Could Pension Reform Disturb Investment Funds?

On Capitol Hill and elsewhere, voices are calling for a major shift in public pension plan management – a shift toward privatization.

Underfunding of public pensions is all too common. The bankruptcies of Detroit, Stockton and San Bernardino have certainly cast light on the pension funding gaps in those cities, but the problem is widespread: a 2013 Pew Center for the States survey found more than $217 billion in unfunded pension and health care liabilities across 61 U.S. cities with populations of 500,000 or greater.

Chicago’s public pension fund faces a $19 billion gap; Moody’s Investor Service, which recently downgraded the city’s credit rating, estimates it near $36 billion. The city of Detroit owes about $3.5 billion to its current and future retirees. At the start of 2013, the cities of Atlanta, San Diego, Baltimore and Philadelphia all had unfunded pension obligations of $1 billion or more. At the moment, nine state pension funds (Alaska, Hawaii, Rhode Island, Louisiana, Kansas, New Hampshire, Connecticut, Kentucky and Illinois) have funded less than 60% of their projected pension liabilities.

Would privatization help to solve these problems? Some economists and legislators think it is, but privatization may carry a price.

Under the privatization model, responsibility for public pension funds would be reassigned to insurance companies. In return for employer-paid premiums, these private insurers would provide retirees with lifetime income payments. Advocates contend that this could help to reduce the risk of municipal bankruptcies – and the need for federal bailouts.

Privatizing defined benefit plans would have financial side effects, however. If insurance companies managed these plans, they might charge plan sponsors and participants higher management fees than anticipated.

Additionally, public pension funds such as the Teacher Retirement System of Texas (TRST) and the California Public Employees’ Retirement System (CalPERS) constitute some of the real heavy hitters in private equity and venture capital. In fact, the New York Times reports that public (and private) pension funds account for almost half the capital flowing into VC and PE funds.

If TRST, CalPERS and other behemoth public pension funds were removed from the fundraising landscape, how adept would insurance companies be at playing the role of limited partner?

They certainly have an acceptable time horizons. On the other hand, insurance firms don’t have a strong track record in alternative investments. What kind of learning curve would the typical insurance executive have to face in order to develop the necessary perspective and understanding?

Public employee and union pension funds are also tax-exempt. Even if insurance firms started managing them, they would likely remain tax-exempt to oblige investors such as college endowments and non-profit foundations. That said, welcoming taxable investors into a public pension fund’s structure could prompt some awkward decisions.

As most public pension fund investors are tax-exempt, they may not deem the tax ramifications of the fund structure as significant. Not so for the taxable investor, who may prefer to pay incentive fees at the fund level (with ordinary tax deductions possibly resulting) instead of allowing carried interest to go to the investment manager. Insurance firms also might like investment managers to restructure portfolio companies as LLPs, LLCs, S corps and other forms of pass-through entities that would let tax losses flow through to investors.

To wrap things up, a bit of good news. While the jury is out on whether privatizing public pension funds will work, the bull market has bought the funds a little breathing room. A recently published Wilshire Associates study notes that from May 2012 to May 2013, U.S. public pension funds enjoyed a median return of 12.4% (albeit only 0.24% in Q2). So perhaps some immediate funding gaps are being addressed, and maybe there is financial room emerging to try and implement some reforms.