That was the unmistakable conclusion from the new strategic investment plan published earlier this month by the Pennsylvania State Employees’ Retirement System (PA SERS). The $27.6 billion fund plans to nearly cut in half its overall allocation to alternative assets in the next decade. Of that, venture capital will be the asset class hardest hit, with the fund looking to slash the venture portion of its private equity portfolio from 18% to 10% over the next five years.
For PA SERS, the rationale is that private equity, and venture in particular, represents a high-risk, high-growth strategy that requires money to be locked up for years in illiquid investments. That can be an attractive proposition for a pension with far more contributors than benefit recipients, as those funds have a long-term horizon and have historically generated higher returns on these investments. But today, PA SERS says, its needs are different.
“SERS is a mature fund, with more members receiving benefits than paying contributions,” the report states. “Liquidity is, and must continue to be, a primary concern in the coming years.”
Part of the issue for PA SERS is that it is currently underfunded. As of the end of 2011, the plan had assets valued at $27.6 billion and an accrued liability of $42.3 billion, resulting in an unfunded liability of $14.7 billion.
To help meet its obligations, PA SERS says it is adopting a plan that includes establishing a liquidity reserve, limiting capital commitments to illiquid investments, and whittling down existing fund relationships in its private equity portfolio. It will implement part of the plan over a five-year investment horizon and part of it over a ten-year period, with the possibility of modifications should fiscal or market conditions change.
While the strategic shift sets PA SERS apart from most public pension funds, which have largely not been announcing sharp cuts in alternative asset allocations, its predicament is not unique. The gap between the promises that states have made for public employees’ retirement benefits and the money they have set aside to pay these bills was at least $1.38 trillion in fiscal year 2010, according to a report published last week by the Pew Center on the States.
States are also taking steps to reduce the gap. Between 2009 and 2011, 43 states enacted benefit cuts, increased employee contributions, or both, according to Pew. The most common actions included asking employees to contribute a larger amount toward their pension benefits, increasing the age and years of service needed before retiring, limiting the annual cost of living increase and changing the formula used to calculate benefits.
For PA SERS, which had 107,000 active members and 115,000 retirees and beneficiaries at year-end, the restructuring is similar to the way 401K plan administrators advise workers to shift their investments from higher to lower risk portfolios as they near retirement age. Broadly, the fund says it will shift away from its legacy “endowment model,” which had significant allocation to illiquid investments, and toward “a more liquid, total return strategy.” At year-end 2011, PA SERS estimates that about 34% of its fund was not liquid and was locked up for as long as ten to twelve years. Approximately 20% of the fund offered liquidity between one and three years, while less than half the fund was liquid.
Over the next five years, the pension plans to whittle alternative investments from 30% of assets (currently $7.6 billion) to 24% and in ten years to 16%, plus or minus 5%. Excluding non-core real estate, the pension fund plans to reduce its alternative assets allocation to 21% in five years and 14% in ten years.
However, it will continue to invest in alternatives. To increase vintage year diversification, improve returns and reduce cash flow volatility, the plan establishes a $500 million per year commitment limit to funds that require capital commitments that extend beyond five years.
PA SERS says its current alternative investments portfolio includes a number of “legacy funds” that will not remain in the fund going forward. In the future, PA SERS will emphasize relationships with the top performers in the current portfolio. As for venture, the report puts it like this:
“Venture capital – which presents the largest challenge for AI rebalancing – will be actively managed to reduce exposure and reallocate capital from inferior funds to higher quality managers.”
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