Chairman Trumbull, members of the committee, thank you for the opportunity to offer our brief analysis of House Bill 971 and expanding Florida Retirement System (FRS) Pension Plan investing into alternative assets.
My name is Steven Gassenberger, and I serve as a policy analyst for the Pension Integrity Project at Reason Foundation, a national 501(c)3 public policy think tank. Our team offers pro-bono consulting to public officials and stakeholders to help them design and implement policy solutions aimed at improving plan resiliency and promoting retirement security for public employees. We have played a technical assistance role in major retirement system reforms in states like Texas, Michigan, Arizona, Colorado, South Carolina, and New Mexico since 2015.
Regarding House Bill 971 authorizing the State Board of Administration (SBA)—which manages the Florida Retirement System Pension Plan trust fund—to expand their holding of alternative assets from 20% to 30%, we are not taking a position on House Bill 971. Rather, this testimony is intended to contextualize the underlying logic behind, and implications of, the investment class expansion based on our analysis of the FRS data. To mitigate the implications of HB 971, we highlight two opportunities before legislators to build on the legislation in a way that ensures the FRS Pension Plan’s long-term resiliency and solvency.
Florida Retirement System Investment at a Glance
- The FRS Pension Plan trust fund holds nearly $200 billion in assets, making it one of the largest investors in the world.
- According to the latest FRS reporting, historic post-pandemic market gains in the 2021 fiscal year resulted in private rquity investments returning 67.93%, followed by global equity with 41.78%, strategic investments with 17.14%, real estate with 8.58%.
- According to SBA Investment Reports, since 2013, the FRS Pension Plan trust fund has spent over $250 million in alternative asset management fees and commissions each year, most recently spending nearly $467 million in FY 21.
- Lowering the artificially high investment return bar for SBA and requiring fee reporting broken down by limited partners would build on House Bill 917 and give future members and taxpayers a more resilient FRS Pension Plan trust fund.
What Are Alternative Assets?
Alternative assets are investments that fall outside traditional cash, publicly traded stocks, and bonds. Commonly, alternative investments take the form of shares in limited partnerships, such as with private equity funds. As a statutorily protected fund worth nearly $200 billion, the Florida Retirement System is one of the largest institutional investors globally and, along with other state-level public pension systems across the country, is considered a major source of capital for alternative investment providers.
Why Would the SBA Seek to Expand its Alternative Asset Holdings?
Globalization taking hold of the world economy began the shift from high bond yields to today’s low-yield environment, pushing fund managers away from safe fixed-income sources to more exotic assets with increased potential upside.
According to the latest SBA annual investment report, private equity has been the highest performing asset class for three of the past four years for FRS. In the same report, SBA classifies private equity assets as having the greatest expected future returns along with the highest annualized risk, followed by global equities and hedge fund assets.
With an investment return assumption set at 6.8% and low-risk bonds yielding less than 4%, the SBA wants to double down on success by moving more of the FRS investment portfolio to high-risk, high-reward-style alternative assets. That logic is used widely by public pension plans throughout the country because many, like FRS, remain underfunded by billions of dollars and are seeking higher risks in hopes of avoiding the fiscal pain of higher contributions. Those missing funds need to be made up somehow. Florida House Bill 917 suggests the SBA be allowed to try its hand in the alternative asset market to make up that difference over time.
Concerns with Expanding Alternative Investments
Ask a group of public pension investment managers if a portfolio full of alternative assets is as safe as a classic large-cap stock and bond mix and odds are some will say yes, others no, and some will say it depends on your investment goals. Calling an investment “safe” implies a guarantee that no investments can claim outright, but traditional fixed income assets like U.S. Treasury bonds come close. Returns on bonds and large, publicly-traded stocks are what sustained large public pension systems like the FRS Pension Plan for generations without the need for unexpected infusions of public funds to close pension funding gaps.
Until the mid-1990s, Treasury bond rates were well above the FRS Pension Plan’s assumed rate of investment returns used by plan actuaries to calculate the cost of constitutionally protected retirement benefits until the mid-1990s. The FRS Pension Plan then began slowly drawing down its surplus, which totaled $13.5 billion in 2000 until the 2008 financial crisis flipped the fund from having a surplus to being underfunded.
The FRS Pension Plan historically assumed an investment return rate as high as 8%, before lowering the assumption to 7.75% in 2004. The plan adjusted the investment return rate assumption routinely throughout the years to reach the current 6.8% for 2022.
With the average FRS market valued returns between 2001 and 2020 barely reaching 5.6%, it would seem that investment market changes over the last two decades have left SBA managers with an outdated and artificially high investment return bar to exceed. The results have seen SBA investing more of the FRS Pension Plan trust fund into assets that they hope will not only meet expectations but greatly exceed expectations to make up for years of underfunding.
That kind of actively managed asset comes with management, administrative, and performance fees that can drain hundreds of millions from the FRS Pension Plan trust fund. Such hefty fees are not inherently bad for the Florida Retirement System if they result in equally hefty returns for the fund, but just like other investments, there is no guarantee those extra fees will result in returns that exceed those gained by passively managed, much less expensive, assets like index funds.
Currently, FRS is a leader in investment reporting among its peers because it provides details regarding its commitments and returns from limited partners, and reports fees by asset class. Combining those two reports to show which limited partners are receiving funds for little return and which deserve additional commitments increases stakeholder involvement and confidence in the funds’ ability to drive strong investment performance overall.
Building on House Bill 917
Although alternative assets are not inherently harmful to public pension systems, it would be prudent for policymakers to install boundaries around the investment decision-making process as well as provide increased oversight capabilities to the public.
Option #1 – Systematically Reduce the Need for Higher Investment Returns
Because SBA feels that alternative assets are more likely to produce the higher yields necessary to avoid the need for future funding increases—and their ability to eventually achieve this greatly depends on the assumed rate that they must achieve—our first suggested course of action is to continue to systematically reduce the assumed rate of return (ARR) used by the SBA from its current 6.8% set in Oct. 2021 by the Florida Retirement System Actuarial Assumption Estimating Conference.
Option #2 – Increase Investment Cost Reporting Details
Shifting to alternative assets usually involves higher costs, as actively managed private equity and hedge funds tend to demand higher fees for the services. A 2018 report by the Pew Charitable Trusts found pension plans spend at least $2 billion a year on investment fees alone, and FRS is no exception to this trend. Despite efforts to reduce fees through increased in-house investment management, unreported fees such as carried interest (i.e., performance fees) are not addressed in the current SBA reporting on FRS. Performance fees for private equity investments are typically far higher than the ordinary management fees for those assets, and most public pension funds—including FRS—do not report those performance fees.
Improving current fee reporting by adopting a robust investment cost report would directly address the issue of opaque fee reporting by outlining the fees and other expenses the public pension system incurs in the process of managing its portfolio. California’s teacher pension system, CalSTRS, offers a model in this regard. CalSTRS produces a report showing investment costs by type and asset category. An example of the report can be found at resources.calstrs.com.
This report is designed to provide stakeholders with detailed fee data and trends over a four-year period for each asset class and investment strategy. Reporting this ratio analysis to show the cost-effectiveness of the total fund, asset classes and strategies over time provides a quantitative metric to compare costs against the returns generated from those costs.
The retirement benefits of the Florida Retirement System’s members are paid for from net returns and not from gross returns. Since increased investment costs reduce net returns, the system’s fees and expenses should be consistently monitored and managers should be held accountable for the effectiveness of investments relative to the overall growth and resiliency of the Florida Retirement System.
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