The overwhelming majority of large pension funds adhere to a time-honored approach to investments that is focused on the concept of total return. Today’s volatile global markets require prudent, yet well-reasoned, new approaches.
A very good approach would be to focus on cash inflows and outflows — not asset value. A fund cannot pay benefits with portfolio appreciation — benefits must be paid with cash.
In this way, outflows that consist of retirement payouts, personnel, administrative costs and operating overhead would be projected for the next four years. Four years are used because a fund can be highly confident of what those outflows will be.
Those outflows would then be linked to cash inflows generated from both pension-fund contributions and cash generated by income-producing assets. The remainder of the portfolio can take on more risk — the risk needed to achieve the sorely needed return.
Much as when a family identifies a source of income, say a monthly Social Security check, to a set of known expenditures — perhaps annual property taxes — so might a pension fund link income streams to known liabilities.
For example, if an investment produces a specific amount of income, say in a real property portfolio, that cash flow might be targeted and “linked” to a set of known liabilities; possibly such things as retirement benefit payouts and operating overhead.
This would be reviewed and evaluated annually and carried forward. As an example; in year one an investor might look at years one to four. In year two, years two to five and so on. The remaining portion of the portfolio can then be committed to maximizing capital formation and shareholder value.
Why is this strategy most relevant now, more than in previous times? The reasons are multiple, complex and interrelated.
Here are just a few reasons:
- The threat of a potential recession accompanies political uncertainty around the globe: the U.K., Europe, Brexit, Middle East conflict among the Gulf Arab States, the U.S.-China trade war and dominance over the South China Sea.
- Other factors are the impact of climate change; disinformation being used to undermine the global order; greater economic inequality and anti-immigration backlash.
Funds must therefore guarantee that they don’t become cash-flow negative. Millions of retirees depend on this!
Meanwhile, the number of public companies available for investment has diminished. In the 1990s it was about 8,000 depending on the moment. There are now less than 4,000. More companies are staying private to avoid the high cost and short-term thinking associated with being a public company.
There now are far fewer opportunities for a public investor than ever before. Much wealth is generated before the initial public offering (IPO). So by the time a pension fund invests in a company that is already public, the private-market investors have captured much of the upside value.
Governments around the world have taken to pre-funding pension promises through investment vehicles to keep the cost of pension promises down through investment returns.
At CalPERS, for example, nearly 60 cents of every dollar paid out to retirees comes from investment earnings. CalPERS is laser-focused on maximizing returns while diversifying risk and reducing costs.
This is barely enough.
Private-market returns have never been more critical in meeting future liabilities. The yield must come from real assets, infrastructure, and private credit and extending the hold period for private equity.
To do this, fund managers must first link cash outflows with cash inflows.
There is $3 trillion in the private-equity markets. Investors around the world are increasing their allocations to private equity. Preqin estimated that there is a record $2 trillion in “dry powder,” or unspent money, in private funds globally, with over $1.2 trillion of that total $2 trillion being earmarked for private equity.
The average hold period for a buyout investment in private equity is about five years. If we are invested in good companies with solid cash flows why should we sell?
Increasing the hold period plays a vitally important role in promoting long-term capital formation, which can insure a growing and vibrant economy. Funds must maintain the option of keeping solid income producing assets while at the same time eliminating excessive transaction fees. We will have more on this in a future article.
And so linking income-producing assets and pension contributions with projected outflows over a four-year period provides the investing discipline for pension funds to both meet their obligations and then take the prudent risks necessary to invest in private markets — these are the risks necessary to afford pensioners the surety of each month’s check.
Dana Hollinger contributed to this report.
Dana Hollinger is a partner of ABG Advisory and previously served on the CalPERS board, ICGN board, and the Women’s Leadership Board to the JFK School of Government at Harvard.
Jackson Eisenpresser is CEO of ABG Advisory and previously served as director of principal and advisory strategies at Tony Blair Associates.
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