Underfunded Pensions and Underfunded Infrastructure: A Match Made in Heaven?

Direct public pension fund investment in public infrastructure is gaining traction but requires a fundamental rethinking of how we conceptualize and manage public assets.

Drive east on the I-90 Indiana Tollway and you are not just escaping the road construction insanity of Chicago and the distinctive aroma of Gary.  You are also paying for a California state public employee’s retirement benefits.  If you instead head west on that section of I-90 known as the Chicago Skyway to watch the now juggernaut Cubs, something no less strange is happening: a retired Toronto teacher is benefitting from your visit.

The 2016 legislative session affirmed two truths about public finance: 1) the demand for infrastructure capital far exceeds its supply; and 2) public pension plans need high and reliable returns.  These truths are certainly not unique to Minnesota, or for that matter to the United States.  But some countries and subnational governments are attempting to turn these fiscal lemons into lemonade by having public pension funds more actively invest in public infrastructure.  Connecting these dots, many argue, creates a true win-win.  From the standpoint of pension fund management, infrastructure investment offers the potential to yield predictable and stable cash flows that are far better matched with the duration of the funds’ long-dated liabilities.  From the standpoint of public infrastructure, pension assets offer a large source of supplemental capital and can play a major role in bridging governments’ infrastructure funding gap.

Roots in an Old Idea: ETI

The idea of using pension assets to support objectives besides paying retirees is not something that has just popped into policymakers’ heads.  The hundreds of billions of pension assets under management nationwide have long been seen as a very enticing source of capital for any number of government policy initiatives.  In the mid-nineties considerable effort and a large body of literature began to be developed around the idea of “economically targeted investments” or ETIs.  ETIs are organized to yield market rates of return commensurate with risk, liquidity and transactional costs and are therefore often considered a subset of the “socially responsible investment” universe.  A 2008 study found that U.S. public pension funds had invested $11 billion in ETIs.1

The most common ETI investment vehicles include housing finance agency bonds, real estate investments including mortgage backed securities, guaranteed SBA loans, private placements, and targeted venture capital.  By all indications, to the extent they exist at all, ETIs remain a very small part of any public pension fund’s asset allocation strategy – typically ranging around 2-3%.

But some have taken the concept of “investing in yourself” to completely different levels.  The prime example is Retirement Systems of Alabama (RSA) which, according to one third-party analysis, invests 16% of its pension assets in the state and local economy.  Its investments include a dizzying array of Alabama real estate holdings including premium office buildings, golf course properties, and hotels.  Through its controlling interest in Raycom, a media empire comprised of 62 television stations and 130 local newspapers, RSA will offer free advertising for this real estate portfolio.  The RSA org chart looks more like a Fortune 500 company than a sleepy state investment board.

State experiences with ETIs appear decidedly mixed, likely a function of the degree to which governments have access to the specialized management and analytical demands associated with this area of the investment universe.  While some states report very positive results with respect to meeting investment performance benchmarks while also achieving desirable economic development/social outcomes, others have backed away from the idea and have repealed statutory in-state investment requirements.  It is not difficult to find high profile venture capital failures and examples of companies declaring bankruptcy after receiving an infusion of pension-based capital, leading ETI critics like the CATO Institute to caustically comment “pension funds can ill afford philanthropy.”

Eliminating the Middleman

If the general buzz surrounding ETI has diminished a bit, the same cannot be said for a very specific subset of this universe: public infrastructure.  To be sure, meeting growing global energy, clean water, communication, and transportation needs has been a compelling investment theme for a very long time.  It would be impossible to find a public pension fund that does not have large equity and debt holdings in manufacturing and service companies supporting public infrastructure maintenance and build out.  But these generic positions are often augmented by targeted private equity positions addressing this specific investment theme.  To provide an example of how this applies to Minnesota, Energy Capital Partners is a private equity firm which focuses specifically on North America’s energy infrastructure including power generation, midstream oil and gas, electric transmission, environmental infrastructure, and energy services.  According to the Minnesota State Board of Investment’s most recent annual report, its Energy Capital Partners holdings are currently worth $100 million, and the SBI has committed to an additional $230 million of investment with the firm in the future.

But what has now captured the attention of both the government and investment press is pension funds’ growing involvement in the direct financing and management of infrastructure projects.  In recent years, a handful of national governments, such as Australia, the U.K, and Switzerland, have led the way in developing this model.  But perhaps the longest and most successful history of public pension fund involvement in infrastructure investment and management lies in Canada.  In 1999, the Ontario Municipal Employees Retirement System (OMERS) established Borealis Infrastructure, an in-house arm devoted exclusively to direct investments in and management of public infrastructure.  Compared to traditional private equity strategies, the “direct investment” model improves the economics by avoiding the “2 and 20” fee structure private equity firms commonly use (a 2% annual management fee on capital deployed plus 20% of profits).  Beginning with four employees, Borealis has now expanded to over 85 employees with offices and projects around the globe.

Traditionally, investments have focused on upgrades, expansions, and improvements of existing infrastructure because of their more favorable risk profile.  However, Canada’s success has now emboldened a closer look at brand new “greenfield” infrastructure projects.  For example, in April Quebec’s public pension fund announced plans to build a fully automated 67 kilometer electric light rail train network in Montreal with the first stations coming on line in 2020.  As the Montreal Gazette reported, “It will be the biggest transit project since the Montreal metro, but this one will be built and mostly funded by a pension fund.”

Even in the United States, where public pensions’ finance of infrastructure is far more embryonic, the “direct investment” concept is getting attention.  Recently, the California Public Employee Retirement System (CalPERS) announced a $1 billion deal with an Australian pension fund to invest in Asian-Pacific infrastructure – a strategic departure from its historical practice of accessing these investment opportunities through private equity.  One of CalPERS’ objectives in this arrangement is to tap into the expertise and experience of those pension funds that have traveled the learning curve and begin to assemble their own internal capacity for becoming “investor managers” of public infrastructure.

Implementation Challenges as Great as the Need

Although this activity is spread across the globe, the roots are the same:  cash-strapped governments, essential infrastructure in need of attention, high debt service payments with overcommitted bonding capacity, and a strong reluctance to raise taxes.  But infrastructure’s attraction as an investment class has also increased in the eyes of pension investment managers because of the ultra low interest rate environment which many financial experts believe is now the “new normal.”  The persistence of this environment has been the absolute bane of pension funds and their efforts to achieve their investment return objectives.  In the eyes of many, long duration infrastructure assets are a substitute for bonds, offering a relatively safe yield between bond and equity returns, and are also are well-matched with the long duration nature of pension liabilities.

Given all this, why aren’t more public pension funds pursuing this strategy?  A 2011 global survey of institutional investors by the OECD2 on pension fund infrastructure investing highlighted several major barriers affecting infrastructure investment opportunities, capabilities, and conditions.  They include:

  • Risk Perception – illiquidity, regulatory, and political.  If investments include international infrastructure, currency risk exists as well;
  • Scale problems – opportunities may be too small for large institutional investors;
  • Due diligence demands  – it is often difficult and very costly to identify, evaluate, and bid on potentially viable investment opportunities;
  • Lack of transparency in the infrastructure sector including a shortage of data on investment performance benchmarking.

But two obstacles in particular stand out.  The first is access to talent, which has both a substantive and a structural dimension.  Global success stories demonstrate that it is absolutely vital to have access to deep operational experience in evaluating, setting up, and/or operating an infrastructure project.  The pension funds that have had success in this asset class have also invested heavily in bringing that talent on-board or have gained access to that talent through strategic partnerships.  Such success requires expertise beyond traditional pension investment manager/dealmaker skill sets.

The structural dimension of the talent issue revolves around conflict with pension governance and pay models employed here in the United States.  As one Canadian analyst has noted, “in the United States, you don't have the right pension governance, which means you can't attract and retain qualified pension fund managers to bring assets internally to invest directly across public and private markets, as well as engage in internal absolute return strategies instead of farming them out and getting clobbered on fees.3  Or as The Economist put it in infinitely less delicate terms, “they (Canadian pension plans) attract people with backgrounds in business and finance to sit on their boards, unlike American public pension funds, which are stuffed with politicians, cronies and union hacks."4

Of course in order to recruit the best talent and executives, Canadian pension funds offer far more competitive pay than U.S. public pension funds do. This typically includes a base salary, bonus, and long-term performance awards which together routinely can total seven figures annually.  Public sector compensation of this nature would be a complete anathema to Minnesota taxpayers, but with billions of dollars and the retirement future of hundreds of thousands of individuals at stake, Canadian provinces do not believe in being pennywise and pound foolish.  (It’s worth noting most of this compensation package is based on performance, unlike certain multi-million dollar public sector salaries in Dinkytown.)

The Larger Framework: Reinventing State Asset Management

The second obstacle, and the greatest of all, is the sea change attitude required regarding the conceptualization and treatment of “public assets” in Minnesota.  Direct infrastructure investment by pension plans is really only part of a much larger policy framework that has been described as “asset recycling” – managing legacy public assets in ways that generate capital to invest in new assets or refurbish existing infrastructure.  A recent report from the University of Toronto describing the various policy dimensions of this idea noted, “traditional 20th century debates between public ownership and privatization are increasingly irrelevant to the real choices facing government… Too often the public debate devolves into a choice between public ownership or privatization when in fact the range of tools and approaches is far more sophisticated and diverse."5

This way of thinking is not completely foreign to Minnesota.  Two years ago, a provocative article appeared in MinnPost with the title, “What If We Made Transportation Systems Regulated Public Utilities?” – essentially a textbook description of various principles and concepts associated with asset recycling.  That article was based on an interview with Professor David Levinson of the University of Minnesota who himself authored a feature for The Atlantic magazine’s “Citylab” website with the no less provocative title, “How to Make Mass Transit Financially Sustainable Once and For All.”  Both articles present an intriguing vision and argument for how adequate and sustainable investments in necessary infrastructure could be realized.  But moving down such a path requires a radical departure from the entrenched governance models and mindsets that have calcified public debate on this topic.

Based on the results of the 2016 session, as bad as our infrastructure challenge may be, it’s still not bad enough to discuss “outside the box” ideas, the risks that accompany them, and how to mitigate them.  A strong case can be made that this issue is tailor-made for the convening of a blue ribbon commission that would kick the tires on the options and opportunities associated with new approaches to public asset management and investment and do so in a robust but politically safe way.  Until the challenge gets bad enough, get used to bumpy roads, grumpy politicians, transit food fights, deteriorating parks, and political paralysis.


Footnotes
  • 1 Hagerman, Clark and  Hebb, “Investment Intermediaries in Economic Development:  Linking Public Pension Funds to Urban Revitalization,” Federal Reserve Bank of San Francisco, 2008.
  • 2 Pension Funds Investment in Infrastructure: A Survey, Organization for Economic Cooperation and Development, September 2011
  • 3 “Fixing The U.S. Public Pension Crisis?”  Pension Pulse, May 2, 2016
  • 4 “Maple Revolutionaries”  The Economist, March 3, 2012
  • 5 Recycling Ontario’s Assets: A New Framework for Managing Public Finances, Mowat Centre, University of Toronto, April 2014