Public Pensions May Have More Illiquid Investments Than You Think

Recent, dramatic declines in the value of equity markets (and more recently, fixed income) will probably appear in weaker public pension funding ratios as plans begin to disclose their returns.

Certainly, some plans incorporate asset value smoothing, which reduces the year-to-year volatility of gains and losses. However, the Government Accounting Standards Board (GASB) in required public plans to disclose how plan sponsors determine the value of their investments, beginning in 2017, and outlined a three-level hierarchy. (The corporate Financial Accounting Standards Board (FASB) implemented this approach in 2008, following the collapse of Enron in 2002 stemming from falsified holdings and off-the-books accounting.)

• Level 1 would include publicly traded equity and fixed income that can be quoted and relied upon for market valuation on redemption.

• Level 2 is for assets that have no visible market quotes, so fair value must be modelled by a pricing service for corporate and municipal bonds.

• Level 3 is reserved for those investments that have neither public quotes nor visibly comparable market securities (“comps”).

• Further, assets where the pension plan owns a portion or percentage share in a fund may be valued using net asset value (NAV).

Since 2000, market volatility, two recessions, and Federal Reserve actions have plagued the returns that public pensions hoped to achieve. As a result, public plan investors have pushed further into riskier securities to boost returns. Private equity funds, hedge funds, real assets such as commodity properties and real estate (commonly called alternative investments or “alternatives”) have become attractive to many public plan sponsors and are valued according to NAV or appraisal.

On average, a sizable 30% of plan assets were categorized as NAV in 2017, according to a report from the Center for Retirement Research at Boston College (CRR). Some of those NAV assets are traditional mutual funds that include publicly traded (or readily valued) equity and fixed income and may be slotted into Levels 1 and 2. However, when researchers Jean-Pierre Aubry and Kevin Wandrei analysed and sorted NAV assets they concluded that about 25% of all assets would fall into Level 3, which require appraisals rather than comps to determine the value of the investment.

The authors commented, “this finding suggests that the reported values for a significant portion of plan assets could vary more from the value that plans would receive if they were to liquidate their holdings.”

Valuation of alternative investments may be “stickier” in that they are appraised less frequently than publicly traded equity and fixed income; certain funds may have withdrawal constraints or illiquidity depending on market conditions. That’s not to say alternatives are bad investments across-the-board, and most valuations, we hope, are signed-off by independent, outside auditors. Rather, the point is that there is less transparency in these valuations. We suspect a probable spectrum in the quality of alternatives valuations that may show up soon, given the recent dramatic market fluctuations. (What was that famous quote from Warren Buffett about the tide going out?)

To illustrate the magnitude of alternatives in some plans, we prepared a few tables from the Public Plan Database (PPD), which comprises 190 state and local plans representing 95% of the U.S. public plan universe. The PPD also allows you to view specific plans over time and see shifts in investment allocation philosophy.

Table 1 shows plans that have the highest proportion of assets in an alternatives basket. We also sort for the highest hedge fund (Table 2) and private equity allocations (Table 3). In addition to a basket of “alternatives”, we show funded ratios as presented by each plan in its audited financial statements.

Table 1: 2018 Public Pension Valuations in Equity, Fixed Income and Alternative Investments

Source: Public Plans Data, The Public Purse

Table 2: 2018 Public Pension Valuations in Equity, Fixed Income and Alternative Investments

Source: Public Plans Data, The Public Purse

Table 3: 2018 Public Pension Valuations in Equity, Fixed Income and Alternative Investments

Source: Public Plans Data, The Public Purse

However, when assessing a community’s ability to meet its pension promises over time, factors other than funded ratios, such as the budgetary impact of required contributions (plus amortisation of unfunded liabilities), the “maturity” of the plan (i.e. status of members: retired vs. active), and the community’s economic conditions (growth, stagnation or decline) offer a more comprehensive perspective.

Finally, we must consider the convergent risk of pension asset declines alongside declines in state, local and federal government tax revenues where capital gains taxes are included in the respective income tax codes. Happily, many governments entered this challenging period following solid revenue growth and larger rainy-day funds. But in the context of the recent market rout, we would be unsurprised to see mid-year budget adjustments later in the year.

Natalie Cohen is founder, principal author and publisher of The Public Purse. She has deep experience in the municipal bond market, credit research, bond insurance, risk management, rating agency and government.

Disclaimer: This article was originally published on “The Public Purse”  and submitted to Macro Hive for republish. (The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)