The Chicago River flows backward. Due to a feat of civil engineering completed around 1900, it flows backward. Its liquidity goes the wrong way. Unfortunately, that is what is happening for the Chicago municipal pension system, too. Its liquidity is flowing the wrong way.
Chicago’s municipal pension plan recently redeemed $50 million from a large-cap equity fund. Seems like a non-event. Happens all the time. But the reason the pension plan did so is chilling: It was done specifically in order to make pension benefit payments. This should be a cautionary flag to underfunded pensions and to the state and municipal governments that sponsor them.
One of the most important parts of a CIO’s job is asset allocation. That allocation requires some amount of cash for new investments and for a degree of diversification. But when a plan is significantly underfunded and does not receive the appropriate inflow of cash from the state or city, the CIO and team become forced sellers of assets just so they can make the required payments.
Like a retailer having a fire sale to raise cash to make payroll, the investment staff must sell assets at whatever the market will bear in order to meet pension “payroll.” This adds millions of dollars in annual costs for pensions that are already underfunded.
This happens in two ways.
First, when pensions are underfunded they have a tendency (or need) to take on more risk in order to try to generate higher returns.
For example, underfunded pension plans are increasing their allocations to private equity. Nothing wrong with that. But that means more of the portfolio is illiquid. It would be very unlikely that private equity positions would be sold to “make payroll,” specifically because they are so illiquid. But this leaves fewer assets that are liquid enough to be sold, and that increases the pressure on those liquid assets to be sold at a decent price. Moreover, if the plan has significant assets in liquid securities, such as large-cap equities or Treasurys, those assets can easily be sold, but then the portfolio will be out of balance and will require additional trading and rebalancing anyway.
Secondly, the pension plan must keep more cash on hand than it otherwise would. If your policy portfolio calls for a 3% allocation to cash, that is designed for diversification and dry powder. But a pension plan sponsor should be providing significant amounts of cash into the pension each year. If the sponsor is not making its contributions, then the pension plan has to carry more cash than it otherwise would.
One former public plan CIO described the situation to me by saying: “We were net sellers eight or nine months of the year. For two months, we would have some cash (not enough) coming in from property tax receipts, but for most of the rest of the year we had to sell assets to raise cash and then keep it on hand. This meant we needed to hold more cash (which was not doing any work for us) than we should. This cost us $20 to $30 million a year.”
Pensions might have a couple of options for dealing with this problem, including interval funds—but they often use leverage, which is not always welcome at public plans—or secondary private equity.
Interval funds afford investors a greater degree of liquidity in asset classes that are generally illiquid by nature. Their regular liquidity windows provide investors an opportunity to liquidate a portion of their ownership interest; this forces investment managers to be more cognizant and disciplined with liquidity. And secondary private equity generally has better liquidity characteristics than ordinary private equity. But the real solution is for public pensions to be properly funded in the first place.
Public pensions are underfunded for many reasons, but first among them is that their sponsors fail to make their required contributions. This means the investment staffs must take more risk, but it also means they are forced sellers and are forced to hold too much cash. This leaves them less funded than they should be; it also costs them literally millions of dollars in lost opportunities and forced sales.
The Chicago situation may be an outlier, because the plan is so extremely underfunded: As of a year ago, the plan’s funding ratio was only 23.2%. The pension plan is not having a fire sale to meet payroll—it is burning the wood from the roof to keep the house warm.
But to avoid these kinds of situations, plan sponsors must resist the temptation to skip pension contributions in these difficult times. Keep the liquidity flowing in the right direction, the roof intact, the fire in the fireplace and the pension properly funded.
Charles Millard is a senior adviser at Amundi US and was the former director of the Pension Benefit Guaranty Corporation (PBGC).The views expressed are those of the author and not necessarily Amundi US.
This feature is to provide general information only, does not constitute legal or tax advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of Institutional Shareholder Services or its affiliates.
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