper “Why Does an Equal-Weighted Portfolio Outperform Value- and Price-Weighted Portfolios?”

The paper finds that the equal-weighted portfolio with monthly rebalancing outperforms the value- and price-weighted portfolios in terms of total mean return, four factor alpha, Sharpe ratio, and certainty-equivalent return, even though the equal-weighted portfolio has greater portfolio risk.

To read the paper click here

 

Public pension funds make up almost a quarter of the world’s 100 largest institutional investors in infrastructure and, while still favouring unlisted funds, they are increasingly investing directly and pushing back on management fees, research reveals.

The research by global alternatives research firm, Preqin, shows a record number of funds on the road seeking a record amount of capital, giving large institutional investors bargaining power to negotiate on fees and conditions.

Pension funds and other large investors are pushing hard on the typical 2 per cent management fee, according to Preqin researcher and author of the report Iain Jones.

In March 2012 there were 150 funds on the road raising money, seeking more than more than $95 billion in capital.

 

Partners push for low fees

However, last year the total number of funds that raised capital and the aggregate capital raised are still short of the peaks of 2007 and 2008.

“Terms and fees is certainly an area that both general partners (GPs) and limited partners (LPs) are looking at, with particular push back over the 2 per cent management fees that became industry standard under the fund model, 2/20, inherited from private equity,” Jones says.

“Essentially this 2/20 fee structure could be justified by private equity fund managers due to the returns that they could expect to make. This however is not the case with infrastructure, where the underlying assets tend to be further down the risk/return spectrum.”

Jones says that investors are looking for GPs to structure funds that take advantage of the traditional characteristics of the asset class, such as inflation hedging and steady cash flows, rather than employ financial engineering, such as leverage, to obtain higher internal rates of return.

Previous information on management fees for 2010/2011-vintage funds and those funds currently fund raising shows that LPs are enjoying some success at negotiating favourable terms.

Half of these funds now charge less than a 2 per cent management fee and just 3 per cent are charging more than that.

The reduction in fees is most marked in so-called big-ticket fund commitments.

Citing the recent CalSTRS and Industry Funds Management mandate as an example, Jones says CalSTRS received concessions and in return invested $500 million with the manager.

According to Jones, GPs are also evolving the way they construct management fees, and are competing for mandates by offering staggered fees for large investors.

Changing the fund structure to better match liabilities for key parts of the investor base is another way that funds can gain an advantage over their competitors, Jones says.

The most recent Preqin study, The Top 100 Infrastructure Investors, shows these large investors are also preferring to invest in infrastructure assets in developed market economies, with energy, transportation and utilities, and waste management the most popular industries.

 

Direct investment on the rise

Pension funds made up 23 of the biggest 100 investors measured by their committed capital. This group of 100 investors have an aggregate of $204 billion committed to the asset class to date through a combination of unlisted and listed funds, and direct investments.

Despite slow growth, Europe and US markets are the most popular destination for infrastructure investment, with Asia proving the most attractive emerging market.

While Jones notes that many larger investors are increasingly looking to invest directly in infrastructure and thereby avoiding the higher fees of funds, the survey showed that unlisted funds still remain the primary route to market.

“As the asset class matures it is likely that a growing number of larger institutions will have the in-house capability to handle direct investments and bypass fund managers, meaning GPs must evolve and adapt in order to secure commitments from the largest investors in infrastructure,” Jones writes.

“However, for the vast majority of smaller LPs, third-party fund managers will remain the only feasible route to the infrastructure market.”

Of these 100 investors, 89 said they gained exposure to infrastructure through unlisted funds. This compared to 64 per cent who say they access the asset class through direct investment.

Jones also broke up the group into three categories, determined by how much they invested in infrastructure.

The top third had the strongest preference for direct investment, with 94 per cent saying they used direct investment compared with 71 per cent and 27 per cent for other investors.

In previous reports Preqin has put the total number of infrastructure investors at 1352 globally and says the mean current allocation to the asset class is 4 per cent.

In its 2011 Infrastructure Fundraising and Deals report released in January, Preqin found that funds are typically looking to increase their allocations, with a mean target allocation of 5.3 per cent.

When it looked at the 100 largest infrastructure investors it found that investors had mean capital commitment of $92.4 billion.

Infrastructure used to be typically categorised in the alternatives or real estate bucket, but Preqin found that almost three-quarters of these large investors now operate a separate infrastructure allocation.

One investor who has looked to build a specific infrastructure allocation in recent years is large US public pension fund CalSTRS. In 2008 the fund decided to target an allocation to infrastructure of 2.5 per cent of the total portfolio.

It has since set up a small internal team that has invested with managers in order to leverage off their specialist knowledge to build the fund’s internal capacity, with a view to eventually investing directly.

Its biggest allocation is to Industry Funds Management’s open-ended fund, which manages $10 billion in infrastructure investments.

 

As debate rages in the US about the generous retirement benefits and high cost of state and local defined benefit (DB) schemes, new research sheds light on the role these funds play in stimulating the economy and creating jobs.

Pensionomics 2012: Measuring the Economic Impact of DB Pension Expenditures looks at the effect of DB schemes and in particular retiree spending of benefits in each state of America.

The report reveals that payments made out of DB schemes collectively supported 6.5 million jobs and produced $1 trillion in total economic output nationally.

Commissioned by the US not-for-profit National Institute on Retirement Security (NIRS), the study aims to measure what it describes as ‘the ripple effect’ in the economy of pensioners spending their benefits in local communities.

For the first time, the study includes information from private sector and federal DB plans.

In separate research utilising the same US census statistics, it is also shown that the proportion of government spending on public pensions has fallen in the last 30 years.

Defined benefit funds are particularly sensitive to accusations that they pay generous retirement benefits to public servants and are a drain on public resources.

Author of the NIRS report, economist Ilana Boivie, shows that for a period from 1993 to 2009 the majority of contributions to DB pension schemes came from investment earning.

Despite two major market downturns, investment earnings contributed 58.85 per cent of aggregate state and local pension contributions, with employers contributing a further 27.15 per cent and employees the remaining 14 per cent.

“Conversations are always focused around state budgets and funding priorities, and it is important to remember that it is not the only story,” Boivie says.

“Every dollar going into pensions is certainly a dollar that could go elsewhere and needs to get looked at, but it is important to note that retirees are contributing back to the economy. Every dollar that goes into these plans is going to multiply over time and investments will finance much of the benefit. But once the benefits are paid out to retirees, it is going to come back to the economy both in terms of the economic effect of the spending and the tax impacts.”

In separate research the National Association of State Retirement Administrators, a non-profit association whose members are the directors of the nation’s state, territorial and public retirement systems, has found that state and local governments spend on average 3 per cent of their annual budgets funding their employees’ retirement schemes.

This funding has fallen from a high of more than 4 per cent in the early 1980s, according to the State and Local Governments Spending on Public Employess Retirement Systems report.

The states with the biggest proportion of their budgets going towards public employee retirement benefits were Alaska (6.35 per cent), California (5.98 per cent) and Nevada (5.39 per cent).

The report notes that in these states more than half of public employee payrolls are estimated to be outside social security.

Investment returns have been a particularly thorny issue for DB pension funds, with even minor adjustments to expected-return objectives used to calculate future liabilities that potentially cost state budgets hundreds of millions of dollars.

 

State-by-state breakdown of the proportion of state budgets allocated to public pension schemes.

[Click to enlarge.]

SOURCE: Table 1 from NASRA ISSUE BRIEF, February 2012. Accessed March 2012.

 

Keep the home funds burning

 

CalPERS is one of several pension funds to recently announce that they would cut their return objective from 7.75 per cent to 7.5 per cent.

These changes are predicted to cost the Californian budget – already $9.2 billion in deficit – $165 million per year.

The CalPERS board have also resisted calls from state politicians for the country’s biggest pension fund to invest more in its home state, arguing that it concentrates risk for the $237-billion fund.

The fund seized on the report’s findings, which also analysed the economic effect of DB schemes in all US states.

According to the NIRS study, DB pensions supported more than 300,000 jobs and $52.5 billion in total economic output in California.

California Governor Jerry Brown has proposed sweeping changes to the state’s public pension system, including introducing a hybrid defined benefit/defined contribution scheme for all new hires.

CalPERS chief executive Anne Stausboll says that secure retirement payments were a vital part of the state’s economy. “According to the report, the positive impacts are ‘quantifiable’ not only in real dollar purchases and jobs that benefit the service, retail and health industries, but they also benefit the quality of life that our seniors experience after retirement,” Stausboll says.

Boivie’s research shows that state and local employees in 2009 received benefits of $23,407 a year compared to private sector employees on DB schemes at $20,298.

A recent retiree on a corporate defined contribution plan typically has an average balance of between $50,000 and $60,000, Boivie says.

It is the certainty of these payments that leads to the most sustained economic benefit, resulting in stable consumer spending in local economies, which flows through to a wide range of industries, Boivie argues.

 

A State by State breakdown of the economic stimulus DB schemes provide to their local economies

[Click to enlarge.]

SOURCE: Figure 4 from Pensionomics 2012. National Institute on Retirement Security. Accessed March 2012.

 

The analysis finds that in 2009 (the most recently available statistics) $426.2 billion in gross public and private pension benefits were paid out.

Of this amount, public pension funds contributed $187 billion. Using US census data and input-output modelling software IMPLAN, Boivie estimates that every dollar paid to retirees with DB pension schemes generates $2.37 in total output nationally.

The research also reveals that in 2009 $50.8 billion of these payments were funded from taxpayer dollars.

Using the same modelling techniques, Boivie estimates that of every dollar of taxpayer money invested in public pensions over the last 30 years, $8.72 of total output was created.

Governments have also gained a tax benefit from DB schemes, researchers find. State and local DB schemes, either directly through beneficiaries paying taxes on benefits or through tax revenue resulting from retiree expenditure, contributed $26.2 billion to state and local tax revenue in 2009.

These same schemes also contributed $32.6 billion to federal tax revenue.

The report’s methodology has been refined in recent years, as the IMPLAN software has become more sophisticated.

One such change to the input-output model has allowed researchers to better estimate where spending goes by matching it to the different spending patterns that occur as household incomes rise. The NIRS will also look to break down the benefits at a state level on a per capita basis.

However, Boivie acknowledges that the economic impact of DB schemes goes beyond just the benefits paid to retirees: there is currently insufficient data and overwhelming complexity in trying to measure what the overall effect of DB investments are on the US economy, she says.