Private Equity Panacea?

Martin Z. Braun of Bloomberg reports, States Miss Pension Targets by 50% Even With Private Equity (HT: Donald):

In the last decade, as a wave of baby boomers began retiring, America's biggest state pension systems earned less than half what they needed to keep up with promises made to millions of graying civil servants.

The state of Washington's 3.92 percent return for the 10 years through June 30, 2010, after fees, was the best in a Bloomberg survey of state pensions with more than $20 billion in assets. That was nowhere close to the average yearly gains of as much as 8 percent that fund managers and public officials count on for meeting obligations to retirees.

“To assume that the median plan will reach 8 percent given this environment, that's optimistic to say the least,” said Karl Mergenthaler, an executive director in JPMorgan Chase & Co. (JPM)'s securities services group in New York. “Public plans have an incentive to maintain their expected rate where it is. The risk is that they'll overreach for returns.”

The last decade is forcing public pensions to re-evaluate the projected returns that determine how much money taxpayers and retirees need to pour into retirement funds. Some systems such as New York, Rhode Island and the California State Teachers Retirement System have reduced their assumptions. It's a tough call because lowering projected gains can widen funding gaps, forcing lawmakers to put even more money into the programs.

Complicating the issue of what returns to expect are the extraordinary reverses of the last 10 years, including the Internet stock bubble, the financial crisis of 2008 and the worst recession since the Great Depression. Returns over 30 years still average more than 8 percent, according to the National Association of State Retirement Administrators. And in the 12 months after June 2010, markets and fund assets surged.

Largest Funds' Gains

For the fiscal year ended June 30, the California Public Employees' Retirement System -- the nation's largest -- said it gained 20.7 percent, and the California teachers program, the second-largest pension plan, 23.1 percent. The third-largest, the New York State Common Retirement Fund, returned an estimated 14.6 percent in the fiscal year ended March 31, according to the state comptroller.

Even though state pension funds posted near-record preliminary returns for the last fiscal year, their 10-year gains are still less than 8 percent. Calpers's 10-year return increased to 5.36 percent last year from 2.6 percent the previous year, and the California teachers' fund, to 5.7 percent from 2.5 percent.

The median state pension fund will achieve an annual return of 6.5 percent in the next 15 years, according to a February 2011 study by Wilshire Associates, the Santa Monica, California, investment adviser.

Alternatives Beat Stocks

In outperforming other public funds over the last decade, Washington's system benefited from investments in real estate and private-equity placements. Private-equity pools may invest borrowed funds, which can amplify returns and losses, and their holdings are often opaque. Calpers cited gains on private-equity investments for its 2011 gains.

“It's an illiquid, high-risk strategy,” said Tim Friedman, head of communications at Preqin Ltd., a London-based private-equity research firm. “You can lose everything.”

Washington's program, with $52.7 billion of assets as of June 30, 2010, is setting the pace as other systems are boosting private-equity investments, according to consultants. Pensions are also cutting their holdings of U.S. stocks and buying assets in developing countries such as China, India and South Africa.

Political Backlash

Three of the top five performing funds -- Washington, Oregon, and the Pennsylvania teachers fund -- had more than 30 percent of their assets in private equity and real estate, according to data compiled by the state retirement administrators' group. Four of the five worst performers -- Maryland, Arizona, the California teachers and Georgia -- had more than 50 percent of assets in publicly traded equities.

State pension funds increased average allocations for private equity to 8.8 percent in 2010 from 3 percent in 2000, Wilshire found in its February study. Meanwhile, the average allocation to U.S. stocks by 126 state pensions declined 13.9 percentage points since 2000.

Retirement funding spurred a political backlash against public workers this year. The meager returns after years of deferred taxpayer contributions magnified funding shortages, forcing legislatures and city councils to divert more money to the pensions. This left less for public services.

Adding to the pressures facing pensions, government workers are accelerating retirements as state budget crises have led to salary cuts. Governors in Wisconsin, New Jersey, Ohio and Florida have attacked unions.

Funding Gap

A quarter of the 363 human resources managers for state and local governments reported a rise in such departures in a 2011 survey by the Center for State and Local Government Excellence. Members of the baby boom generation, born from 1946 to 1964, began turning 65 this year, but many programs allow early retirements for civil servants in their 50s.

Statewide U.S. retirement programs were short $694.2 billion, or 24 percent, of having enough assets to pay future pensions at the end of their 2010 fiscal years, based on data compiled by Bloomberg as of July 15. Hawaii and Wisconsin haven't reported and weren't included.

Already, 14 states raised retirement age and length-of- service requirements to help close pension funding gaps, including New Jersey, Florida and Maryland, according to the National Conference of State Legislatures. Fifteen states increased employee contribution requirements in 2011, the conference said.

State judges in Colorado and Minnesota have thrown out lawsuits by retired public employees challenging reductions to cost-of-living adjustments, ruling the increases not protected.

Performance Data Opaque

Following the money in public pensions is no easy task for retirees and taxpayers, based on the 10-year performance survey by Bloomberg. Audited results may be published online no sooner than six or nine months after a fiscal year. Returns aren't reported consistently from fund to fund. Some disclosures may appear in annual reports, or in documents for bond sales that are unrelated to the pension funds themselves.

Bloomberg compiled data from the most recent annual reports of state pension funds with more than $20 billion in assets as of June 30, 2010. Bloomberg made follow-up calls to ensure the returns were after deduction of management fees and to request adjustments when they weren't. The research also obtained 10- year net returns as of June 30, 2010, for funds that use a different fiscal year-end.

Two of the biggest funds whose fiscal years don't close on June 30 -- New York's Common Retirement Fund and Colorado's Public Employee Retirement System -- said they couldn't provide returns on that basis.

Median Return

For the 25 programs in the survey, the median 10-year return was 3.15 percent. The pensions did beat the Standard & Poor's 500 Index, which had an annualized loss of 1.59 percent for the period, according to Wilshire.

Maryland's fund, which stuck with conventional investments, ranked at the bottom of the survey with annual gains averaging 2.10 percent. The fund had assets totaling $31.9 billion as of June 30, 2010. It posted preliminary returns of 20.04 percent for fiscal 2011, boosting its 10-year return to 5.01 percent.

Top-Performing Washington

Gary Bruebaker was behind Washington's decision to pour money into alternatives to stocks and bonds. He has been chief investment officer of the State Investment Board since 2001, leading a team of 30 investment professionals. The 56-year-old son of a single mother who worked 29 years for Oregon, Bruebaker says he takes his mission personally. He describes it as getting the best return for 400,000 public employees, retirees and beneficiaries at a “prudent” level of risk.

“Most of these people are people just like my mom,” he says. Before taking over management of the Washington fund, Bruebaker was a civil servant in Oregon for 23 1/2 years, eight of them as deputy treasurer.

At the end of fiscal 2010, the system was fourth-best funded at 92 percent, behind those of New York, North Carolina and South Dakota, according to Bloomberg data.

Alternative investments such as private-equity and hedge funds carry higher risks for retirees and taxpayers than conventional stocks and bonds. Some of the instruments are seldom traded, or not traded at all, so pensions face uncertainty about how much their investments are worth. Investing borrowed funds can amplify losses, which can be hard to limit because money placed with private-equity and hedge funds generally can't be cashed out on demand.

Private Equity

Public retirement systems don't disclose most details on their private-equity and hedge-fund portfolios, making it impossible for taxpayers to assess the risks. Pensions themselves may get limited information on holdings from money managers, who argue that disclosing the information could harm their strategy.

Washington was among the first public pension to invest in private equity, Bruebaker says. The state committed $13 million to a 1982 KKR & Co. buyout fund. In 2010, 26 percent of Washington's assets were in private-equity, Bruebaker said.

They've picked some big winners. A placement of $25 million in Menlo Ventures VII, a 1997 Silicon Valley venture capital fund that invested in early Internet companies, was valued at $117.5 million as of Dec. 31, 2010, for a 135.6 percent return, according to fund records.

Investing Advantage

Washington's 30-year history with private equity gives it an advantage, Bruebaker says. The state has relationships with some of the best-performing funds and takes advisory seats on big investments, allowing it to work closely with the general partner, including sharing investment ideas, he said. Serving on advisory boards enables Washington to closely monitor operations and investments, the investment chief said.

“Whenever they do something special, we want to be one of the first calls,” Bruebaker said.

Washington's heavier weighting toward private equity gave it a boost from 2004 to 2007, as easy credit enabled buyout funds to borrow cheaply and distribute cash to investors. In 2006, Washington's private-equity portfolio gained 39.5 percent, compared with 8.6 percent by the S&P 500. Over the decade through June 2010, the fund's private-equity investments returned 6.6 percent, fund records show.

Index Funds

In asset classes such as U.S. stocks where it believes managers can't beat the market consistently, Washington has moved to funds that track an index, Bruebaker says. All of Washington's $10.4 billion of U.S. shares, as of March 31, are in a BlackRock Inc. (BLK) fund matching all American equities, he says. The state has $7 billion of its international developed- market stocks in index funds too, according to the fund's March 31 quarterly statement.

Washington is also increasing its allocation to emerging markets, Bruebaker says. In April, the state agreed to invest $75 million in a $750 million fund being raised by Prosperitas Real Estate Partners to invest in Brazilian property.

“Growth is clearly not going to come from the U.S.,” Bruebaker said. “That's not a slap against the United States. It's the reality of the marketplace.”

Some pensions invested as much as 65 percent in stocks, helping to account for the decade's low returns, according to Eileen Neill, a Wilshire managing director. The opening 10 years of this century was the first in 70 years in which the U.S. stock market had a negative return, she said.

“If you had a lot of equity-like investments in your portfolio, you certainly didn't get anywhere near that 8 percent return,” Neill said.

Stocks Betray Maryland

Maryland had 67 percent of its assets in stocks in 2001, a figure that declined to 51 percent by the end of the decade, according to the fund's reports.

The state's pension assets at 2010 year-end were 37 percent short of covering pensions promised to 120,247 retirees and 144,343 active vested civil servants, 10th-worst among state systems, according to Bloomberg data.

During the decade, the state's domestic stock portfolio performed worse than the market, trailing the S&P 500 or the Dow Wilshire 5000 five years out of 10, including four straight from 2005 through 2008, the fund's financial reports show.

Legislative Critique

The state Department of Legislative Services, a nonpartisan agency that provides research and policy analysis to Maryland's legislature, has “repeatedly expressed concern” about the performance of the state's active U.S. equity managers, according to a draft November 2010 presentation to the Joint Committee on Pensions.

For five straight years through 2010, passively managed funds structured to match a stock market index did better than actively managed ones, which collect higher fees, the legislative services analysts found. The percentage of the state's domestic stockholdings placed with passive funds declined to 45 percent from about 71 percent in fiscal 2008, according to the office.

The performance of active U.S. stock managers has improved this year, beating their benchmark by 0.59 percentage point, said Robert Burd, the deputy chief investment officer for Maryland's pension system since March.

“We have confidence in our current manager lineup to add value over time,” said Burd, 42, who has been with the system since 2001.

The state's decision in 2008 to allocate money to a program targeting so-called emerging managers led to the decline in the percentage of passive managers, Burd said. Emerging managers are small firms that may be ignored by large institutional investors and often are women or members of minorities.

Maryland's New Plan

Manager performance “only slightly explains,” why the fund did worse than its peers, Burd said. “Asset allocation explains 90 percent,” he said.

“A lot of our peers were earlier into private equity,” Burd said. It took the fund's trustees time to get comfortable with the illiquidity, use of leverage and lack of transparency that are characteristic of private-equity funds, Burd said.

Maryland now aims to put 10 percent of its portfolio in private equity and the same share each into bonds, real estate and “credit opportunities,” which include high-yield instruments and distressed debt, according to Burd. It is also allocating 15 percent to assets that will protect against inflation such as commodities, 7 percent to hedge funds and 2 percent to cash. The program is cutting the proportion for stocks to 36 percent from 51 percent, Burd said.

As Maryland diversifies its investments, it has improved expected returns while reducing portfolio risk, according to an analysis by the investment consulting group Hewitt EnnisKnupp Inc., cited in the Department of Legislative Services report.

Boom, Bust, Reaction

Maryland's Sharpe Ratio, a measurement of the return that can be expected from each unit of risk, increased to 0.377 as of June 30, 2010, from 0.242 as of June 30, 2007, according to the report.

Although it may not appear achievable based on the last decade, public pensions should be able to return 8 percent a year on average over 30 to 40 years, said Wilshire's Neill. Stocks have earned about 10 percent annually over the last 70 years, and will continue to produce “high single-digit” returns, she said. The debt weighing on the U.S. government, businesses and consumers will decline over the next 10 years, Neill said.

“There are regular booms and busts, and then there's reactions,” Neill said. “Ultimately, there's always recovery, and that's what you have to keep in mind as you're looking out over a 10-year period.”

Public pensions should be able to return 8 percent a year on average over 30 to 40 years? I think this is a dangerous pipe dream, one that got us into the current mess to begin with. An aging society, high debt and unemployment do not bode well for stocks or private equity. There will be growth sectors but you have to pick your spots carefully (ex. alternative energy, medical equipment, software to fight cyber crime, infrastructure, etc.).

And what about private equity? Will it be the great panacea for public pensions? Of course not. As every pension fund around the world listens to their brainless consultants and starts pouring billions into private equity, their collective actions will severely dilute future returns. That's why smart pension funds are focusing more on hiring talent and developing their direct investments and co-investments.

Sure, the top PE funds will continue to outperform, but don't get to enamored by them or else you risk being disappointed. When it comes to the pension crisis, there is no magic bullet that will cure all deficits. Only tough political choices will help avert a total disaster.

**Feedback***

Jonathan Jacob of Forethought Risk had these insightful comments to share:

What is worse, in my opinion, is that these private market allocations are being made without regard to the overall liquidity of the fund…what if mature funds (and some of those mentioned may be included in this group) which have a net funding deficit (benefits exceed contributions) put 50-60% in private markets such as real estate, private equity, infrastructure, etc and in a few years another 2008 hits? That means a few years of public market investments providing liquidity to the fund and then a decline in those values could put private allocation above 80% - a very dangerous and illiquid situation for a fund to be in. Just a thought.