Public pensions shift funding structure

A global shift from guaranteed to employee-contributed public pensions raises questions about the future of private equity funding, writes Zoe Hughes.

When private equity managers assess future risks to their business model, their thoughts will generally centre on their ability to deliver great IRRs to investors thereby allowing them to raise new investment vehicles in the years ahead. Few, if any, will be thinking about whether their investors will even be around in 20 or 30 years time.

As pensions face ever-mounting liabilities from their ever-aging retirees, debate is raging over whether public and private funds should structure themselves as defined benefit schemes, where employers guarantee beneficiaries a stream of income until their death, or defined contribution plans, where employees take charge of their own investments.

Zoe Hughes

Of course, that’s not to say that corporate and public pensions globally are set to disappear from the private equity investment scene — far from it. However, the long-term fall-out of global pensions’ shift from DB schemes to DC plans will have a fundamental impact on the ability of all alternative asset classes to raise future funding.

And rather than being a distant unspecified risk on the investment horizon, the future viability of DB schemes is front and centre of many pension investment officials’ minds today.

Just this week, Florida’s Governor Rick Scott – trustee of the $156.8 billion Florida State Board of Administration public pension – backed new efforts to replace the state’s DB scheme with a DC plan. In supporting the “Floridians for Sustainable Pensions” coalition, which is calling for public pensions to be replaced with personal retirement savings plans, Scott said government pension reform was a “priority issue”.

Scott is certainly not alone in his thinking. Since 2000, the proportion of DC schemes in the US has risen from 49 percent to 57 percent as of the end of 2010, according to a Towers Watson global pension asset study. And with the US representing 58 percent of all pension fund assets globally, what happens in America has far-reaching implications for GPs everywhere.

It’s not just about the US, though. The Towers Watson report reveals DC plans could overtake DB schemes within the next decade, with the proportion of defined contribution plans now representing 44 percent of all pension assets up from 35 percent in 2000.

For private equity managers and their alternatives colleagues, the crux of the DC problem is how they invest their capital. Rather than pooled capital being managed by professional pension fund investment officials, DC plans give individual employees much greater control over how and where to invest their retirement pot. Such delegation of control leaves DC plans with a penchant for equities, fixed income and cash with little, if any, money flowing to private equity, real estate and other alternatives.

For some, the answer to the DB/DC debate is some form of hybrid model that offers the professional management of defined benefit with the portability of defined contribution. It is an answer, though, that will take years – if not decades – to make itself known. In the meantime, private equity managers need to understand that the risks to their investment model don’t just relate to interest rates and return rates but also where the next generation of LPs is set to come from.