Pension Plans and Private Equity

Shooting for the moon?

Is time running out on public pension plans?

The WSJ recently published an interesting article under the title “Retirement Funds Bet Bigger on Private Equity”. The gist of the article is captured in the first sentence, “Government retirement funds are pumping record sums into private equity, defying concerns about risk and cost as they try to plug pension shortfalls.” It seems that many underfunded pension plans, particularly those sponsored by state and local governments, are counting on their increasing allocations to high-return private equity investments to bail them out after decades of inadequate contributions to the pension funds by plan sponsors. This strategy seems to have worked in recent years, most notably in 2021, but can the trend continue? Will PE save the day for underfunded pension plans? Why should we care?

Before we address these questions, let’s review some of the basics concerning both pension plans and private equity:

What are pension plans and why are they important? Simply put, pension plans are legal entities which facilitate the funding and payment of employee retirement benefits by a plan sponsor (the employer) on behalf of plan beneficiaries (current and future retirees). In the US, pension plans come in two basic forms: defined benefit plans and defined contribution plans, which differ in exactly the way their names suggest and are discussed in more detail below. Pension plans play an important role in both the public (government) and private (non-government) employment sectors, with the vast majority of US employees benefitting from some type of employer-provided pension plan. Pension plans are big players in the investment management business, with over $50 trillion of retirement assets under management globally and over $35 trillion just in the US. Pension plans are professionally important to those of us who work in corporate finance or the financial services industry and they are personally important to all of us who must think about the funding of our own retirements. The financial health of US public and private pension plans is critically important to the continued sustainability of our nation’s retiree funding model, which Social Security alone cannot support, and should therefore be important to all of us as citizens and taxpayers.

What are defined benefit plans and how do they work? Defined benefit plans promise employees an agreed amount of future retirement income, typically linked to salary, age and length of service and adjusted for inflation. These retirement benefits continue for the life of the retiree (and his/her spouse), with no residual amount owing to the retiree’s estate. Plan benefits are paid out of plan assets contributed by the plan sponsor (the employer) and the funds generated by the investment return on past sponsor contributions. Employees accept lower cash pay during their working years in exchange for this promise of continued income to be paid for life during retirement.

We can think of a defined benefit pension plan as a form of employee retirement income insurance provided and paid for by the employer. With an active defined benefit pension plan, the obligation to make future retirement payments remains with the plan and plan sponsor rather than being transferred to an insurance company, as would be the case if the employer terminated its plan and purchased annuities for the benefit of current and future retirees. And so the continued financial health of the pension plan and the plan sponsor are of great interest and importance to both current and future retirees.

The financial risk associated with defined benefit pension plans—the risk that plan assets will not be sufficient to fund all plan liabilities—results primarily from uncertainties associated with the amount and timing of future benefit payments, the investment performance of plan assets over time and the amount and timing of future employer contributions. These risks can all be quantified and accounted for by actuaries and other professionals, but the future remains uncertain and so we should consider the current reported funding status of pension plans to be at best an informed estimate subject to unexpected and significant change over time.

The financial risk of defined benefit pension plans is borne in the first instance by the pension plan itself, in the second instance by the sponsoring employer (who must top up its contributions if the plan fails) and only in the final instance by the employees and retirees (if both the plan and the employer fail to make payments and are declared insolvent). US pension plans also benefit from a form of insolvency insurance provided by the Pension Benefit Guaranty Corp (PBGC), which is itself underfunded according to the GAO.

What are defined contribution plans and why are they so popular? In contrast to defined benefit plans, defined contribution plans do not promise employees anything in the way of future retirement benefits and they are funded directly by employees (perhaps with an employer match-funding of some amount). With a defined contribution plan—either an Individual Retirement Account (IRA) or company-sponsored 401k Plan—employees set the amount and timing of their own periodic contributions, select and manage their own investments, and determine the amount and timing of retirement withdrawals, largely at their own individual discretion.

With defined contribution plans, the individual owners of segregated retirement investment accounts bear all of the associated financial risk themselves rather than sharing this risk with the employer and other plan participants (as is the case with defined benefit plans). If the individual owner of an IRA or 401k account does not contribute enough money during his working years, or the investments he selects perform poorly, or he lives to be 100 and simply runs out of money, too bad. On the other hand, if everything goes well over time the financial benefits will accrue solely to the individual retirement account owner and after his death to the beneficiaries of his estate.

Pension plan pros and cons. We can think of defined benefit plans as “socializing” (or “pooling”) retirement income funding and benefits risk and defined contribution plans as “privatizing” (or “individualizing”) these risks. One approach is not necessarily better than the other; they are just different and will appeal to different people with different values who may be situated differently or at different points in time. And in the US retirement system, both types of plans feature prominently along with Social Security, another form of socialized or pooled retirement program.

Over 90% of US public sector workers and about two-thirds of US private industry workers are covered by some form of employer-sponsored retirement plan. The vast majority of private sector employees have access only to defined contribution plans, whereas government workers are more likely to have access to defined benefit plans or to both types of plans. Part-time workers are generally not eligible to participate in employer-sponsored retirement plans, but they do contribute to and benefit from Social Security. Retirement plan participation rates are generally greater among higher-paid employees, with 90% participation for the top quartile of earners but under 50% participation for the bottom quartile. The lower participation rates (and contribution amounts) among low earners is evident even in retirement plans with employer-match funding, resulting in sizable opportunity costs borne by those who can least afford them and further burdening our Social Security system. Employers who require employees to actively “opt out” of retirement plans generally see higher employee participation rates than do those who require employees to “opt in”, an interesting example of applied behavioral economics discussed in the Thaler and Sunstein book, Nudge, which I can recommend to those of you interested in this field.)

As noted above, defined benefit plans are now concentrated primarily in the public and unionized sectors of the US economy. Almost 85% of public sector employees are covered by defined benefit plans, but in the private sector this number falls to 15% (mostly unionized employees). Many employees like defined benefit plans because the promised benefits are often generous and the structure of the plans shifts funding risk to the employer (and ultimately to the taxpayer in the case of many public plans). Private sector employers generally prefer not to offer defined benefit plans, for the same reasons that many employees like them, but are often required to do so for some workers covered by union contracts.

Defined contribution plans are popular with employers because they shift pension funding and benefits risk to the employees, relieving the employer of the uncertainty and liabilities associated with investment plan performance and adverse changes in retiree demographics or in the sponsoring company’s business. Despite this financial risk shifting, many employees like defined contribution plans because they allow the individual participant more flexibility in managing his or her retirement plan contributions, investments and withdrawals, and because the individual participant can benefit from more aggressive or suitable investment strategies than might be deemed prudent for the trustees of a pooled pension plan covering a wide range of employees (from new graduate hires to 90-year old retirees).

What do we mean by pension plan “underfunding”? A pension plan is said to be “underfunded” at any point in time when the assets currently in the plan plus the estimated amount of future contributions and investment returns are deemed to be insufficient to satisfy in full all of the estimated future payments to plan beneficiaries (retirees). Pension plan underfunding is by definition a phenomenon associated solely with defined benefit plans, which commit to make agreed future benefit payments to plan participants independent of the level of plan funding. Defined contribution plans do not work this way; they commit only to pay out whatever assets are in the individual’s plan at the time of future withdrawals and so cannot be deemed to be “underfunded” in this same sense. But defined benefit plans can and do become underfunded, sometimes seriously so, as is currently the case with many state and local government plans.

Pension plan underfunding may result from overly generous retiree benefits commitments, years of inadequate employer contributions, poor investment performance, unexpected changes in retiree demographics or a combination of these and other factors. Pension underfunding seems to be particularly prevalent in state and local government plans, where the plan sponsors often find it easier to make future benefits commitments to employees than to raise revenues (taxes) and fund the plan properly. But even well managed plans can become underfunded due to unanticipated developments in the financial landscape (eg high inflation or a prolonged bear market) or changes in retiree demographics (age, length of service, longevity etc).

How underfunded are US public pension plans? I have had some difficulty finding comprehensive and consistent data to answer this question, but here is what I have come up with. The total liabilities of US pension plans—the estimated present value of the promised future benefits payable to current and future retirees—is about $18 trillion, of which close to 60% ($10tn or so) is attributable to state and local government plans. These are the estimated values of just the plan liabilities, not the current underfunding amounts (ie the difference between the current assets and liabilities). As of year-end 2019, US state and local pension plans were collectively underfunded by 30% or so, meaning the market value of their assets at that time equalled only 70% of the present value of their liabilities. And the funding level in some states was much worse, with the state plans of Kentucky, New Jersey and Illinois underfunded by 60-70%.

But we should take these funding estimates with a big pinch of salt. Estimating the amount and timing of future benefit payments is quite complex and the discount rate used to convert these estimated future payments into present value dollar terms is often suspect, with big implications for required contributions by the plan sponsors. If we were to discount the estimated future plan benefits payments (which are themselves uncertain) at the low AA corporate bond yield (currently 2% or so), this would generate high PV liability estimates and low required sponsor contribution amounts. But if we were to discount future benefit payments at a much higher rate equal to the plan’s estimated return on plan assets, this would reduce substantially the estimated plan liability as well as the amount of required sponsor contributions.

As you might expect, many state and local pension plans currently assume relatively high future rates of return, generally in the range of 6.5-7.5%, which has the result of reducing the estimated pension liability and underfunding amount as well as the required amount of future sponsor contributions. And if these plans are substantially underfunded even with these high assumed future investment returns, the situation would be far worse if the discount rates were lowered by even small amounts. [Note here that an assumed blended rate of return of 7% on total plan assets implies compounded annual returns of 10% or more for that portion of the plan invested in equities. This may not seem high relative to the recent performance of the US stock market, but it is very high relative to long-term historical returns and to the future returns implied by the high current valuation of the US stock market.]

Pension plan funding levels are not only imprecise they can also change rapidly, particularly when we experience big moves in financial market conditions, as we have witnessed on numerous occasions in recent history. During the financial crisis in 2008, for example, pension plan funding levels dropped precipitously due to the collapse in stock prices (which lowered asset values) and the big drop in bond yields (which increased the PV of future pension liabilities, offset only partially by the increased value of the bonds held in the pension portfolios). And this situation was not improved by the subsequent economic recession, which reduced the revenues of the plan sponsors (including tax revenues for public sponsors) and made it tough for the plan sponsors to increase their pension contributions even if they had the will to do so (which they generally did not).

Something similar happened during 2020 with the covid pandemic, but the financial impact was less pronounced and shorter-lived due to the massive injection of liquidity and fiscal stimulus provided by the US government and the quick rebound of the stock market. By the end of 2021, the public pension plan funding situation had improved markedly due in large part to the exceptional performance of the US stock market (up 25% for the year) and other equity-linked asset classes (most notably private equity, up 50%). Of course most public pension plans hold only a portion of their total assets in public and private equities, typically around 50%, and so the total realized return on plan assets was diluted by the much lower return on fixed income securities. But all in all 2021 was still an outstanding year for investors with exposure to the stock market, including public pension plans, even if it wasn’t nearly good enough to bail out the likes of Illinois, Kentucky and New Jersey.

The role played by private equity. Public and private pension funds and other institutional investors (eg university endowment funds) have for many years been big investors in a variety of “alternative assets”, including private equity. The pioneer in this regard was David Swenson, who managed the endowment fund at Yale for 35 years and who died early last year at the age of only 67. His book, Pioneering Portfolio Management, is an investment management classic and one that I recommend to all students pursuing careers in this field. Swenson demonstrated that large investment funds with long time horizons and manageable liquidity needs can generate above-average portfolio returns by increasing their investment allocations to certain illiquid, high-risk and high-return asset classes like private equity and venture capital. Because of the wide disparity in realized returns among fund managers in these asset classes, however, Swenson understood that it is critical to invest only with the top performing managers, meaning not just those who performed best in the past but those who will do best in the future. This is obviously much easier said than done, but Swenson demonstrated that it was possible (if not easy) to do both and to do so consistently over long periods of time.

Very few pension or endowment fund CIOs have matched Swenson’s 35-year investment track record however. During the period when Swenson was in charge (ending in 2020), the Yale endowment generated a 13.1% compound annual return, which exceeded the Cambridge Associates peer group mean by 3.4 percentage points a year and beat the traditional 60/40 equity/bond portfolio by 4.3 percentage points. Swenson’s stewardship of the Yale endowment—with its large overweight allocation to PE and other alternative assets—generated over $45 billion of total investment returns and $36 billion of value added relative to the CA mean performer. Not all of this incremental return was due to private equity, of course, but much of it was and the lesson was not lost on others in the fund management world, many of whom are still scrambling to catch up.

As noted in the WSJ article cited above, the amount of public pension fund assets invested in private equity has increased markedly in recent years, due in large part to the outperformance of this asset class (particularly in 2021, when PE returned over 50%). On the back of this exceptional performance, a number of pension plans have increased their PE allocations even further, in some cases from 10% to 20% of total assets, in the hopes of continued PE outperformance in the future and an improved plan funding position made possible without the necessity of large increased contributions by the plan sponsors.

PE fund performance, past and future. PE funds have on average generated excellent investment returns over the past decades. Over the past 20-years (through mid-2020), PE funds on average generated compounded returns of over 10% per annum (higher if we include 2021’s exceptional performance), substantially outperforming their public equity benchmarks and other categories of alternative assets (including venture capital). And the top-performing PE funds did even better than this, much better in fact. However we should keep in mind that these are realized past returns, not risk-adjusted or expected future returns, and it is fair to say the past performance of PE funds has varied significantly with the time period selected for the comparison and has differed greatly between the top and bottom quartiles of managers.

All of which raises some interesting questions for pension fund trustees to consider as they deliberate their future investment strategies. Will the US stock market continue to generate double digit annual returns in the future, as it has in the recent past? Will PE funds continue to outperform public equities, by how much and how consistently? Will the most underfunded pension funds be able to access the top ranked PE fund managers, those who have demonstrated (so far) a consistent ability to deliver exceptional absolute and relative returns?

I don’t know the answers to these questions, but I think we all have reason to be skeptical of PE fund performance going forward as well as the magnitude of the contribution that increased PE allocations will likely make to pension plan funding levels. In part this is due to the extremely high current valuation of all equities, public and private. And in part it is due to the exceptional performance of PE in 2021 (up 50%), which cannot possibly continue and may well demonstrate some serious and painful mean reversion in the coming years. And the top PE fund managers now manage so much money—the top three firms now have AUM of over $1 trillion (not all of it in PE strategies)—that it will likely be increasingly hard for them to replicate the performance of prior decades let alone that of 2021.

My conclusions? As usual, I have more questions than answers but some things do seem clear to me. There is no doubt that many public pension plans are severely underfunded, even after the outstanding performance of their public and private equity investments in 2021. And these reported plan funding levels are likely understated, perhaps significantly so, due to the high future investment returns assumed by the plan trustees. Finally, the outlook for inflation, interest rates and economic growth in the US remains highly uncertain, and seems to be changing rapidly, which could have significant although uncertain implications for future capital market conditions, investment returns and pension plan funding levels.

I am a big fan of PE, but I think this asset class has been over-hyped, certainly for the average or below-average fund manager. And I am a firm believer in the phenomenon of mean reversion, to which the PE asset class and even the top PE fund managers seems vulnerable in future years. Far be it from me to throw cold water on the PE party currently taking place in the pension plan world, but I don’t see increased PE allocations as the silver bullet for solving the underfunding problem among public pension plans. The funding hole is simply too big, and the financial strength of pension plan sponsors too weak, for even exceptional future PE performance alone to solve.

I don’t know what the real solution is to the public pension plan underfunding problem, but it seems to lie more with reduced future benefit payments and increased sponsor contributions than it does with asset allocation or accounting gimmicks. If I had to predict how this will play out, I would guess that the pension trustees will continue to employ aggressive accounting to disguise their plans’ true funding status while hoping for continued high investment returns to bail them out. And this will happen until we have civil servants, policemen and teachers rioting in the streets because their retirement checks have finally bounced.

At which point our elected officials will lead us all in a rousing and patriotic chorus of Happy Days are Here Again.

Links:

Retirement Funds Bet Bigger on Private Equity, WSJ 1.10.2022

State of Pensions 2021, Equable.org 9.23.2021

The State Pension Funding Gap, Pew 9.14.2021

State Pension Funds Reduce Assumed Rates of Return, Pew 12.19.2019