Public Pensions Explore Alternative Models of Investing
December 8, 2020 — Boston
Plan sponsors adopt direct investing and strategic partnership models to curb costs and attain greater control
Overly optimistic investment return assumptions have caused government pension plans to consistently underestimate future contribution increases required to keep plans adequately funded. As governments are strained by falling tax receipts and balanced budget requirements, and as many governments direct spending to COVID relief measures, pension funds could see a stream of revenue shrink in the years to come, according to The Cerulli Report—North American Institutional Markets 2020.
Since 2000, the state and local defined benefit (DB) plan channel has derived over half (55.1%) of its revenue from investment returns. Government contributions are the second-largest source of revenue for public pension funds (32%), followed by employee contributions. “Although investment returns are the largest source of revenue over time, they can be extremely volatile in any specific year,” says James Tamposi, senior analyst. “In the absence of investment returns, public plans increasingly rely on contributions.”
With government contributions likely falling short this year, and the Federal Reserve maintaining low rates, many plan sponsors will likely focus efforts on securing alternative sources of yield, such as private equity. Institutions that have large enough private investment portfolios may pursue different models of investing, including direct investments or co-investments, to achieve certain long-term objectives. By taking on investment responsibilities, institutions attain greater control over their portfolios and generally curb costs but also invite additional reputational risk.
Institutions that look for greater control over their investments but want to stop short of full-scale insourcing may consider collaborative strategic partnerships. Generally, this model entails both a manager and an investor participating in the investment decision-making process. It offers many of the same benefits as full insourcing, but the institution can still leverage an asset manager’s resources to either create extensions of their own internal investment staffs or to run experimental portfolios meant to test strategies or achieve objectives. Managers attract a source of seed capital and are able to test certain ideas through these relationships.
Among institutional channels in North America, strategic partnerships are most popular among public pension funds, as they maintain large asset pools and are generally return-oriented (as opposed to liability-oriented). A similar channel, and new to Cerulli’s coverage, is sovereign wealth funds, including the Alaska Permanent Fund and the Texas Permanent School Fund. As these investors look to build long-standing relationships and negotiate better terms with their managers, engaging them at the partnership level may lead to long-term alignment.
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These findings and more are from The Cerulli Report—North American Institutional Markets 2020.