Funds' looming liquidity crisis

Asset allocation decisions will affect ability to pay benefits in future years

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Warning: Jay Kloepfer said a negative net outflow of 10% raises alarm bells.

Asset allocation changes that chief investment officers and boards of trustees have made at U.S. public pension funds since the market crisis of 2008 could be the difference in whether the funds will be able to meet benefit payments over the next 10, 20 or 30 years.

Consultants say public fund executives diversifying their portfolios — away from equities to manage downside risk and adding more investment return potential through increases in illiquid, alternative asset classes — likely will be in good shape when the next generation of retirees and those that follow begin to tap their benefits in ever larger numbers.

But that's true only for public funds with healthy funding ratios now (generally 80% or higher) and that expect to receive future annual required contributions — the cost of benefits accrued in the current year plus the money needed to amortize unfunded liabilities — so they can afford to lock up as much as 20% or 30% in alternative investments.

For investment executives overseeing public plans now suffering from poor funding ratios and insufficient future contributions and a bleak outlook for future, the need to provide liquidity to pay benefits over the next few decades will mean they can't increase or even maintain existing allocations to real estate, private equity, timber, hedge funds and other alternative asset classes, sources maintained.

Just last week, the $24.4 billion Pennsylvania State Employees' Retirement System became one of the first large, mature pension plans to radically alter investment of the fund in anticipation of liquidity shortfalls over the next 10 years.

At their Dec. 1 meeting, PSERS' trustees cut targets to four illiquid asset classes — private equity, venture capital, real estate and hedge funds - by 17.5 percentage points to 32% of plan assets and moved the assets to liquid public equities and fixed income, raising the combined target for both asset classes to 65% of the portfolio from 47.5%.

Other plans that also are making changes now to ensure being able to meet benefit payments well into the future are the $54.9 billion Minnesota State Board of Investment and the $4.2 billion Milwaukee Employes' Retirement System.

Indeed, sources said pension fund investment returns could make a huge difference in a pension fund's long-term ability to meet benefit payments.

Some plans already are paying out more in benefits than they are taking in through contributions.

“Month by month, quarter by quarter, year by year, demographically mature plans with chronic funding problems begin to experience an imbalance where benefit payments outstrip contributions. This won't create an immediate crisis, but rather, a slow death by 1,000 lashes, absent a change in investment returns or the contribution policy,” said a public fund investment consultant who asked not to be named.

"Absolutely normal'

Christopher Levell, partner and director of asset allocation research at investment consultant NEPC LLC, Cambridge, Mass., said: “This imbalance between contributions and benefit payments is to be expected in mature pension plans. It's absolutely normal.”

Even in the absence of an increase in contributions or a decrease in benefit payments, the goal for public plan chief investment officers is to generate enough cash to meet benefits without seriously depleting the principal of funds that likely will remain open in perpetuity.

Sources said a significant number of state and local plans instituted reforms such as raising employee contributions and decreasing benefits this year that will reduce liabilities that grew sharply after poor equity performance in 2008 and early 2009 dropped the value of portfolios.

Investment consultants said most of their clients are not having immediate difficulties meeting benefit payments, even when they aren't regularly receiving full employer contributions, as is the case this year with Illinois' five state pension plans.

Over the next three decades, however, consultants predict liquidity problems for plans with chronic negative net benefit payments, insufficient annual required contributions and funding ratios below 70%.

“We're starting to foresee potential trouble with liquidity, not today, but in the future — five, 10 or 20 years from now,” said Jay Kloepfer, director of capital market research at investment consultant Callan Associates Inc., San Francisco.

“For a $20 billion plan, a 5% negative net outflow isn't particularly alarming, but we're warning clients that they need to pay attention. When that (negative) net outflow gets closer to 10% of plan assets, it starts to shape your asset allocation,” Mr. Kloepfer said.

“It becomes much less tenable to be invested in illiquid assets,” he said, especially for public plans that can't be sure there will be “enough of a change in the contribution stream to ensure that there will be sufficient liquidity.”

NEPC's Mr. Levell said without a positive change in those three vital factors — chronic negative net benefit payments, insufficient annual required contributions and funding ratios below 70% — public pension plan officials will be forced to move their portfolios over time to a more liquid allocation to be sure they can pay benefits.

Because of the necessary reliance on liquid assets, the problem with such an allocation is that it's unlikely to achieve the classic 8% assumed rate of return or even the 7% to 7.75% lowered assumptions that a number of public pension plans have recently adopted, Mr. Levell said.

“The problem ... is that many of these plans matured a decade earlier than expected because equity returns were negative for the past 10 years. The lesson from the last decade is that equities can't be relied on,” Mr. Levell added.

For plans facing a future liquidity crunch, Hewitt EnnisKnupp Senior Consultant Russell K. Ivinjack said a significant change in asset allocation ranges and a more dynamic investment approach are essential.

Executives at public funds without healthy funding ratios “need to carefully review their current asset allocation. Are the allocations to illiquid asset classes appropriate? For most plans, it probably would be a bad idea to decrease the allocations before they mature, but you need to know when you will be able to harvest profits. It's unlikely that allocations to illiquid assets would be increased,” said Mr. Ivinjack, who is based in Chicago.

More vigilant

Public plans with potential constraints also need to become more vigilant in monitoring contribution levels and investment returns and adjusting asset class exposures to be sure there is enough liquidity to meet benefit payments at any given time, Mr. Ivinjack said.

Funds facing future liquidity constraints would be well served by an asset allocation that increases the exposure to high-quality, liquid core fixed-income securities to between 30% and 50% of total assets, up from 20% to 30%; gradually decreases illiquid investments from about 20% now; and leaves the balance in equity beta strategies, he said.

“Many boards of trustees tend to be focused on manager-level decisions, but picking between Manager A and Manager B is going to be far less important for public pension plans in the future than getting the asset allocation right and adjusting it dynamically in response to market conditions and changing contribution levels,” Mr. Ivinjack said.

Actions by the board of the Pennsylvania State Employees' Retirement System, Harrisburg, provide a glimpse into the future of a mature state plan, “one with almost as many retired as active members. Since the year 2000, annuitants and beneficiaries increased 24% while the number of active members has remained relatively steady,” wrote spokeswoman Pamela Hile, in an e-mailed response to questions.

According to Pensions & Investments' analysis of PSERS' most recent annual report, the plan's funded ratio was 84.4% as of Dec. 31, 2009; net benefit payments (contributions less benefit payments) were -$1.7 billion; and net benefit payments as a percentage of plan assets were -6.59%.

Annual required employer contributions to PSERS have been “artificially suppressed” by legislation passed in 2003 and as a result, SERS benefit payments and expenses far outstrip cash inflows, according to Ms. Hile. Over the past 10 years, for example, SERS paid $18.2 billion in benefits and expenses, while combined employer and employee contributions were $4.6 billion.

Investment earnings make up the difference, Ms. Hile said, noting that PSERS' investment staff raises cash to pay benefits by periodically rebalancing the portfolio back to long-term investment targets and taking money from asset classes and managers that have outperformed.

The Pennsylvania fund's board is dynamic in managing the portfolio, annually resetting the plan's long-term investment targets based on an analysis of future benefit payments and the expected liquidity needs over the next five and 10 years, factoring in “illiquidity from various asset classes,” Ms. Hile said.

Changes made last week in PSERS' long-term target allocation raised fixed income to 26% from 17.5% and equity to 39% from 30%. The long-term target for private equity and venture capital drops to 15% from 24.5%; absolute return (including hedge funds of funds) drops to 9% from 15.5%; and real estate drops to 8% from 9.5%. The target allocation to inflation-protected securities (including commodities) will remain at 3%.

The target shifts will be made gradually by 2015 and are subject to annual review, Ms. Hile said in a separate e-mail.

“This is a measured process that will be done through cash flows and distributions,” she wrote.

Negative cash flow

Howard J. Bicker, executive director of the Minnesota State Board of Investment, St. Paul, said in an interview that his fund, like “a majority of mature plans, is in a negative cash flow mode.” The board manages $48.1 billion of DB plan assets.

P&I's analysis of the Minnesota fund's June 30, 2009, annual report data found the funded status was 77.1%, net benefit payments totaled -$1.6 billion, and net benefit payments as a percentage of plan assets were -3.7%.

Like the Pennsylvania fund, “so far, we've been making up the negative cash flow with investment returns,” Mr. Bicker said, relying on regular portfolio rebalancing to provide cash for benefit payments.

“We have a permanent, long-term allocation of 2% to cash, which covers about six months of benefit payments. When we rebalance ... other asset classes to their targets, the investment proceeds go to replenish the cash allocation,” Mr. Bicker said.

Mr. Bicker said the “aggressive changes” that the Minnesota Legislature made in the last legislative session to increase employee contributions and cut benefits will help the plan remain solvent.

“If the markets don't collapse, we'll be OK. We're not jumping for joy, but reality has set in. Some states, like Minnesota, have taken really serious action to address their pension issues. What's going to be really interesting is what happens when some of the plans that haven't done the right thing run out of money down the road,” Mr. Bicker said.

For plans with healthier funding ratios, pumping up returns sufficiently to breach the gap between contributions and benefit payments, as well as to reduce market volatility, NEPC's Mr. Levell and other consultants interviewed recommend a much higher allocation to illiquid, alpha-generating asset classes.

“There is an illiquidity premium available now to public pension plans with their long-term investment horizons because of a supply-and-demand imbalance,” Mr. Levell said. “There will be a dichotomy in future years between these better-situated pension funds that are able to take advantage of the illiquidity premium in order to earn 10% over the next decade and those plans that can't afford to do so because they need liquidity, which will earn 5% or perhaps even lower over that time period,” he said.

To get close to that 10% return, Hewitt EnnisKnupp's Mr. Ivinjack said officials at “many well-funded plans not worried about future contributions” are upping their range to 20% or even “north of 30%” to hedge funds, private equity, real estate and other alternative investment strategies. He said a 20% to 30% allocation to high-quality, core fixed income will add liquidity, as will a 25% to 40% global equities allocation.

The $4.2 billion City of Milwaukee Employes' Retirement System qualifies as one of the healthy public pension plans, with a funded ratio well over 100% for 15 of the past 16 years, said Bernard J. Allen, executive director, in a joint interview with CIO Thomas Rick.

Because the plan “took a drubbing in 2008 and 2009, just like everyone else,” its funded status dropped to 99% as of Jan. 1, 2009. A year later, it had jumped back to 113%.

With just 7% of plan assets invested in an illiquid asset class - real estate - in 2008, the Milwaukee fund was able to easily meet liquidity needs. But Mr. Rick said he and his staff are working to refine and diversify the portfolio in order to lower risk and volatility.

“With mostly public equities and fixed income, we want to add investment in more uncorrelated strategies like private equity, infrastructure, hedge funds and commodities. We also moved a portion of our domestic and international equity portfolio into global equities, and we're close to hiring a global fixed-income manager,” Mr. Rick said. He said the plan also is working on changing the asset manager lineup a little to make sure there is diversification among the strategies and managers within the same asset class.

The plan has a huge advantage over many other public plans because “the city has hard-wired full required pension contributions into its charter. That means that by law, employers can't skip their required contributions ...,” Mr. Allen said.

“We don't have to deal with many of the issues that underfunded pension plans do,” Mr. Allen said, but he noted changes might be coming because many of the city's agencies that participate in the pension plan are experiencing budget problems.

“Meeting the normal cost of pensions as well as retiree health care going forward is going to be tough for many city departments. It won't happen this year or next, but over the next 10 years, meeting required contributions may become a huge problem,” Mr. Allen said.

Rob Kozlowski contributed to this story.