LP Radar: Ill-defined commitments

The shift from defined benefit to defined contribution models is already underway at US pension systems – which means alternative asset managers need to start offering different structures and relationships, writes Christopher Witkowsky.

During a lively discussion recently with a limited partner, our chat led onto an issue that I’d always considered a serious threat to private equity’s future prospects, but one that was still a way out on the horizon: the rise of defined contribution pension schemes.

But the issue is not so distant, according to this LP. US public pensions are already undergoing what he describes as an “inevitable shift” away from a ‘defined benefit’ model, where a retiree is guaranteed a specific pension, to a ‘defined contribution’ model, where the retiree’s pension is based solely on what he or she has paid into their personal retirement account.

The move towards ‘DC’, as industry insiders typically refer to it, stems from pensions’ inabilities to meet rising liabilities. In the US, a number of city authorities have gone bankrupt in part due to liabilities related to defined benefit plans they can’t afford.

Last year, at least eight states made structural changes to their retirement plans, according to a report from Pennsylvania’s state office of the budget. Pennsylvania governor Tom Corbett has proposed closing the state’s defined benefit programme to new employees, who would participate instead in a 401k-style offering (a type of retirement savings account controlled by the retiree and typically associated with private company pensions).

The change that’s taking place appears to be a gradual shift from a purely DB model to a hybrid structure that leaves intact the benefits promised to existing members, but puts more responsibility on future workers to fund their own retirements. That’s why this shift requires such a long horizon; it’s not going to take place overnight. But the seeds are being planted.

Rhode Island is perhaps one of the most notable cases so far. The state’s retirement system was woefully underfunded for many years until Gina Raimondo was elected state treasurer in 2010 on a platform of pension reform. Under Raimondo’s leadership, the state put into place a hybrid model that shrank the defined benefit portion while requiring employees (other than those retiring by June 2012 who saw no change in their benefits) to contribute more to their own retirements. Raimondo’s reform also tied cost-of-living adjustments to the fund’s investment performance.

This new system has rapidly improved the fund’s financial position:  it’s estimated unfunded liability has fallen from about $7.3 billion as of 30 June 2010 to $4.5 billion as of 30 June 2012, according to a study from consulting firm Gabriel Roeder Smith & Company. 

Other states made changes last year, too. Michigan, for example, is now offering defined contribution plans to new enrollees in the public school employees’ system. Florida’s state legislature has been working on a proposal to close the defined benefit programme to new employees, who would instead be given a defined contribution plan (currently workers can choose between either, with the traditional defined benefit plan not surprisingly the most popular choice). Virginia also plans to close defined benefit plans to new employees at the end of 2013, and replace them with hybrid models that include defined contributions.

All of this should be ringing some alarm bells for private equity – because it may leave traditional private equity funds without their major source of funding in the not-too-distant future.

US public pension funds accounted for about 43 percent of all capital raised for private equity funds globally in 2011, according to the Private Equity Growth Capital Council. However, defined contribution plans put more investment decision control into the hands of the employees – and given their requirements for portability, regular pricing and redemption, they’re far less compatible with the private equity model.

Private equity firms and funds of funds that aren’t already thinking about solutions to this problem – and how to make their products accessible in other formats – are going to end up behind the curve.

Possible structures do exist. Europe has had a long tradition of publicly-listed investment trusts that invest alongside private equity funds. Some of these vehicles have struggled in the aftermath of the financial crisis, constantly battling with big discounts to net asset value. But they offer a degree of transparency and tradeability that privately-held closed-end funds do not.

Last year, Kohlberg Kravis Roberts opened up two of its funds (although not its private equity funds) to retail clients of US brokerage Charles Schwab. Investors could choose from a high-yield fund with a minimum contribution of $2,500, or a distressed vehicle with a minimum commitment of $25,000.

It remains to be seen how attractive these funds will be to retail investors and whether they’re also workable within DC-style public pension models. But at least it shows that KKR is thinking about these issues and experimenting with new ways to access capital (not least of which was the NYSE-listing of its management company). Every firm is going to have to go through a similar process soon enough – because it might not to be too long before the big pool of long-term pension fund capital, which has sated the industry for such a long time, starts drying up.