Questions Surrounding Pension Policy in 2023

As taxpayers digest their quarterly 401k statements along with the stiff beverage needed to make the results go down easier, they may be wondering how well the state’s pension funds are weathering the current environment.   Valuation reports won’t be out for another month or two, but investment markets, governance issues, and economic conditions promise a busy 2023 for the Legislative Commission on Pensions and Retirement.   We take a look at some of the topics.

Private Equity Returns: Are Those Numbers for Real?

The Minnesota State Board of Investment has reported a net -6.4% return for the fiscal year ended June 30.  It’s a far cry from the assumed 7.5% return on which pension policy is based but a seemingly admirable accomplishment in light of what has happened in the equity and fixed income markets in the past fiscal year.  The accompanying table breaks down the total return by asset class and shows most of the SBI’s portfolio was not immune to the impact of rising interest rates and the bear market which officially arrived in mid-June.   Nothing was spared; all traditional equity and fixed income asset classes were down substantially.   However, in stark contrast, the returns of alternative investments – funds and assets that are not publicly traded consisting mostly of private equity -- were nothing short of spectacular.

FY 22 SBI Combined Funds Asset Class Performance Summary 

Source: MN State Board of Investment Quarterly Performance Report and Alternative Asset Holdings Report as of 6/30/22.

We have previously written about the rationale and appeal of investments in private equity for public pension funds, how increasingly important this asset class has been to meeting SBI’s return objectives, and the headwinds it may face in the future.  But the magnitude of the difference in returns between alternatives and publicly traded assets is both striking and perhaps puzzling.  Some discrepancy can be expected since one of primary benefits of investing in private equity is the resistance to “short-termism” and embrace of patient capital that avoids the endemic volatility of publicly traded companies.   Yet new ventures and restructured/reorganized businesses comprising private equity portfolios are still exposed to the same general economic conditions all businesses face.

Most of the explanation appears to be a timing issue.¹   Unlike publicly traded investments whose values can be ascertained every day, private equity valuations are done quarterly.  Given the time needed to assemble these valuations, private equity reporting is provided on a lagged basis – often 3 to 6 months --which can distort SBI end of fiscal year performance reporting.   Most of the damage to the investment market was done in the last quarter of the state fiscal year (April-June) which the state’s alternative returns have not captured. 

How big a correction remains to be seen.  Pension & Investments reports “investors are in for a rude awakening on alternative investment returns” when actual June data is reported.  A managing partner with Maketa Investment Group (whom the SBI also uses as a consultant) recently told another state investment committee to expect write downs in the next three or four quarters to reflect what has happened in the public markets, because “they are not immune to what happens in the general economy or to the capital markets at large, and that has not yet been reflected in the portfolio.

The relevant issue for pension policy is that the SBI’s fiscal year reported returns, used as the basis of pension fund valuations and determining contribution requirements, will have not factored in future asset write downs in nearly 20% of the state’s investment portfolio.  The state’s actuarial practice of asset smoothing -- factoring in annual investment gains or losses over a five-year period -- will mitigate the immediate reporting impact on fund valuations when they are realized, but they will still exist.

It would be worthwhile for the SBI to preview what might be expected over the next 6 months and what consideration any of this should be given in next year’s pension policy decision-making.   For that matter a pension commission hearing to hear from officials and other experts on the continued reliability of these historically outsized returns, their growing relevance to reported pension health, and possible transparency improvements would be welcome.  Fifteen years ago, alternatives comprised just 10% of the SBI asset mix; today the targeted allocation is 25% of the SBI portfolio.   Minnesota and other states are placing billions of dollars into this extremely opaque, exceedingly complex, and decidedly untransparent area of investment with potentially profound public finance implications.

How’s Liquidity Looking?

Even though private equity and other pension plan assets are invested with a long-term perspective, enough liquid and near liquid assets must always be available to pay state employee pension benefits now totaling $5.4 billion a year and growing.  A reader in the banking industry brought to our attention the fact that times like these may also be impacting sources of plan liquidity.  Many shorter duration securities commonly held for such purposes have experienced unprecedented changes in pricing and are significantly underwater.  The relevant issue for pension plans is whether and to what extent the impact on liquidity demands is disrupting the funding needed to obtain long term expected returns. 

This issue can be exacerbated by the fact that one of the underappreciated characteristics of mature defined benefit plans like Minnesota’s, is the existence of negative plan cash flows -- i.e.  benefit payments and expenses exceeding contributions and aids going into the plans.  Investment returns are only as good as the money made available to invest.  Collectively, $2.61 billion more went out of state pension plans than went into them in FY21, and that figure also continues to grow.

Does the ESG Debate Have Any Real Bearing on Pension Management?

Seldom does pension investment policy make the news let alone become a topic in a state office race.   But such a two-fer is taking place right now in the debate surrounding “ESG investing” which stands for Environment, Social and Governance.  It’s a movement to consider environmental protection, social justice and equity issues in investment decision-making all based on the reasoning that better investment risk management and investment opportunity are both served by identifying companies understanding and acting on these issues.   As MinnPost observed, in the State Auditor race it is a topic injecting some liveliness into an election battle usually bereft of interesting topics to talk about.

ESG’s relevance to state pension policy revolves around the marketing of it, the substance of it, and how those two get intertwined in politics.  With respect to marketing, those who may casually dismiss this as nothing more than an ethereal, fringe concept being pushed by the left haven’t been paying attention to what has been going on in the investment industry.  According to Morningstar, ESG fund investing is the fastest growing segment in the asset management industry growing 53% year on year to $2.7 trillion worldwide at the end of 2021, while Bloomberg Intelligence reports expectations of an astonishing $50 trillion of ESG assets under management worldwide by 2025.   Nearly every investment industry powerhouse around the world now has sustainability vice presidents or chief investment officers employing swat teams of freshly-minted MBAs and exploding numbers of sustainability consultancies and rating agencies, all eager to sell analytical methodologies and services to dig into the operating policies, practices, and data of companies and their supply chains. 

Why this topic is giving off a Dutch tulip bulb vibe is another question. To some extent, the answer lies in high school economics: where there is an increase in demand there will be a supply response, especially when the demand is created and legitimized by the supply side.  For example, in 2019 CEOs of the U.S. Business Roundtable, representing 200 of the biggest corporate heavyweights in the world, advocated for embracing sustainability practices to advance the interests of employees, communities, and the environment as well as shareholders.  CEOs in the banking and investment industry were quick to echo and market the idea that being a responsible corporate citizen can yield better shareholder returns.   Private equity ESG funds have now entered the arena arguing patient capital is the best capital for realizing this marriage of doing good with doing better (and ownership control doesn’t hurt either).  As a result, one industry that has clearly demonstrated the return potential from ESG thinking is the investment industry itself.  According to a Wall Street Journal report, ESG ETF funds average 43% higher fees than standard ETF products. 

The substance of ESG is a lot more complicated as recent research is bearing out:

• Researchers in a paper published in the Journal of Finance analyzed the Morningstar sustainability ratings of more than 20,000 mutual funds.  Although the highest rated funds in terms of sustainability attracted more capital than the lowest rated funds, none of the high sustainability funds outperformed any of the lowest rated funds.
• Researchers at Columbia University and the London School of Economics compared the ESG record of U.S. companies in 147 ESG portfolios and that of U.S. companies in 2,428 non-ESG portfolios.  They found that companies in the ESG portfolios had worse compliance records for both labor and environmental rules.
• A European Corporate Governance Institute paper compared the ESG scores of companies invested in by 684 institutional investors that signed the United Nation’s Principles of Responsible Investment and 6,481 institutional investors that did not sign the principles.  The financial returns were lower and the risk higher for signatories.   

Despite the considerable attention devoted to this topic, no universal, objective, rigorous framework for ESG Investing exists.  Researchers at MIT and the University of Zurich examined data from six prominent ESG rating agencies and found the correlations between their assessments fall between .38 and .71 compared to a .92 correlation between credit rating agencies.  They concluded such results “make it difficult to evaluate ESG performance of companies, funds and portfolios.” 

The most interesting argument questioning the wisdom of ESG investing is laid out by an ultimate insider.  In “The Secret Diary of a Sustainable Investor,” Tariq Fancy -- former Chief Investment Officer of Sustainable Investing for BlackRock, the world’s largest investment firm -- describes how his thinking evolved from being an evangelizing supporter of ESG and its goals to decrying it as “a dangerous placebo that harms the public interest.”  He discusses the many conceptual and practical conflicts, challenges, and trade-offs inherent to ESG in fulfilling fiduciary responsibilities and the problems with “good sportsmanship leads to more three-pointers” thinking.  But he also argues that ESG is a feel-good distraction from tough discussions and decisions that need to be made regarding regulations and rules under which capitalism operates.  

So how should the State Board of Investment handle the sensitive politics and practice of ESG which progressives tend to laud and conservatives tend to criticize if not ridicule?  (An example of the latter was featured in the previously referenced MinnPost article in which a legislator observed, “What we don’t want to do is use that as a baseline to let some woke shitheads take all our pension funds and put them into solar roadways or some other boondoggle projects.”)  From our review of SBI’s 2021 ESG Stewardship Report, the answer to that question is pretty much exactly what they are doing right now.

SBI divides their ESG work into two parts: stewardship and incorporation.   Stewardship largely consists of membership in and engagement with the numerous associations, agencies, coalitions, and research institutions which have blossomed around this concept and participating in proxy voting on ESG proposals before companies.  It has also hired a consultant to work with the SBI specifically on the high-profile climate change issue.   This satisfies lawmaker and public interest in seeing state engagement and activity on this topic, and to the extent some useful ideas or information might be gleaned from this involvement, all the better.  

With respect to integration – where investment rubber meets the road – the SBI appears to be taking a more careful approach surveying public and private market managers on their ESG practices (what they do with the responses isn’t exactly clear) and engaging in some quite limited screening as dictated by legislation or Board resolution.   Most importantly, the SBI appears to be coming at the integration issue from a perspective of better portfolio risk management in response to a changing technological and regulatory environment.  That’s an approach to investment due diligence which even solar roadway skeptics should appreciate.

How Will the Proposed 2022 Benefit and Funding Provisions Fare in 2023?

The Omnibus Pension bill passed last year consisted of mostly administrative, non-controversial elements.  However, a “second” omnibus-type bill, made it relatively close to the finish line in each body but died with the session.   This second bill contained the benefit and funding provisions that capture the interest of beneficiaries and should capture the interest of taxpayers.   A look at some of the elements and how their discussion might play out in 2023:

• Increase the Post-Retirement Cost of Living Adjustment (COLA) -- This was a big push by the plan beneficiaries last year, and in light of the inflation rates we have experienced, one can wager it will be a full court press in 2023.  Last year’s proposal essentially sought to bring all plans up to a 1.5% annual COLA increase.  The issue is likely an especially sensitive one for public safety retirees whose pensions are not coordinated with (i.e. do not receive) Social Security and its 8% annual benefit increase that has just been announced.  The challenge is that larger COLA adjustments can get expensive in a hurry because of their compounding features.   Since the state has developed a skill set for cutting targeted checks out of surpluses, we wouldn’t be particularly surprised to see a proposal for some kind of one size fits all “13th check” to retirees to provide some additional compensation for recent inflation.   What we absolutely should not do is reprise the 80’s when high rates of inflation resulted in retirees receiving the “excess returns” above the assumed rate of return triggering double digit compounding base benefit increases for several years.
• Lower the assumed investment rate of return from 7.5% to 7.0% -- This effort really should be renamed the “lower the required discount rate from 7.5% to 7.0%” since the primary economic relevance of this assumption lies in its faulty use as a discount rate for determining the present value of future liabilities (which calls into question the dependability of the valuations themselves.)  What the SBI actually returns or expects to return on its investments is irrelevant to the proper valuation of pension liabilities.  Ironically, the recent rise of interest rates does a better job of serving that purpose than this proposal would.  Be that as it may, an assumed rate of return is still needed to develop appropriate contribution policies, and there is consensus supported by the actuaries that a 50 base point cut needs to be done.
• Lower employee contribution rates – The proposal included a provision for employees in most all of the plans to see a reduction in employee contribution rates ranging from 3.3% to 32% as a percentage of pay.  Many times over the years, the term “shared sacrifice” had to be invoked in which retirees, current employees and government employers would all take a hit in pension repairs.   In light of the state surplus and a whopping 30% return on investments in FY21 which propelled several of the funds to near fully funded status and generated “contribution sufficiencies” on a current market value basis, these contribution cuts qualify as a “shared benefit.” 

Upcoming valuation reports, market conditions, and the economic forecast will have much to say about how much of this agenda stays intact.  As of this writing the S&P 500 is down an additional 5% from fiscal year end.    More disconcerting is that the US Bureau of Labor Statistics reports that productivity suffered its weakest first half performance since the agency began recording data 75 years ago.   Core personal consumption inflation is still well over the Fed’s target suggesting more rate hikes to come (with likely implications for the assumptions used in plan valuations).   In short, the same words of caution MMB expresses with every economic forecast given the volatile conditions we are facing should apply no less to decision-making in the “off-budget” world of state pension policy.

FOOTNOTE

¹ It is worth noting there are academic and investment professional contrarians who question how real private equity’s consistently reported outperformance compared to public markets actually is.  For example, see “Cliff Asness Questions Whether Investors in Private Equity Are Being Rewarded — or Penalized — for Taking Illiquidity Risk” Institutional Investor, June 2, 2022; and “An Inconvenient Fact: Private Equity Returns and the Billionaire Factory” Ludovic Phalippou, Said Business School, Oxford University, Journal of Investing, December 2020