Benchmarks, Transparency Could Bring More Pension Funds to Infrastructure, Says Group

Roadwork

The European Association of Paritarian Institutions (AEIP) last week called for greater transparency and more performance data in the infrastructure sector.

These changes, according to the AEIP, could help attract more pension funds to the sector.

From Investments and Pensions Europe:

Infrastructure markets need to be more transparent, with greater emphasis placed on the development of sector benchmarks, according to the European Association of Paritarian Institutions (AEIP).

Setting out its views on infrastructure, the association said that while pension funds were long-term investors – and therefore well-suited to invest in the asset class – they first and foremost needed to abide by their fiduciary duties to members.

“The reality is that infrastructure represents a valuable asset class and for sure a viable option for long-term investors, but these latter face several hurdles to access it,” the AEIP’s paper noted.

It said the lack of comparable, long-term data was one of the hurdles facing investors and that the absence of infrastructure benchmarks made it difficult to compare the performance of the asset class.

It also identified an organisation’s scale as problematic to taking full advantage of the asset class.

“Direct investments, those that yield the most interesting returns, are the most difficult to pursue, as their governance and monitoring require skilled individuals and a strict discipline regulating possible conflicts of interests,” it said.

“National regulation does not always simplify direct investments, and pension regulators in some cases limit the use of the asset class in a direct or indirect way.”

The association called on governments to play their part in making infrastructure accessible.

“Often the lack of infrastructure investments is not due to a lack of projects but not finding the right match with investors,” the AEIP added. “Some form of standardisation might be investigated.”

Read the paper here.

Institutional Investors Bullish on Stocks, Alternatives in 2015

stock market numbers and graph

Institutional investors around the globe believe equities will be the best-performing asset class in 2015, according to a survey released Monday.

Investors are also bullish on alternatives, but not as thrilled when it comes to bonds, according to the survey.

The results summarized by Natixis Global Asset Management:

Forty-six percent of institutional investors surveyed say stocks will be the strongest asset category next year, with U.S. equities standing above those from other regions. Another 28 percent identify alternative assets as top performers, with private equity leading the way in that category. Only 13% predict bonds will be best, followed by real estate (7%), energy (3%) and cash (2%).

Natixis solicited the market outlook opinions of 642 investors at institutions that manage a collective $31 trillion. The survey found:

Realistic expectations of returns: On average, institutions believe they can realistically earn yearly returns of 6.9 percent after inflation. In separate surveys by Natixis earlier this year, financial advisors globally said their clients could anticipate earning 5.6 percent after inflation1 and individuals said they had to earn returns of 9 percent after inflation to meet their needs.2

Geopolitics leads potential threats: The top four potential threats to investment performance in the next year are geopolitical events (named by 17% of institutional investors), European economic problems (13%), slower growth in China (12%) and rising interest rates (11%).

– Focus on non-correlated assets: Just under three-quarters of respondents (73%) say they will maintain or increase allocations to illiquid investments, and 87% say they will maintain or increase allocations to real estate. Nearly half (49%) believe it is essential for institutions to invest in alternatives in order to outperform the broad markets.

Words of advice for retail investors: Among the top investment guidance institutions have for individuals in the next 12 months: avoid emotional decisions.

[…]

“Institutional investors have an enormous fiduciary responsibility to fund current goals and meet future obligations,” said John Hailer, president and chief executive officer for Natixis Global Asset Management in the Americas and Asia. “The current market environment makes it difficult for institutions to earn the returns that are necessary to fulfill both short-term and future responsibilities. Building a durable portfolio with the proper risk management strategies can help investors strike a balance between pursuing long-term growth and minimizing losses from volatility.”

[…]

“Institutional investors have an unusually good perspective about markets and long-term prospects,” Hailer said. “Like ordinary investors, institutions have short-term worries. They also feel the pressure to take care of current needs, no matter what the markets are doing. Because of their longer-term time horizon, they offer valuable perspective.”

The full results of the survey can be read here.

Kentucky Chamber of Commerce Calls For Audit of State Pension System

Kentucky flag

The Kentucky Chamber of Commerce is pushing for an audit of the Kentucky Retirement Systems – specifically, a review of its investment performance and policies.

Reported by the Courier-Journal:

Chamber President and CEO Dave Adkisson announced Thursday that the group wants a review of the investment performance and use of outside investment managers — among other issues — at Kentucky Retirement Systems, which has amassed more than $17 billion in unfunded liabilities.

While the state has made progress in addressing pensions, “serious problems persist that pose a significant threat to the state’s financial future,” Adkisson said. “The business community is concerned about the overall financial condition of our state.”

[State Auditor Adam] Edelen said in a statement Thursday that he shares the chamber’s concerns, but he also noted that at least three major reviews of KRS have occurred over the past few years.

[…]

KRS Executive Director Bill Thielen said officials will fully cooperate if Edelen decides to perform an audit. But also he pointed out that the system has been subject to continuous examinations, including audits, legislative reviews and a two-year investigation of investment managers by the federal Securities and Exchange Commission.

“None of those have turned up anything that is out-of-sorts,” he said. “A lot of the questions or concerns that the chamber seemingly raised have been answered numerous times.”

Thielen added that KRS doesn’t disclose the individual fees it pays managers because confidentiality helps officials negotiate lower rates.

State Auditor Adam Edelen said Thursday he hadn’t made a decision on whether to begin an audit of KRS. He said in a press release:

“For this proposed exam to add value and bring about real fixes to the system, it will require broad, bipartisan support and additional resources for our office to conduct the highly technical work…We have begun discussing the matter with stakeholders. No final decision has been made at this time.”

The founder of one retiree advocate group laid blame for the system’s underfunding on the state’s contributions, not investment policy, and was skeptical that the audit would yield fruitful results. Quoted in the Courier-Journal:

Jim Carroll, co-founder Kentucky Government Retirees, a pension watchdog group organized on Facebook, called the proposed audit a “red-herring” and argued that the financial problems in KERS non-hazardous are the result of year of employer underfunding.

He said KRS investments don’t yield the returns of some other systems because the low funding levels force them to invest defensively.

“I’m skeptical that anything useful would come out of another audit,” he said. “Not to say that there shouldn’t be more transparency, but that’s a separate issue.”

KRS’ largest sub-plan – KERS non-hazardous – is 21 percent funded.

Big Raise on Horizon for Massachusetts Pension Investment Head

one dollar bill

On Tuesday, the Massachusetts PRIM Board will vote on whether to give a big raise to PRIM CIO and Executive Director Michael G. Trotsky.

The raise, not including bonuses, would bring his annual salary from $295,000 to $360,000.

It’s a big raise, but the Boston Globe’s Steven Syre makes the case that the salary bump represents a “prudent investment” for taxpayers:

That is certainly a lot of money, nearly twice what Jackson’s commission thinks the governor should be paid. It would put Trotsky’s salary above average — but hardly on the top shelf — among people holding comparable public-sector positions around the country. He will remain wildly underpaid compared with people who do similar work for private companies.

[…]

Like many states, Massachusetts does not have enough money saved to cover pension payments due in the years ahead. The state has made some progress in closing that gap but the investment performance of the existing pension fund is a big part of the equation.

The dollars involved are huge. If the people running the pension fund can add a single percentage point to investment performance in a year, they will contribute an extra $600 million to the state. Mistakes can be equally expensive.

Pension fund executives do not manage money themselves. They allocate it to many different kinds of assets and then choose a long list of private firms to do the investing. This year, they have been moving money to become more conservative after years of strong financial markets.

Trotsky left the hedge fund world to become executive director of the state pension fund four years ago. Two years later, the fund’s chief investment officer left, and Trotsky took over those duties, too. He was paid another $50,000 for the added job, which would have cost well over $200,000 a year to fill, but otherwise has not gotten a raise since he arrived.

The fund’s investment performance has been good over the last four years, averaging more than 13 percent annually in strong financial markets. One point of reference: The investments outperformed Harvard’s endowment in each of those years.

Taxpayers have a lot at stake in the state pension fund. It’s a prudent investment to pay the people who manage your money.

The Pension Reserves Investment Management (PRIM) oversees management of $60 billion of the state’s pension assets.

Chart: How Did Kentucky’s Pension System Become So Underfunded?

KY systems funding

Here’s a chart of the funding situations of Kentucky’s largest public pension funds as of 2012. At 27 percent funded, the KERS non-hazardous fund was considered among the unhealthiest in the country. Since 2012, its funding ratio has dipped even further. But the entire system is experiencing big shortfalls.

How did they get this way? Pension360 covered earlier today the system’s lackluster investment performance — but the state’s funding shortfall has been influence by a confluence of factors.

KY shortfall breakdownOne of the largest reasons for the shortfall is the state failing to make its actuarially-required payments into the system:

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Chart credits: Pew Charitable Trusts

Study: Has a 400 Percent Increase in Alternatives Paid Off For Pensions?

CEM ChartA newly-released study by CEM Benchmarking analyzes investment expenses and return data from 300 U.S. defined-benefit plans and attempts to answer the question: did the funds’ reallocation to alternatives pay off?

The simple answer: the study found that some alternative classes performed better than others, but underscored the point that “costs matter and allocations matter” over the long run.

In the chart at the top of this post, you can see the annualized return rates and fees (measured in basis points) of select asset classes from 1998-2011.

Some other highlights from the study:

Listed equity REITs were the top-performing asset class overall in terms of net total returns over this period. Private equity had a higher gross return on average than listed REITs (13.31 percent vs 11.82 percent) but charged fees nearly five times higher on average than REITs (238.3 basis points or 2.38 percent of gross returns for private equity versus 51.6 basis points or 0.52 percent for REITs). As a result, listed equity REITs realized a net return of 11.31 percent vs. 11.10 percent for private equity. Net returns for other real assets, including commodities and infrastructure, were 9.85 percent on average. Net returns for private real estate were 7.61 percent, and hedge funds returned 4.77 percent. On a net basis, REITs also outperformed large cap stocks (6.06 percent) on average and U.S. long duration bonds (8.97 percent).

Many plans could have improved performance by choosing different portfolio allocations. CEM used the information on realized net returns to estimate the marginal benefit that would have resulted from a one percentage point increase in allocation to the various asset classes. Increasing the allocations to long-duration fixed income, listed equity REITs and other real assets would have had the largest positive impacts on plan performance. For example, for a typical plan with $15 billion in assets under management, each one percentage point increase in allocations to listed equity REITs would have boosted total net returns by $180 million over the time period studied.

Allocations changed considerably on average from 1998 through 2011. Of the DB plans analyzed by CEM, public pension plans reduced allocations to stocks by 8.5 percentage points and to bonds by 6.6 percentage points while increasing the allocation to alternative assets, including real estate, by 15.1 percentage points. Corporate plans reduced stock allocations by 19.1 percentage points while increasing allocations to fixed income by 10.5 percentage points (consistent with a shift to liability driven investment strategies), and to alternative assets by 8.6 percentage points. For the DB market as a whole, allocations to stocks decreased 15.1 percentage points; fixed income allocations increased by 4.3 percentage points; and allocations to alternatives increased by 10.8 percentage points. In dollar terms, total investment in alternatives for the 300 funds in the study increased from approximately $125 billion to nearly $600 billion over the study period.

The study’s author commented on his findings in a press release:

“Concern about the adequacy of pension funding has focused attention on investment performance and fees,” said Alexander D. Beath, PhD, author of the CEM study. “The data underscore that when it comes to long-term net returns, costs matter and allocations matter.”

[…]

“Many pension plans could have improved performance by choosing different allocation strategies and optimizing their management fees,” Beath continued. “Listed equity REITs delivered higher net total returns than any other alternative asset class for the fourteen-year period we analyzed, driven by high and stable dividend payouts, long-term capital appreciation and a significantly lower fee structure compared to private equity and private real estate funds.”

Read the study here.

How Does Implementation Cost Affect Private Equity Performance?

graphs and numbers

A recent paper in the Rotman International Journal of Pension Management analyzes the costs and performance of private equity investments of large public pension funds.

There were a few interesting findings, but the authors admitted that the “most interesting” was how drastically implementation style affects performance.

The paper finds that “higher-cost implementation styles resulted in dramatically reduced net performance”.

But a larger problem is that this cost isn’t often adequately reported in financial statements.  Further analysis from the paper, titled “How Implementation Style and Costs Affect Private Equity Performance”:

Our findings confirm those of other CEM research indicating that the highest-cost implementation styles have the worst net returns. We believe that since costs have such a significant impact on performance, fund managers should understand the true costs of investing in private equity. However, CEM experience indicates that costs are underreported in the financial statements of many funds. This is unfortunate, because what gets measured gets managed, and what gets poorly measured gets poorly managed. This underreporting is not intentional. In fact, the accounting teams of many funds believe they are reporting all costs.

The four most common reasons that private equity costs are underreported are the following:

• Accounting teams often rely on capital call statements to collect management fees. Yet these statements often show management fees on a net basis, whereby the management fee owing is offset by the LP’s share of transaction and other revenues (commonly called rebates) generated and kept by the general partner (GP). Therefore, accounting teams have no record of their share of the gross management fee paid to the GP.

• The repayment of management fees before the carry has been paid is treated as a reduction in cost. This is an accounting shift; no money is coming back. For every dollar of repayment, there is a dollar of carry.

• Carry (e.g., performance fees) is excluded.

• For FOF LPs, the costs of the underlying funds are excluded. The underreporting in financial statements is material. For example, the cost of private equity LPs is frequently reported to be less than 0.70% by funds’ financial statements, whereas Dutch funds that are beginning to collect and report all private asset costs are reporting a median of 3.03% (0.12% internal monitoring costs + 1.66% management fees + 1.10% carry or performance fees + 0.15% transaction fees. For a fund with US $5.0 billion in private equity assets, the difference between 0.70% reported and 3.03% actual represents US$116 million in costs.

There’s much more analysis available in the full paper, which can be read here.

Some Private Equity Firms Want More Opacity In Dealings With Pension Funds

two silhouetted men shaking hands in front of an American flag

Private equity firms are growing uncomfortable with the amount of information disclosed by pension funds about their private equity investments.

PE firms are cautioning their peers to make sure non-disclosure agreements are in place to prevent the public release of information that firms don’t want to be made public.

Stephen Hoey, chief financial and compliance officer at KPS Capital Partners, said this, according to COO Connect:

“We had correspondence with a municipal pension fund relating to the Limited Partner’s inquiry regarding the SEC’s findings from our presence exam. We objected to our correspondence with the LP of matters not relating to investment performance including notes taken by the LP representatives being submitted to reporters under the Freedom of Information Act (FOIA). It is our communications with LPs other than discussions about performance metrics that we object to being in the public domain.”

Pamela Hendrickson, chief operating officer at The Riverside Company, said PE firms should know exactly what pension funds are allowed disclose to journalists. From COO Connect:

“GPs should make sure their LP agreements and side letters are clear about what can be disclosed under a Freedom of information request. GPs must comply with any non-disclosure agreements they have with their portfolio companies and information provided under the Freedom of Information Act should be restricted to ensure that the GPs remain in compliance,” said Hendrickson.

It’s already very difficult for journalists to obtain details and data regarding the private equity investments made by pension funds.

But PE firms are worried that the SEC will crack down on fees and conflicts of interest:

The SEC has recently been questioning private equity managers about their deals and fees dating all the way back to 2007. There is speculation the US regulator could clamp down on private equity fees following its announcement back in 2013 that it would be reviewing the fees and expenses’ policies at hedge funds amid concerns that travel and entertainment costs, which should be borne by the 2% management fee, were in fact being charged to end investors.

“The SEC is taking a strong interest in fees, and this has become apparent in regulatory audits as they are heavily scrutinising the fees and expenses that we charge. Following the Bowden speech, we received a material number of calls from our Limited Partners whereby we explained our fee structure and how costs were expensed accordingly. We also pointed out that our allocation of expenses was in conformity with the LP agreements, which is the contract between the General Partner and a fund’s limited partners,” said Hoey.

COO Connect, a publication catering to investment managers, encourages PE firms to use non-disclosure agreements to prevent the public release of any information the firms want to remain confidential.

 

Photo by Truthout.org via Flickr CC License

The Value of an Investment Policy Statement

stack of papers

Pension funds, both public and private, each have an Investment Policy Statement (IPS). An IPS provides a formal framework for investing the pension fund’s assets, including asset allocation targets and investment objectives.

But what are the values of having such a statement? A recent paper by Anthony L. Scialabba and Carol Lawton, published in the Journal of Pension Benefits, dives deep into that question.

Regarding the value of the statement, it can be used to show that trustees are indeed acting as “prudent investors”. From the paper:

With regard to the duty of prudence, conduct is what counts, not the results of the performance of the investments. An IPS can show that a prudent investment procedure was in place. In addition, an IPS can protect plan fiduciaries from inadvertently making arbitrary and ill-advised decisions. The directions outlined in the IPS can provide the fiduciaries with confidence in bad economic times that they made sound investment decisions in accordance with the plan sponsor’s or administrator’s intentions.

An IPS can also be a good communication tool, both for plan participants and for trustees:

An IPS can enhance employee morale in providing clear communication of the plan’s investment policy to participants. A plan sponsor can post a plan’s IPS on the Internet to provide participants with helpful insight into how the plan’s investments are chosen and maintained. This can reassure employees and encourage participation because they know that the investment fiduciaries have a sound investment structure in place. In addition, an IPS can enhance the morale of management if its members serve on the investment committee of a plan, as they are given guidance by which to judge their decisions and performance.

The authors also note that having a strong IPS – and sticking to it – can translate into strong investment performance.

There are some drawbacks to IPSs as well. To read about them, and read the rest of the paper (titled “Investment Policy Statements: Their Values and Their Drawbacks”), click here [subscription required].


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