Pensions’ Cash Crunch Poses Challenge for PE

U.S. pension funds have a cashflow problem: the gap between their income and obligations is the widest it’s been in at least 15 years, prompting some to rethink their approach to illiquid investments such as private equity.

Private equity’s coffers have been overflowing in recent years, in part thanks to pension funds’ appetite for higher-yielding alternative assets. Buyout firms amassed a record $324 billion to invest globally in the first half of 2017, according to Dow Jones & Co.’s research database LP Source.

But their biggest benefactors—pension funds—are battling a snowballing cashflow problem. Even as some pensions pour more money into private equity in the hopes of addressing that problem, others are forced to reexamine their allocations to the asset class, or shift a portion of their pension assets to defined contribution plans that are often less suited to private equity. If private-equity distributions slow, the ability of private-equity portfolios to fund themselves would decline, putting fresh liquidity pressure on pensions to fund capital calls. 

Public pension plans in the U.S. saw their income hole grow at the fastest rate in six years last year, according to data prepared for Dow Jones & Co. by the Center for Retirement Research at Boston College. The gap between their total annual income and obligations jumped by nearly 37% in 2016 to an estimated $37.7 billion, their biggest annual cash hole in at least 15 years, the data showed.

“Even when you include money from income they still don’t have enough to pay benefits,” said Jean-Pierre Aubry, associate director of state and local research at Boston College.

That could spell bad news for alternatives funds, which are heavily funded by public pension plans. Private-equity, hedge fund and other “alternative” investments accounted for 17.6% of U.S. public pension allocations last year, according to Boston College research.

The pension deficit has ballooned since the global financial crisis driven partly by weaker-than-expected returns and an ageing population. Most pension money is locked up in bonds, which have yielded little in recent years due to low interest rates. Volatility in equities and alternatives has brought mixed results. Pension funds have doubled their investments in alternative assets since 2006 but are consequently paying higher fees, “with large funds posting fiscal year gains [total annual returns] of over 12% in 2013 and 17% in 2014, but only 2% in 2012, 4% in 2015, and 1% in 2016”, according to Pew Charitable Trusts. 

To combat negative cash flows, some pension managers are reducing allocations to alternatives or cutting back the amount they invest on behalf of beneficiaries. Others are making more subtle shifts seeking to reduce the cost of managing their portfolios. But all of these moves stand to put pressure on private-equity managers that rely on pension capital.   

“You’ve seen some large public pension funds announce that they’ve pulled back on their private-equity allocations,” said Marc Friedberg, managing director at investment consultancy and investment manager Wilshire Private Markets. “It’s because they’ve judged they’ve had too [many] illiquid assets in the portfolio. Some of those illiquid categories they’re looking at haven’t met their expectations.” 

Liquidating securities

David Eager, interim executive director of the Kentucky Retirement Systems, said the pension fund has stopped making new commitments to private equity and is eliminating illiquid investments from its portfolio. 

“Every month we were having to liquidate securities to make the benefit payments,” he said. “The last thing you want are any significant amount of securities that are illiquid. It restricts your ability to choose the securities you want to liquidate to meet cash-flow obligations.” 

The move was partly in response to speculation that one of its funds, the KER non-hazardous vehicle, would eat through its assets within five years. Mr. Eager said: “The markets were not producing strong returns such as there was negative cash flow that—had it persisted—would have exhausted assets within five years.”

Kentucky Retirement Systems’ net negative cash flow grew to $692 million in 2016, up from negative $597 million, according to its annual statement. 

The State Employees Retirement System of Illinois, which is financed partly by the state of Illinois, also experienced more cash outflows than inflows in 2016, according to its annual report. The plan is severely underfunded and, as a result, is moving towards passive investment strategies, including a plan to exit hedge funds within two years, a spokesman said.

But that hasn’t stopped the pension system’s manager, the Illinois State Investment Board, from committing more capital to private-equity funds. In March alone, its investment committee recommended $130 million in commitments to three separate private-equity and venture-capital vehicles, according to committee minutes. New commitments like these add to the future obligations that the pension system owes to private-equity managers.

As of June 30, 2016, uncalled private-equity commitments in the Illinois pension system’s portfolio totalled $284 million, with another $72 million of outstanding commitments to real assets funds, the state comptroller’s annual report stated.  It added the pension system’s manager, the Illinois State Board of Investment, would fund outstanding commitments by utilising available cash and selling liquid securities in the portfolio as necessary.

The California Public Employees’ Retirement System, meanwhile, plans to reduce the number of external money managers it deals with to 100 by 2020 in a bid cut costs amid widening funding liabilities.

The pension system is exploring a range of options to cut fees, which will involve looking at “how to do private equity differently”, a spokeswoman said. Doing more direct investments is one option, but the pension manager is also considering outsourcing management of some, or all, of its private-equity portfolio.   

Although its funding ratio is far better than the Illinois system, the gap between the value of the California Public Employees’ Retirement Fund assets, the largest of several funds that Calpers manages, and the fund’s total obligation grew to $111 billion as of June 30, 2015, according to the most recent data published by Calpers. 

“The severe economic downturn and financial crisis of 2008-09, the volatility in the market, and changing workplace and worker demographics are the primary drivers for Calpers’ unfunded liability growth,” a spokeswoman said.

Defined contributions

Some public pension funds are tackling their liability issues partly by moving towards less costly “defined contribution” schemes mirroring a similar shift in the corporate sector. Defined contribution, or DC, plans typically involve matching employees’ pension contributions rather than guaranteeing them a pre-determined salary when they retire.

But DC plans pose unique challenges for private-equity firms seeking to tap into them. Because they shift responsibility for investment allocations to individual employees rather than a central investment office, decision making over capital flows tends to be more fragmented, making it tougher for private-equity firms to raise money from them. DC plans must price daily to allow investors to move money easily in and out of them, which creates a structural mismatch with illiquid assets like private equity.

The states of Pennsylvania and Michigan and the City of Detroit are among only a few governments that in recent years have shifted some or all of their public pension assets to defined contribution plans or approved plans to do so going forward. 

The British Venture Capital Association said in a report last autumn that 60% of all public and corporate pension plans in the U.S. are now defined contribution plans versus 18% in the U.K. Over time, Mr. Friedberg said this shift will reduce the money flowing into asset classes such as private equity, “unless they figure out a broader way of including private equity in a defined contribution plan”.

Some firms are trying to accomplish just that. Multi-asset manager Pantheon introduced a private-equity vehicle structured to capture the wider shift to defined contributions in 2014. To enhance the vehicle’s appeal, the firm is testing fee waivers to individual plan-holders unless a profit threshold has been reached. The firm would not specify how much capital  it has raised for the strategy.

In the current environment, strong public equity performance and a robust flow of private-equity distributions that have outpaced capital drawdowns have helped mitigate the pressure that cashflow liabilities put on some pensions. 

But as a higher percentage of the population ages and concerns grow about the ageing of the economic expansion, private-equity firms face a greater likelihood of feeling the pension cashflow pinch more acutely.

Kevin Albert, global head of business development at Pantheon said: “If we don’t have the peak this year, it will be the runner up to 2007 and so it is a time to be more cautious. If you’re committing more money to private-equity funds, everybody should be assuming that within the next few years there’s some sort of downturn.”

During the financial crisis, pension funds were often unable to meet drawdowns because of a slump in returns from their private-equity investments, according Mr. Friedberg.

A similar type of downturn could have an even broader impact, particularly given the wider liabilities that most pensions experience today. Those challenges could be complicated even further if more cities and municipalities seek bankruptcy protection, an option that was all but unheard of in recent decades. In recent years, the city of Detroit and the territory of Puerto Rico have both entered bankruptcy or bankruptcy-like processes and the city of Hartford is weighing it as an option.

Affects of bankruptcies

Exactly how municipal bankruptcies affect private-equity programmes remains to be seen. Liabilities at public pension plans tend to be backstopped by state and local governments and the taxpayers that support them. State and local governments often contribute to their public plans to help those plans meet liabilities.

However, the ability of bankrupt funds to tie up assets in illiquid investments is likely to be limited. At the same time, the public coffers’ capacity or the public’s will to support pension liabilities may also face constraints. Already the one U.S. pension guarantor set up to stem a crisis across the corporate pension world has become increasingly strained, offering a window into potential challenges that could lie ahead for public pension peers.

The federal U.S. Pension Benefit Guaranty Corp., which takes possession of pension assets of failed corporations that can’t maintain retirement plans, said in August that its insurance programme for multi-employer plans is “likely to run out of money by the end of 2025”. Its deficit for that strategy was $58.8 billion in 2016, up from $52.3 billion in 2015, according to its annual report.

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