At its Southwest Institutional Forum in Santa Fe, N.M. on September 20, Markets Group gathered together three New Mexico-based institutional investors to discuss a variety of investment-related topics. They included Bob Jacksha, chief investment officer, New Mexico Educational Retirement System, which administers $13 billion; Robert “Vince” Smith, chief investment officer, New Mexico State Investment Council, with $24.2 billion; and Dominic Garcia, chief investment officer of the $16 billion Public Employees Retirement Association of New Mexico. The panel was moderated by John Linder, managing director, Ryan Labs Asset Management, which offers actively managed fixed-income separate account vehicles and mutual funds to institutional investors and has approximately $9 billion under management.
What are the biggest concerns dominating your thinking today as directors of investment pools? Linder asked.
We think we’ve entered [the] late cycle [of the U.S. economy] and our biggest concern is raising and structuring liquidity ahead of the next recession. Being sufficiently liquid going into the recession was one of the big lessons learned by our industry in the GFC (global financial crisis). My strategy group and I did a study of large public funds and found that in June 2009, near the bottom of the GFC, many funds were underweight risk assets—some quite underweight—relative to their targets. We surmised that funds on the whole ran out of liquidity prior to the bottom of the market sell-off and couldn’t—or, for other reasons, didn’t—rebalance into risk assets as the markets fell. As markets recovered, funds were not able to take as much advantage of the recovery as they would have otherwise.
There are really three problems. First is the low-return environment over the next ten years. For the last 30 years, a simple indexed 60/40 portfolio was able to do 7.5 percent, but if you push that forward, it’s going to be 5.5 percent, and we have to get to 7.25%. So how do you bridge going from 5.5% to seven and a quarter? You have to be creative and do innovative things.
The second problem is that over the next 15 years, we are going to have a demographic and liability bulge that we have got to get through. A lot of that liability bulge is stemming from the late 1990s. In our plan, we enhanced benefits without paying for it. That was costly, even back in the 90s, when you could throw darts and could get your required return. Now, that bill is coming due. Since we had the benefit enhancements, we went through the dot.com bust, and then we had a great recession, so our returns were about 6.5 percent, which is short of our required returns. On top of all that, we were paying fixed COLAs (cost of living adjustment). We paid three percent COLAs over that 20 year period, but based on our returns we should have paid 1%.
So today, when we look at the liability stream, we got a pig in a python that we have to work through. It’s a cash outflow problem. Cash flow is going to go from negative three percent, which is very comfortable to a peak around 5.5 percent. That is, if we are making a 7.25% return, if we make 6 that cash-flow problem is unsustainable.
The third problem is that we are in late-cycle. Not only do we need to figure out a way to make 7.25% over the next 10 years, which we all agree is hard, it also matters when we get those returns. If we get poor returns in the first five years, because we are paying out so much of our cash flow, we might get 7 and quarter ten years from now, but our terminal wealth and funding status could still be less because of the compounding drag of the cash outflow.
So, overall there are three problems. We are 73 percent funded today, forecasted to 77 percent funded 25 years from now. In my view, that is a very thin line, if we get seven and a quarter, and if we get a short-run disappointment that forecast could easily get wiped out. Those are my concerns. And believe me, I can’t sleep at night thinking about it.
We are a public pension fund, so we have all the same issues, the defining issues. It’s not structured quite the same as yours, but when we look at our protections for the future, we potentially would get to 100% funding for many years. But, because of the funding-level fears, your cushion of safety in there is reduced. We are 63 percent funded, which isn’t bad, but if you have several down years, then you have issues. So to me, the funding levels are a safety cushion issue. We have all the same concerns of liquidity, although a major micro concern is about the amount of capital that is flowing into private assets. As I said, we have a lot of money in private assets we could sell, but on the other hand, if we sold it what would we buy? It’s going to compress returns there as well, maybe more so than public markets.
Public pension funds over the last ten years, we depended on private credit, private equity and real estate. Ten-year forecasted returns for these strategies will not be the same as the past. Are plan sponsors ready to deal with that? Particularly those plan sponsors that have 40%, 50% or more in their portfolio.
It’s one of the reasons we are looking at alternative alternatives, but so are a lot of other people, so we are seeing the same thing there.
Regarding the private markets, we look at it a little differently. We agree that there is a lot of dry powder out there to be invested. Our private equity team is telling me that prices paid for investments have risen and continue to rise with this pressure, which we expect will reduce future returns. But on the other side, we see these markets expanding and able to use more capital, at least partially offsetting “dry powder” concerns.
What solutions are you seeing? Linder asked.
You don’t want to be staff at an unfunded public pension fund, the cards are stacked against you. But it doesn’t stop you from coming up with solutions. I think there are two approaches, using our beta and alpha construct. We think the best way to improve returns, without changing volatility, is to continue to risk diversify. That means using dirty words in finance: leverage and derivatives, and apply them to the things that are currently not taking up a lot of risk in your portfolio, particularly bonds and inflation-sensitive assets. Use these tools to increase expected return. The benefit is risk or volatility doesn’t increase by much.
In addition to that, embrace active management. You have to play that game and you need to find skill out there to reach that gap because beta won’t get there for you, unless you take some huge risk. It’s hard, but if you embrace active management and true risk diversification, I think there is a good chance to meet required returns.
Earlier, I mentioned that we surmised that funds generally appear to have run out of liquidity near the bottom of the GFC and weren’t able to, or for other reasons did not, rebalance strongly to long-term risk targets and were at minimum risk positions when assets were cheapest. So, I think one of the solutions is to start getting your liquidity in place, and use it to get into higher risk positions during the next bear market, in anticipation of being fully risk-exposed when the next bull market is born.
Be willing to take on nontraditional approaches.
Also, the funding issue: it’s not solely an investment problem. Investments have limitations. They can’t fix the ills of the past 20 years. Holistically, the sustainability of public pensions has 4 key elements: good governance, good plan design, ability to attract and retain talent, and finally a well-diversified portfolio.
So the solution involves more than just investments. The issues we have as institutions—it’s a social contract, Linder stated.
As a public pension industry, we need to do better across these four elements. Good governance is a big one, which requires delegating authority to the staff and talent. But we pay poorly, so the value proposition for these professionals needs to change. The model needs to change and be updated to be agile and skillful to bridge the return gap.