Consolidation of Public Pension Plan Investment Management: Is This a Solution to the Problem?

As public retirement systems across the nation grapple with underfunded systems, shrinking returns, and reducing rate of return assumptions to more accurately plan for the future, fiduciaries and other stakeholders find themselves under growing pressure to account for these realities. Thus, states and localities are struggling to find solutions.

In February, lawyers from across the nation gathered at the National Association of Public Pension Attorneys Winter Seminar to discuss a variety of issues relevant to public retirement systems. Co-author Shawn Wooden led a panel discussion (the “NAPPA Panel”) on the topic of consolidation of asset management.

Given the challenges that state and local public pension plans face, including underfunding that some estimate to be as high as $5 trillion across all public pension funds, some believe public pension plans should combine asset management functions. In other words, consolidate to survive. Others think consolidation would be a mistake. Most in the field see the status quo as problematic. However, there are definitely differences of opinion on whether or not consolidation of asset management is part of the solution.

Common Structures and Current Landscape

There are generally four basic governance models across the U.S. state and municipal pension fund landscape. As described below, Randy Miller and Rick Funston, in their 2014 work Public Pension Governance That Works, outline these categories well.

The most common is an “Integrated Investments” model, which combines investment and pension administration and utilizes a single fiduciary board. The board delegates its power over investments and pension administration to a CEO or Executive Director. Reportedly, 60 percent of state public pension funds in the U.S. utilize this structure.

The Massachusetts Pension Reserves Investment Management Board (“Mass PRIM”) is an example of the second most common structure. The model features a separate investment management organization with its own investment board. This “Separate Investment Management” configuration features a board which manages investments only and coordinates with a separate structure to match assets and liabilities. Reportedly, 20 percent of the largest funds in the U.S. are structured this way. Interestingly, in Massachusetts, poor performing local funds are mandated by statute to have their assets managed by Mass PRIM. Additionally, other local funds have the option to have all or a portion of their assets invested by Mass PRIM for management.

Chris Supple, Deputy Executive Director and General Counsel of Mass PRIM, participated in the NAPPA Panel. He brought an insightful perspective on the effectiveness of the consolidated asset management approach based on Mass PRIM’s experience.

The third most frequent form, the “Separate Organizations, Same Board” structure, typically internally bifurcates investment and pension administration organizations. But, each organization reports to the same fiduciary board. In arrangements like the California Public Employees’ Retirement System, this is operationalized by having pension administration responsibilities delegated to an Executive Director while investments are managed by a Chief Investment Officer, with both reporting the same fiduciary board.

The “Sole Fiduciary” model is the least common. This structure is used by only four states with significant pension funds: Connecticut, Michigan, New York, and North Carolina. Generally, a Comptroller or State Treasurer, is the sole fiduciary and manages investments through a CIO and investment staff, some with advisory board oversight. In Connecticut for example, the State Treasurer is the sole fiduciary who reports to an investment advisory council.

While success and failure levels vary across these structures, it is generally agreed that a new model must emerge for pensions to thrive going forward. The disagreement has played out in various ways across jurisdictions.

New York City

New York City has five separate retirement systems with five separate boards. Investments are centrally managed by the New York City Comptroller as the investment adviser. Each board determines each fund’s asset allocation. In 2011, there was a proposal to reduce the city’s pension system from five boards and 58 directors into one smaller board. The proposal failed in the face of labor concerns (among others) about losing influence and seats on boards.

Pennsylvania

Pennsylvania has over 2,600 separate local government pension plans with separate management. In 2012, a State Auditor called for merging local and county pension systems into a state managed entity. Opponents feared losing power over the funds and doubted that Pennsylvania, with large amounts of pension debt from some state funds, could better manage the consolidated local plans. However, the question of consolidation is not going away. In fact, in March of this year, Treasurer, Joseph Torsella announced a plan to consolidate three state funds.

Indiana

Recent consolidation in Indiana reportedly led to $370.8M of investment fee savings (net present value). The Indiana Public Retirement System, with approximately $30 Billion in assets, serves approximately 460,000 members and over 1,200 public employers. Executive Director Steve Russo discussed Indiana’s positive experience with consolidation as part of the NAPPA Panel earlier this year.

Has Ontario Solved It?

Many believe Canada’s consolidation model is the key. On July 1, 2016, Ontario established the Investment Management Corporation of Ontario (“IMCO”). Headquartered in Toronto, the second-largest North American financial services center by employment after New York, IMCO will provides investment management and advisory services to pension funds that join voluntarily and board members are elected from representatives of the participating pension funds. Experts believe IMCO could eventually rival the largest money management corporations in the province.

The IMCO consolidation model is attracting attention as an option expected to lower costs by leveraging scale, thereby increasing overall returns while allowing participating pension funds to retain influence over the assets through board participation. Moreover, this is done without forcing the government or taxpayers to subsidize IMCO. Jill Eicher, a senior advisor at the Bipartisan Policy Center, thinks Ontario’s approach “takes the advantages of the asset pooling already being realized by the U.S. state investment boards to the next level.” She and other experts think it’s “a model worth studying.”

The Debate

While the Ontario approach is attractive to many, not every decision maker is convinced. A theoretical tug of war between pro and anti-consolidators is taking place in different parts of the country. During the NAPPA Panel, arguments ranged from the political to the practical, a microcosm of the debate at large.

Pro-consolidators believe combining fund assets will increase efficiencies. Separate funds mean separate relationships and access to services from actuarial, legal, accounting and other professionals. Larger pools of assets, some argue, will allow consolidated fund management to access greater talent for internal pension fund asset management. This will save on the amount of fees paid to external managers.

Anti-Consolidators respond by framing the argument in terms of substance over efficiency. They contend that each plan is better able to respond to the needs of its particular beneficiaries and circumstances. They fear the detriment of a “one-size fits all” mentality may outweigh any fiscal benefits.

Pro-Consolidators also argue that consolidation will lead to economies of scale. Larger funds are able to mitigate risk while diversifying into a broader range of asset classes. As the old adage goes: bigger risk, better reward. Also, a bigger fund means better leverage. As the consolidated funds will be in a position to make larger investments, they will be positioned to negotiate more favorable terms.

Anti-Consolidators retort: bigger risk means bigger risk. They refuse to rely on hopes of reaping benefits from risky investments and argue that consolidation offers no increased assurance that in the aggregate, positive investment returns will result. Additionally, challengers question whether economies of scale will, in fact, be realized given that increased size will mean increased costs.

These are just a few of the arguments for and against consolidation of asset management.

Conclusion

This debate will endure for the immediate future. Those in favor of consolidation of asset management argue for a bigger boat and largely frame the issue as a matter of scale. Those against such consolidation believe it’s the motion in the ocean that counts, a “quality over quantity” position.

However, in The Consolidation of State-Administered Public Pension Systems in the U.S. States, David S.T. Matkin & Gang Chen found that size and concentration of pension funds are positively associated with measures of financial health of state pension funds.

While representing large pension funds for many decades, we at Day Pitney have also witnessed the increased negotiating leverage that comes with investing larger pool of capital. But, it seems likely the issue will nonetheless be a source of continued debate and discussion given political interests, fears of loss of control and genuine substantive disagreements.

Nonetheless, with many state and local funds being significantly underfunded and no positive signs about the current direction, all observers agree that something has to change. However, ultimately, the real stakeholders – retirees, workers and taxpayers – will have to play a larger role in getting to sustainable solutions to the significant challenges that threaten the security and viability of pension systems today.