For state pension plans, manager selection more important than alts allocation

U.S. state pension plans with higher allocations to alternative investments generally experienced better 10-year returns than those with less exposure, a new analysis from consultant Cliffwater LLC shows.

Contrary to common market wisdom, researchers at Cliffwater, based in Marina Del Rey, Calif., also found that those decade-long returns owed more to manager and fund selection than to the size of the alternatives allocation, according to the firm's most recent biennial study “Trends in State Pension Asset Allocation and Performance.”

In analyzing data culled from the 2011 comprehensive annual financial reports of 96 state pension plans, Cliffwater took “a big picture, 10-year point of view in analyzing the experience of state pension funds by digging beyond simple performance rankings to find out how these funds have achieved their results,” said Stephen L. Nesbitt, the firm's CEO, in an interview.

The $7.8 billion Missouri State Employees' Retirement System, Jefferson City, was the best-performing state pension plan for the 10-year period ended June 30 that Cliffwater studied; it had an annualized 7.1% return.

The South Dakota Retirement System, Sioux Falls, was second with a 7% return, and the Oklahoma Teachers Retirement System and the Texas County & District Retirement System shared third place with 6.9% each. Four funds each returned 6.7% for the period: Delaware Public Employees' Retirement System; Louisiana State Employees' Retirement System; Municipal Fire and Police Retirement System of Iowa; and Washington State Investment Board.

Rounding out the top 10, each with a 6.5% return, were the Massachusetts Pensions Reserve Investment Management Board and Oregon Public Employees Retirement Fund.

All returns are annualized.

All but one of the top 10 had alternative allocations greater than 24%. Cliffwater researchers found that “above-average allocations to alternatives played a key role in all but one of these funds achieving strong 10-year returns,” according to the report.

That single outlier was the $10.1 billion Oklahoma Teachers system, Oklahoma City, where the “selection of traditional managers was the primary contributor to a comparatively strong 10-year return,” according to the report.

By contrast, as of June 30, 2011, MOSERS had a 55.3% allocation to alternatives when leverage from the fund's portable alpha program is included, and the $7.8 billion South Dakota system, Sioux Falls, had 27.6% of total fund assets invested in real estate, private equity and hedge funds. The $17.6 billion Texas County & District system, Austin, had 30.7% invested in the full panoply of alternative asset classes.

The $58.8 billion Washington State board, Olympia, had the largest allocation to alternatives excluding leverage at 42.1%.

To set the stage for deeper analysis, Cliffwater researchers first considered 10-year overall returns of the 69 state pension funds in the study universe whose fiscal years end June 30 and found that they were well below the 7.5% to 8% range of assumed rate of return used by most public pension plans. Returns were annualized for the 10 years ended June 30, 2011.

The highest 10-year return for the universe was 7.1% while the lowest was 4%. On a quartile basis, Cliffwater's analysis showed that the first-quartile return within the 69-plan universe was 6.2% and the third quartile return was 5.4%. The median return for the universe for the decade was 5.7%.

Cliffwater's report noted the 10-year pension fund returns were “fairly tightly distributed” with less than a percentage-point difference between the first- and third-quartile returns, which “is to be expected with only a one-percentage-point difference in stock (4.78%) and bond (5.75%) index returns, thereby dampening any return differences among funds as a result of variations in stock/bond allocations.”

By contrast, the distribution of 10-year annualized median returns of real estate portfolios (7.3%) and private equity portfolios (10.2%) for the 69 pension funds was “very wide ... suggesting that differences in implementation — manager selection — proved to be very important for individual state fund returns in real estate and private equity.”

Cliffwater was unable to apply the same analysis to hedge fund investments because far fewer state pension plans have been investing in them for 10 years.

The annualized 10-year returns of the 10 best-performing state pension funds all were well above the 5.7% median return of the full universe but also were tightly distributed, ranging from 7.1% to 6.5% for the year ended June 30, 2011.

By Cliffwater's calculation, the median funding ratio among the 69 state plans was 80%, “a deficit that is entirely the byproduct of a shortfall between the 5.7% median investment return and the 8% mean actuarial rate compounded over 10 years,” according to the Trends report.

Other state pension plans are very likely to follow suit in increasing alternative investment targets in order to compensate for dismal investment prospects for stocks and bonds. With a consensus expected annualized return of 6.1% for stocks and bonds combined over the decade ending June 30, 2020, “most pension boards and staffs are fully aware of the investment challenges ahead and have been gradually shifting their asset allocation strategies,” the report said.

Cliffwater's research showed that the asset-weighted average allocation to alternative investments by all 96 U.S. state pension funds doubled to 20% in the five years ended June 30, 2011. Funding for the shift came from public equities, which dropped by 10 percentage points to 51% of total assets.

The Cliffwater report noted that the 20% average allocation to alternatives masks “considerable variability among (the 96) individual pension plans” in the universe, ranging from zero for five state funds, including the $48.1 billion Teachers Retirement System of Georgia, Atlanta, and the Oklahoma Teachers' fund, to the highest allocation of 61% for the $25 billion Pennsylvania State Employees' Retirement System, Harrisburg.

In an interesting twist, while the public retirement systems in Georgia were this spring granted legislative authority to invest up to 5% of assets in alternatives (with the exception of the Georgia Teachers system), PennSERS trustees recently reduced the 10-year target allocation to alternatives to 16% to reduce the fund's illiquid assets (Pensions & Investments, April 18 and June 25).

For state pension plans in Cliffwater's first quartile, the average asset-weighted alternatives allocation was 26%, and 11% for the third quartile. The median allocation for the full universe was 18%. n