PennPSERS CIO Benjamin Cotton reflects on eventful first year

It was an eventful first year for Benjamin Cotton at the helm of the Pennsylvania Public School Employees' Retirement System, which featured significant asset allocation changes, and he hopes in the future to drop the system's target to private investments to lower its illiquidity allocation.

Cotton joined the $72.5 billion Harrisburg-based pension fund in January following a tumultuous period at PennPSERS in which an error in its reported investment figures led to internal and federal investigations. While the system was ultimately cleared of any wrongdoing, both CIO James Grossman Jr. and Executive Director Glen Grell retired amid the federal probe in early 2022 and the pension fund is still in the midst of an ongoing lawsuit it filed against now-terminated investment consultant Aon Investments USA related to that error.

Both PennPSERS and Aon have declined comment on the pending litigation.

The arrival of Cotton, however, seems to purport a fresh start for the pension fund. A U.S. Marine veteran, he came to the pension fund after completing the doctoral program on Leadership and Learning in Organizations through Vanderbilt University's Peabody College in December 2022 following a long stint as senior managing director at the $58.6 billion United Auto Workers Retiree Medical Benefits Trust. He had been a member of the investment team since the trust's inception in 2009.

Cotton said in a Dec. 19 phone interview that one of his priorities has been adjusting to the new interest rate environment, since institutional investors for well over a decade had pushed out on the risk spectrum in search of returns given the low-return fixed-income environment.

The result at PennPSERS was a change in its asset allocation approved by the board in August, which included raising the target to investment-grade fixed income to 14% from 10% and lowering inflation-protected fixed income to 9% from 11%, commodities to 5% from 7.5%, and credit-related fixed income to 4.5% from 6%.

Other changes included the elimination of the 4% target allocation to absolute return, raising the target to domestic equities to 18% from 15% and lowering the targets to international equities to 12% from 15% and public real estate to 2.5% from 4%. Targets that currently remain unchanged are 12% private equity, 7% private real estate, 6% private credit and 5% each private infrastructure and public infrastructure.

PennPSERS also changed its -7.5% target to net leverage to zero.

"When the facts on the ground change, you have to reflect that in your asset allocation," Cotton said. "For example, historically, PSERS has benefited from the use of a modest amount of leverage at the plan level, as well as a fairly strong allocation to private markets or an illiquidity premium across time."

"And that has also been accompanied with a relatively light allocation to investment-grade fixed income, although we do have an allocation to it, always have," he said. "But with the change in the cash market right now, cash is yielding five-plus percent…If it comes down based on the market thinking it's going to come down 150 basis points, it's still fairly significant. You know, that's the cost of leverage right there. And so the benefit of leverage over the long run is theoretically the risk premium that you get access to through that leverage."

The cost of leverage is now high, Cotton said, so the pension fund has moderated its view on leverage and taken it down to net zero.

"That doesn't mean we're not using derivatives and/or leverage," he said. "It just means that at net we're holding it at zero. But also the higher-rate environment allows us to then put some assets in the book that traditionally have been very diversifying to our growth assets, but for a while now haven't been paying their way, so to speak, or yielding much."

That is why the pension fund has raised that target to investment-grade fixed income, he said. It will also help ensure it can bring the illiquidity allocation lower.

"We're at 36% (actual) private allocation right now, but our target's 30%," Cotton said. "We'd like to take that down another 6% (to 24%). That sounds like a lot, or maybe it doesn't sound like a lot, but to get there takes a while because of the nature of the allocation."

Since the pension fund is overallocated, Cotton and his staff have moderated their commitment pacing accordingly until they reach the current 30% or slightly lower.

"I'd like to be slightly under target because you've got more flexibility to manage the portfolio with public assets than you do with private assets," Cotton said, "but there is a role for both types of assets in the portfolio longer term."

Cotton also noted that higher interest rates and the concerns about inflation have set up the situation in which the cost of capital to buy companies is higher than it's been for quite some time, which applies across the spectrum in private markets, including private equity, real estate, infrastructure and to some extent in private credit, although he noted that private credit benefits from the current economic environment.

"What we've got now is a situation where people who bought assets before had expectations around the returns and had price expectations to sell, and people who are looking to buy assets today have a higher cost of capital, so their cost to buy is a little lower," Cotton said. "So we're trying to find this clearing point where buyers and sellers can agree and transact."

What that's creating is what Cotton calls a numerator effect, "because the distributions that were assumed and modeled in a lot of the pacing work that was done aren't necessarily coming through as modeled, and until that clears it's going to create an overallocation situation."

Cotton said the primary challenge of allocating to private markets is weighing the illiquidity premium with the labor intensiveness and higher cost of those asset classes.

"I've often been misquoted on this aspect, (but) I'm not skeptical of private markets, per se," Cotton said. "I'm skeptical of paying higher fees without compelling evidence that the manager is going to deliver premium returns … So it's up to us to really do our diligence and make sure we're allocating to our partners in this space … that can continue to deliver value for the higher fees as well as the liquidity that we take on."

One side benefit very early in his stint at PennPSERS was working through the fallout of the collapse of Silicon Valley Bank in March.

"I actually got to work with the team and see how they react in a crisis situation and got to really understand the nature of our liquidity," Cotton said. "And I think we're positioned well from a liquidity perspective as well, and because of how our portfolio is constructed, if we were to have any surprises in 2024, I think that liquidity buys us the time that would be needed to assess the situation and make any adjustments we need to."

PennPSERS has an investment staff of 60 professionals, and Cotton said the plan is to remain at about that staff count, although there are a number of retirements coming in the near future and they will be in the market for talent.

"We have a good portion of the staff that's been here for a long time and is committed to helping us kind of transition to the next generation," he said, "And so that'll happen over the next several years."