Senate Bill 483, or the concept of the legislature requiring a report from the largest state-sponsored pension plan regarding their assumed rate of return policies directly spotlights the leading cause of pension debt in Texas.
Public pension systems like the Employees Retirement System of Texas (ERS), for example, rely on contributions from public employees and their public employers—as well as compounding investment returns—over long periods of time to save the necessary amounts needed to pay the retirement benefits promised to generations of public employees.
Over the last 20 years, ERS has gone from 105% funded with a surplus of $867 million to 66% funded with over $14.7 billion in earned, yet unfunded, pension obligations protected by both the state and federal constitutions. According to ERS reporting, deviations from investment return assumptions have been the largest contributor to the ERS unfunded liability, adding $8.43 billion in debt since 2001.
This is because ERS actuaries have historically used an 8% assumed rate of return on investment assets to value the plan and calculate member and employer contribution requirements. In response to shifting market conditions that include negative interest rates, ERS has slowly lowered this important assumption to its current 7% rate, but when the plan has averaged a 5.77% rate of return over the last 20 years, the damage has been done.
Given the fact that investment returns make up nearly a third of ERS contributions each year, when the market does not perform, contributions from taxpayers or members (or both) must increase to keep the plan’s benefit funding on track. When contributions are not increased, plan managers are forced to search for higher yields in the market and they often pursue risky investments to do so.
This reality makes investment transparency crucial to the financial wellbeing of the state.
The Sunset Commission staff identified the need for investment transparency when reviewing the Teachers Retirement System over the summer, leading the Sunset Commission staff to issue recommendation 3.3, which is equally, if not more, applicable to ERS.
In addition to the reporting standards recommended by Sunset staff, it is our opinion that ERS, TRS, would benefit from two annual reports regarding the system’s alternative investment holdings specifically. Both suggested reports below are currently produced by comparable state-sponsored pension systems outside Texas and would not require any additional appropriation from the legislature.
Report #1: Private Equity Portfolio Performance
The Private Equity Portfolio Performance report would make public specific information regarding the private equity holdings of TRS for third-party monitoring and evaluation available to the public. The report takes the form of a simple six-column table populated with the following data points per holding:
- Name of Each Investment Vehicle
- Date of Each Investment
- Amount of Capital Committed
- Amount of Capital Contributed
- Amount of Capital Distributed
- Internal Rate of Return (Annualized Return Estimate on Capital Invested)
This level of transparency is provided by similar sized public pension systems in similar sized states, such as California State Teachers’ Retirement System (CalSTRS). CalSTRS’ publishes a report, which can be found at www.calstrs.com, that lists these data points in a stakeholder friendly format. CalSTRS’ private equity performance report, including the internal rate of return, is maintained internally by CalSTRS and published annually.
Report #2: Annual Investment Cost Report
Shifting to alternative assets usually involve higher costs, as actively managed private equity and hedge funds tend to demand higher fees for the services relative to passively managed assets like bonds. A 2018 report by the Pew Charitable Trusts found pension plans spend at least $2 billion a year on investment fees alone, and TRS is no exception to this trend. TRS administrators have set the system on a five-year plan to reduce fees by over $1.4 billion through increased in-house investment management. However, unreported fees such as carried interest (i.e. performance fees) are not addressed in the recent operational changes set in motion by TRS. Performance fees for private equity investments are typically far higher than the ordinary management fees for those assets, and most public pension funds—including TRS—do not report those performance fees.
An Investment Cost Report directly addresses the issue of opaque fee reporting by directly outlining the fees and other expenses a pension system incurs in the process of managing its portfolio. Again, CalSTRS offers a model, producing a report showing investment costs by type and asset category. An example report can be found here.
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 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.
Excess Value Method
In addition to these two reports, Landmark Partners and the Public Employees Retirement Association of New Mexico recently developed a new data point to help better assess the true value of private equity and other alternative asset investments; it is called the Excess Value Method.
The Excess Value Method calculates, in dollar terms, the performance of managers of private limited partnerships above or below a comparable public investment benchmark, in addition to a multiple or a rate calculation used by some pension funds today. The current carried interest compensation formula, widely used by public pension funds, compensates private limited partners by their absolute return, completely removing any consideration of the risk associated with such an asset. It’s important to understand, in dollars, the performance of a private limited partner of a public pension fund by directly comparing the value gain to the fund in choosing a volatile and less transparent asset like a private equity investment over a public and highly transparent regulated asset like a mutual fund. In a nutshell, the Excess Value Method lets public pension stakeholders know if the juice was worth the squeeze.
Providing data that allows stakeholders to calculate a metric to compare the costs of risky alternative assets against returns generated from those costs is clearly in the best interest of all public pension system stakeholders. There may be a legitimate and clear need for these multi-billion-dollar public pension investment funds to leverage alternative assets to navigate the treacherous waters of global investing as safely as possible, but public pension benefits are paid from net returns, not gross returns or benchmark returns. Since increased investment costs reduce net returns, fees and expenses should be transparent, consistently monitored, and managers held accountable for the effectiveness of investments relative to the overall growth and resiliency of the public pension fund they are meant to support.
The benefits of ERS members are paid from net returns and not from gross returns. Since increased investment costs reduce net returns, fees and expenses should be consistently monitored and managers held accountable for the effectiveness of investments relative to the overall growth and resiliency of ERS as a long-term provider of pension benefits to Texas workers.
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