…Public defined-benefit (DB) pensions leverage the advantages of pooled funds, pooled risk, a long investment horizon, and professional money management to reduce the cost of providing retirement benefits to employees over the long term. Given recent economic shocks and their impact on the status of pension funds, there is increased attention on public sector pension investment management practices. Debate about these practices can be better informed with insights into how the public pension investment process works—a process that is not widely understood…
The following are key highlights:
1. Public pension funds have a clear division of labor for making investment-related decisions. Fiduciary standards apply to each key role in the investment process.
· Nearly all public pension plans are overseen by trustees who bear primary fiduciary responsibility and are also subject to strict ethical standards. Trustees set investment policies with the advice and support of a number of different professionals… a Chief Investment Officer (CIO) who leads the investment unit within the pension fund… Investment consultants who have a deep background in finance and work with staff and the board to help develop and review investment policies. Investment managers who conduct the day-to-day business of managing each asset class portfolio (e.g., domestic stocks or corporate bonds)—buying and selling securities and reporting on investment performance... Actuaries who also play an important role in pension fund investment policy by predicting the cost of future pension benefits and working with consultants and staff to determine that the asset allocation adopted by the Board of Trustees over the long run, combined with adequate contributions, will generate sufficient income to meet pension obligations.
2. Public pension funds have rational and systematic processes for setting asset allocation in a diversified portfolio, estimating expected investment returns, and evaluating investment performance.
· Investment policy begins with an analysis of pension liabilities—how much money will be needed to pay for promised benefits over the long term… Typically, pension trustees adopt an Investment Policy Statement (IPS) that establishes how much investment risk will be tolerated by the fund and sets asset allocation targets, i.e., the percentage shares of the fund total investments assigned to different asset classes, also called the target asset mix…
· The IPS also sets expectations for investment performance in each asset-type portfolio and the fund as a whole. Investment performance targets are tied to benchmarks—usually market indexes, such as the S&P 500 for large company stocks—against which portfolio and fund returns are evaluated. The fund’s expected rate of return on its investments is determined from the target asset mix based on expert consensus on the long-term returns that can be expected in each asset class in light of historical data and current capital market assumptions.
· All pension funds periodically conduct asset allocation studies and/or asset liability modeling to determine if their investment strategy as outlined in their IPS remains appropriate, or needs modification. [Moreover], portfolio performance in each asset class is regularly evaluated against internal benchmarks on a quarterly, annual, and multi-year basis
3. The Board of Trustees of each public DB pension fund determines the acceptable level of risk that is prudent for their plan given its particular circumstances. They then adopt an asset allocation that is designed to maximize returns within the established level of risk.
· During the asset allocation process, pension trustees—with the assistance and advice of staff and consultants— carefully select asset allocations designed to minimize risk and maximize return.
· Research based on asset allocation over time shows that public pensions are patient investors, much more so than individual investors. That is, they are not unduly swayed by the ups and downs of financial markets and do not take on more risk in order to compensate for market downturns.
· Public pensions have reviewed asset allocations in light of adverse market conditions in the last decade and implemented measures intended to mitigate risk…This more diversified portfolio is aimed at smoothing out the effects of market volatility. Public pension fund exposure to alternative assets, while increasing for larger plans, remains relatively low compared to endowment funds.
4. The level of risk assumed by public pension funds, as indicated by the percentage of assets invested in equities, is consistent with other institutional investors and with many prudent individual investors.
· The risk profile of public pension funds—currently about 60 percent in corporate equities on average—has remained fairly stable and is consistent with other institutional investors…The average equity position among pooled public pension funds entails no more risk than is considered prudent for an individual investing over a finite career using a commonly recommended lifecycle investment strategy…
5. Actual investment returns for the overall fund and for the individual portfolios are evaluated over multiple periods including the short term and long term, and evidence indicates that current rate of return assumptions are realistic.
· Returns have met or exceeded expectations over the long term, i.e., 20-30 years. Public funds have the advantage of being able to smooth the effects of bubbles and downturns, though the sheer magnitude of the 2007-2008 financial crises and its aftermath has challenged all funds.
· In response to the current economic climate, public pension funds are incrementally adjusting their rate of return assumptions downwards. Nonetheless, independent studies indicate that the average rate of return assumption of 7.8- 7.9 percent is not unrealistic, both in nominal terms, and in real (constant purchasing power) terms after controlling for inflation.
· It is important to distinguish nominal and real return assumptions because inflation impacts pension liabilities. Shortfalls in investment income due to slow economic growth, for instance, can be accompanied by reductions in liabilities resulting from slow wage growth. Nominal return assumptions among public pensions cluster tightly around a median of 7.9 percent, and real return assumptions are spread more broadly around a median of 4.5 percent…
By leveraging the ability to pool risks and invest over a long time horizon, public pensions serve the public interest by delivering retirement benefits efficiently at the same time that they provide a secure and modest retirement income to public employees. The financial goal of pension funds is to have sufficient contributions and investment returns to match these liabilities over a long time frame… The overall risk-return profile of public pension funds is consistent with other institutional investors—corporate pensions and endowments—that invest over the long term. Studies indicate that public pensions are patient investors, adjusting asset allocation gradually and tending to decrease rather than increase risk in response to increasing contribution requirements following major asset value declines. Large public pension funds have responded to the challenging financial environment since 2008 by decreasing their overall position in stocks and fixed income assets and increasing their investment in alternative assets in an effort to improve portfolio diversification and reduce volatility…
TRS POSTS STRONG INVESTMENT RESULTS FOR CALENDAR YEAR 2012
SPRINGFIELD, IL – Teachers’ Retirement System investments earned a positive 13.92 percent for its 366,000 members during 2012, recording strong gains in all asset classes. Altogether, TRS investment assets at the end of December totaled $38.16 billion, an increase of $1.86 billion in the market value of the portfolio in the six months since the end of fiscal year 2012 on June 30. The System’s rate of return for calendar year 2012 is net of all investment fees.
“We’re very proud of these returns for our members. But the ups-and-downs we saw in our investment returns during 2012 are a perfect example of why TRS always places more emphasis on long-term investment results,” said TRS Executive Director Dick Ingram. “Our members are counting on us to deliver for them for decades and that is the true measure of our success.” The System’s 30-year investment return at the end of fiscal year 2012 was 9.6 percent against the 8.5 percent long-term rate-of-return target in place at the end of June. The TRS Board of Trustees re-set its long-term target at 8 percent in September, 2012.
TRS recorded strong returns in all seven of its major investment classes in the 12 months ending on December 31, 2012, led by a 17.02 percent return in international stocks. Investments in U. S. stocks posted a 16.3 percent return and private equity investments returned 16.22 percent. Investments in fixed income recorded a return of 13.67 percent while real return investments returned 9.92 percent; real estate investments saw an 8.4 percent return; and absolute return investments posted an 8.15 percent gain.
The volatility of the world economy and investment markets can be tracked through TRS investment returns. Investment income lagged during the last three months of fiscal year 2012, resulting in the 0.76 percent rate of return for the 12 months in that fiscal year. However, the portfolio demonstrated its ability to participate in a rebounding market during the second half of 2012. Here are the 12-month investment returns for calendar year 2012 by asset class:
Investment Category Assets Allocated 12-month Return Rate on 12/31/12:
International Equity $ 7.94 billion +17.02%, Domestic Equity $ 8.54 billion +16.34%, Private Equity $ 4.35 billion +16.22%, Fixed Income $ 6.42 billion +13.67%, Real Return $ 3.76 billion + 9.92%, Real Estate $ 4.66 billion + 8.40%, Absolute Return $ 2.02 billion + 8.15%, Short Term Investments $ 0.46 billion + 4.68%: TOTAL $38.16 billion +13.92%
NOTE: All returns are calculated net of investment fees. Total rate of return is based on the System’s asset allocation and performance of the underlying asset classes.