Public Pension Funds An Overview October 2008 CONTENTS Introduction 1 Types of Retirement Plans 1 Pension Fund Structure 2 Specific Issues Facing DB Plans 3 Asset Allocation 4 International Equit 5 Corporate Governance 6 Conclusion 6 Introduction While the financial press often focuses on the growth and evolution of the market towards alternative investments (investments outside of stocks, bonds and cash) and the players that comprise this market, such as hedge funds and private equity funds, a key player within both the traditional and the alternative investment space is often overlooked: pension funds. In this document, we will examine the shift in types of retirement plans within the U.S. and the change in asset allocation and investment strategies that public pension funds have undertaken in an attempt to resolve this funding shortfall. Types of Retirement Plans There are two predominant forms of retirement plans: Defined Benefit Plan - A defined benefit ( DB ) plan guarantees the participant a specific monthly benefit upon retirement. The fund is professionally managed, and the risk of investment decisions is entirely under control of the company. The participating member is not required to make investment decisions. Defined Contribution Plan - A defined contribution ( DC ) plan provides an individual account for each participant. The participating member is responsible for deciding which investments are incorporated within the retirement portfolio. There are no guarantees of a specific monthly benefit upon retirement. Examples of defined contribution plans include 401(k) plans, 403(b) plans, employee stock ownership plans and profit-sharing plans. It should be noted that DB plans have been on a decline in the U.S. since the mid-1980s. Corporations lead the way in this transformation due to the lower corporate exposure of DC plans. This movement has made its way into public pension systems as well, with Alaska, Michigan, and the District of Columbia closing their DB plans and offering new hires DC plans. Primary differences between the two plans: 1) Who is responsible for the ultimate investment decisions? 2) Is a distribution amount assured to the plan participant?
Pension Fund Structure Most public pension funds have a similar organizational structure. An example of a typical public pension fund structure is below: Board of Directors: The members are a mixture of political appointees representing the given state s citizens and the pension fund constituency. A sample composition of a state pension board 1 : a. Voting - ten members, comprised of state legislators and other members of the state retirement system b. Non-Voting five members, comprised of investment professionals who inform and educate the board on investment trends and economic theory Operational Staff: The Chief Investment Officer ( CIO ) of the fund holds one of the voting seats on the board of directors. The CIO s staff consists of portfolio managers and research analysts in varied areas of expertise (domestic and international equities, domestic and international fixed-income, real estate, private equity, hedge funds and other alternative assets). Sub-advisors and Consultants: These parties provide specialty services to the pension fund that are currently unavailable through the combined expertise of the full-time operational staff, or for services that are more cost-efficient to outsource, such as fund management, back-office facilities and trade execution, risk analysis/mitigation, etc. According to an examination of the 2007 Comprehensive Annual Financial Reports ( CAFR ) for 80 U.S. public pension funds performed by the Depositary Receipt ( DR ) Division of The Bank of New York Mellon the fund management process is as follows: - Internal fund management 20 pension funds - External (sub-advised) fund management 39 pension funds - Internal/external fund management 21 pension funds The final category often had a split between internal investment personnel, acting directly as fund managers on domestic equity and domestic fixed-income portfolios, while international and alternative asset fund management was sub-advised by external experts in these respective fields. 2 1 Raising the Stakes, Institutional Investor, February 2008, Pensions Section, p. 38.
The chart below highlights the top investment managers used by the public pension fund industry as sub-advisors for international equity funds, based on Bank of New York Mellon analysis. Figure 1: Top External International Money Managers for Public Pension Funds (80 Public Pension Funds Analyzed) # of State Pension Funds Using this Manager 20 18 16 14 12 10 8 6 4 2-12 Acadian 10 Alliance Bernstein 13 Barclays Global 18 Capital Guardian 14 Mondrian Data from 2007 CAFR Pension Fund Annual Reports as of June 2008 Note: Outside of this group of six managers, the next highest rated external mgr. starts at six pension funds. 13 SSGA Specific Issues Facing DB Plans For DB plans, which promise a set annuity to participants upon retirement, two issues have had a noteworthy impact on the direction of current and future asset allocation trends: underfunding underperformance The combination of underfunding and underperformance, declining ratios of active employees to retirement beneficiaries, and cost-of-living adjustments have created a situation of significant concern for members of the baby boomer generation approaching their retirement years. The unfunded balance for state and local pension plans is estimated to be anywhere between $200 to $700bn. 2 States have several options to alleviate the issue of underfunding for DB plans: raise state and local taxes to cover shortfalls; sell government-owned assets in an effort to cover the shortfall; decrease administrative costs of running the state pension fund systems; increase portfolio performance through re-allocation of assets (by adding assets with higher risk/ greater possible return). 2 Issues Facing State And Local Government Pensions, Economic Perspectives, 3Q 2007, p.2. 3
The re-allocation of fund assets into higher alpha (the return on an investment not attributed to the rise of the market in general) generating investments is a key focus of this document, as in recent years, international equities have outperformed domestic equities and have been a logical choice for portfolio diversification. However, it can be observed that the motivation for asset re-allocation lies in the inherent difficulties with implementing the previous options. For example, a local government experiencing an environment of economic decline will generate less taxable revenue. If few attractive assets are available to sell, and the proceeds to cover a shortfall inadequate, the pension fund must either attempt to decrease the costs of running the fund or reallocate the fund s assets into higher-return (and often higher-risk) investments. Asset Allocation Historically, U.S. pension funds have focused on two asset classes: Fixed Income - domestic U.S. fixed income (treasuries, municipal debt, and corporate debt) Equity - domestic U.S. equity (company stock and exchange traded corporate securities) However, this has undergone a shift in recent years, as pensions have re-allocated their assets in an effort to generate higher returns. Based on our analysis of target asset allocations listed in the 2007 CAFR reports of these 80 public pension funds, current asset allocation is as follows (as a percentage of total assets) 3 : Domestic Equity International Equity Domestic Fixed Income International Fixed Income Real Estate Alternative Investments Mminimun Value: 20.6% 6.4% 8.0% 0.9% 1.0% 0.5% Maximum Value: 62.5% 28.9% 100.0% 16.7% 18.0% 19.3% Average: 41.4% 19.3% 25.6% 4.6% 7.2% 7.9% Median: 42.0% 20.0% 23.9% 3.0% 7.0% 7.0% Mode: 42.0 20.0% 22.0% 3.0% 4.0% 6.0% Standard Deviation 8.3% 4.7% 11.1% 3.8% 3.5% 4.3% Evident within the data is the fact that domestic equity maintains a dominant position within the current asset allocation of pension funds. Yet it is worthwhile to note that the continued underperformance of U.S. equities relative to other international markets (particularly emerging market countries) and high returns from alternative investments (hedge funds, private equity funds, real estate, and commodities) have demonstrated the need for diversification beyond domestic U.S. investments to generate ample returns. Pension fund managers now actively lobby for greater independence and a broader investment mandate. Consequently, alternative investments are beginning to lose their alternative designation and entering the mainstream vocabulary for pension funds. 4 3 Public Pension Fund 2007 Comprehensive Annual Financial Reports (CAFR). 4 Ibid.
The public pension funds with the largest investment in the hedge fund industry are 4 : Pennsylvania State Employees Retirement System, $10.6bn California Public Employees Retirement System, $6.2bn New York State Common Retirement Fund, $5.4bn Not only have pension funds sought to increase alpha from investments in hedge funds, but other sources of alternative investment are playing key roles in their asset allocation strategies, such as private equity. Private equity has been a dominant source of advancing the level of return for pension funds. A prime example is the Washington State Board of Retirement s relationship with the private equity firm Kohlberg Kravis Roberts & Co. (KKR), which began with an initial investment on January 1, 1983 of $12,990,000 in the KKR 1982 Fund. The public pension funds from both Washington and Oregon have each been long-term investors in KKR funds with annual returns estimated at 16%. 5 International Equity International equity represents one of the key performance linchpins of effective pension fund portfolio management, addressing the funding concerns of the pension fund industry. A growing list of pension funds have been adjusting asset allocations to a 50:50 split between domestic and international equities (non-u.s. stocks now comprise 55% of global stock-market capitalization 6 ) and joining heavyweights such as: 7 California Public Employees Retirement System ($253.6bn in assets under management [ AUM ]) Florida State Pension Board ($118bn in AUM) Washington State Investment Board ($71.4bn in AUM) Change to Pension Fund Allocations - 2002 to 2007 Domestic Equity Int l Equities Domestic Fixed Income Int l Fixed Income Real Estate Alternative Investments California Public Employees Retirement System -8.6% 3.5% -1.4% 2.1% 0.9% 3.3% Florida Division of Retirement -9.6% 10.5% -2.7% 0.0% 1.9% -0.9% Washington State Board of Investment -9.1% 8.6% -4.7% 0.0% 1.2% 4.6% In addition to fundamental asset allocation changes, domestic equity fund managers have been significantly increasing their requests for pension funds to increase the allocation of DRs within their domestic equity portfolios, to mirror the globalization trends of the financial markets and include foreign companies whose primary revenues come from the U.S. According to Pensions and Investments magazine, roughly 20% to 25% of U.S. institutional money managers have asked their clients to allow them to increase their exposure to ADRs [American Depositary Receipts]. 8 The article also makes the argument that an exposure of 10% of a domestic equity fund s portfolio to DRs would not be considered extreme. 5 Carol J. Loomis, KKR: The Sequel, June 13, 2005, Fortune magazine archives. 6 Douglas Appell, Equity Allocations Shed U.S. Bias, Pensions and Investments, posted December 10, 2007, 6:01 AM EST. 7 Public Pension Fund 2007 Comprehensive Annual Financial Reports (CAFR). 8 Jay Cooper, Domestic Equity Managers Boost Exposure To ADRs As U.S. Recession Looms, Pensions and Investments, posted January 21, 2008, 6:01 AM EST. 5
Corporate Governance Public pension funds are not merely investment vehicles. Some may also play a vital role in corporate governance through the active monitoring of the firms in which they are invested. Some pension funds are better performers than others, just as some of the firms in which they are invested are better performers than others. The level of institutional activism displayed by public pension funds is far from homogenous. Those that have the ability to take a prominent public role tend to have a greater economic incentive to do so as a consequence of the large size of assets under management. Smaller funds tend to be either completely passive or to undertake coalition building with more active funds, whether by voting anonymously with an active fund or by publicly supporting a course of action with others. Institutional activism may also take the form of litigation. The fact that a large number of public pension fund assets are managed externally can result in the delegation of the governance function, whether to the fund s external portfolio manager(s) or to a proxy advisory firm. This attenuation often means that the fund itself may allocate limited internal resources to corporate governance. Where that is the case, funds that place greater reliance on external agents over an intense internal examination at the fund level are more likely to have a diminished level of monitoring and less activism. Contrary to popular sentiment, it is the exception rather than the norm for pension funds to target specific companies. For the most part, pension funds engage in low-cost activities designed to avoid confrontation with management - participating in corporate governance programs, communicating with other institutions regarding corporate governance, or soliciting support from other institutions, all of which serve to establish their presence without being openly activist. Larger funds are able to spread the cost of activism across their asset base, and, due to the nature of their economic stake, they have a greater relative interest to pursue an activist strategy to achieve improved returns. Conclusion International equities are an essential and growing component of the evolving investment strategies of public pension funds as they continue to seek investment opportunities that generate higher returns than traditional domestic-only allocations. DRs allow investors to diversify globally with the same convenience and simplicity as investing in other U.S. securities. Investors are able to receive their dividends in U.S. dollars, and price their portfolio in U.S. dollars, minimizing costly local custody fees and other challenges that come with direct investing in local markets. The Bank of New York Mellon s Depositary Receipt Division is committed to educating the key investment decision makers at public pension funds on the benefits of using DRs for international diversification. As our network of contacts and knowledge of these institutions expands, our goal is to share this detailed intelligence with our issuer clients to facilitate potential investor introductions, increase the liquidity and visibility of our issuer clients DR programs and provide insight on the market activities and investment trends within this substantial segment of investors. 6
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