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The CalPERS board is likely to wrestle back control of setting the pension fund’s discount rate or investment rate of return, a process that had been done automatically since 2015 when it was enshrined in the pension fund’s risk mitigation policy.

Under the current system, when returns at the $485 billion asset owner exceed 2 per cent of the discount rate, the rate of return is automatically lowered. A recent meeting of the finance and administration committee in an “information only” item that will go back to the board in April 2024, found enthusiasm to take back control of setting the discount rate, foreshadowing future debate and deliberation ahead around what the discount rate should be.

“I think the board has the wherewithal to make these decisions without this automatic trigger,” said Theresa Taylor, recently re-elected as board president. She noted how adjustments in the discount rate impact employers and members because it causes their contributions to rise.

“I didn’t realise that anything over 17 points is a 2.5 per cent reduction. That could be pretty hard.”

The trigger policy rests on various conditions. If investment returns outperform the discount rate by 2 per cent, the discount rate is automatically reduced by 0.05 per cent. If returns outperform the discount rate by 7 per cent, the discount rate will automatically reduce by 0.10 per cent. If investment returns outperform the discount rate by 17 per cent, the discount rate will automatically reset 0.25 per cent lower.

“There is a ceiling of 25 basis points when investment returns outperform the discount rate by 17 percentage points,” said Michele Nix, interim chief financial officer.

The trigger has only gone off once. In 2021 when CalPERS returned 21 per cent off the back of record pandemic-fuelled returns in private equity and stocks, the discount rate was lowered from 7 to 6.8 per cent where it currently sits. Prior that that, in 2015 the board lowered the pension fund’s discount rate from 7.5 per cent to 7 per cent, phased in over three years.

Nix explained that the automatic strategy is designed to lock in the benefits of higher returns by lowering volatility over time and providing greater predictability for employers around contribution rates. Exceptional performance of previous years helps to ensure sustainability and reduce risk, she said.

Board member David Miller also voiced his doubt over the automatic trigger. “It is our responsibility to make reasoned judgements on these things. We should have things come back to us for input. It shouldn’t just happen as a matter of course without us stepping up to responsibilities,” he said.

The board heard that many of CalPERS stakeholders are not familiar with the automatic policy which also triggers new strategic asset allocation targets based on the reduction of the discount rate.

Something that typically results in investing in less risky assets. “If you expect to earn less, you can invest in less risky assets,” said Nix. When the discount rate was reduced in 2021 CalPERS had been going through an asset liability study, and the allocation was changed as part of the change in the discount rate, said Nix

CalPERS will conduct another asset liability study in February 2025.

The pension fund is in the process of selecting a new CIO following the resignation of Nicole Musicco last September. Last year the pension fund said it hopes to onboard a new CIO “in early 2024” and has budgeted $300,000 for the hunt, including all search fees.

Illinois Treasurer Michael Frerichs, in office since 2014, oversees a $55 billion portfolio of which he is sole fiduciary, including a $25 billion state funds portfolio and an $9 billion investment pool called Illinois funds.

Frerichs, the state’s CIO and banking officer, does not oversee pension assets in this sole fiduciary model. The capital feeding the portfolios under his watch comes from taxpayers rather than people saving for their pensions.

But the governance structure offers a window into other US states where sole fiduciaries are also responsible for pension assets. A model that has been criticised for opening the door to politicising investment and is often seen as outdated. In 1848 Illinois’ voters chose to make the treasurer an elected office, and Frerichs is the 74th person to serve in this role. [See The politicisation of investments at US public funds]

And the funds under the treasurer’s management are steadily increasing, thanks to higher interest rates, income tax increases as well as market gains. The portfolio made $1.33 billion in investment earnings during 2023.

Frerichs likens the structure to himself as a CEO of an organisation reporting to a corporate board. In this case, Illinois’ General Assembly which sets guide rails that restrict the way the portfolios can invest. For example, the state treasurer is not allowed to invest directly in publicly traded stocks and most of the portfolio is invested in low-risk, short-term investment vehicles like government bonds, bank deposits and money markets.

In another example, he points to the processes underlying his decision to increase the carve out from the state funds portfolio to the Illinois Growth and Innovation Fund (“ILGIF”), originally set up in 2002. It involved presenting a case to the General Assembly on the rationale to move away from the long-term preference for low risk fixed income investments and invest more in alternatives, upping the private equity allocation from 2 to 5 per cent and pushing into infrastructure, real estate and student debt. The fund is now authorized to invest over $3 billion in alternative investments over the next ten years.

“I am the sole fiduciary, but I think of it like I have a large board in terms of the General Assembly. They give me guideposts and I can’t invest anyway I like,” he says. “The General Assembly doesn’t like risk and generally, the state treasurer hasn’t taken much risk. But we convinced them that a program like ILGIF can produce better returns and have an impact on the state.”

He says one of the most obvious benefits of having one person run things is that day-to-day decision making is easier and quicker, and opportunities aren’t missed, particularly in the ILGIF allocation.

“The manager may be doing another round of funding and come to us. If we had to wait for a board meeting, we’d miss out.” Quick decision-making is also important in the liquid allocation during fluctuations in the market and when things change, like in 2023 when low expectations for growth turned more positive. “We are able to change as circumstances change,” he says.

Moreover, Frerichs, a Democrat who will go back to the electorate in 2026 for a potential fourth term, says his political beliefs don’t impact investment strategy and his two hats as both an elected politician and fiduciary don’t conflict. He says both these roles have the same purpose – to serve Illinois.

“Every decision we make is on behalf of taxpayers or account holders of our state. Every dollar made via investments is a dollar that does not need to be raised in taxes, earned income that can be used to fix roads, repair bridges and invest in our local communities,” he says. Meanwhile, ILGIF, the growth, innovation and impact allocation champions Illinois, retains quality technology-enabled businesses in the state and crowds in other investors.

Still, US public pension fund CIOs that align investments with social goals and believe that shareholders have a role guiding corporate behaviour (particularly around ESG) have attracted criticism from the right. They argue asset owners should always put returns first and shouldn’t interfere with corporate freedom. But Frerichs believes investors are right to not simply “trust the CEO.”

“I have a problem with this, ” he says. “Why wouldn’t investors want more information? Investing is hard and access to more information can lead to better results. We are owners of these companies, and they chose to go public and should listen and communicate with ownership. Not listening to shareholders is anti-capitalist,” he says.

At Illinois, ESG is integrated into the investment process via asset managers, all required to consider risk and opportunity “outside traditional metrics.” Illinois actively manages around $30 billion of state investments and pooled funds in-house. Leaving around $19 billion managed externally via direct relationships with asset managers. “We build true partnerships with managers with consistent performance, a repeatable process and clearly defined philosophy that guides decisions,” he lists.

Frerichs says he views sustainability as an evaluation of one of many risks in pursuit of long-term value. He says investors need to look at the intangible elements that increasingly make up an asset’s value; companies are valued on their reputation, IP, and brand value and susceptible to a new kind of risk, for example.

Asset management

The portfolio’s small cohort of external managers is rarely changed although the manager for the college saving account recently was, mostly because of fees. Frerichs says he holds managers “feet to the fire” regarding fees to stop these costs eating into growth. He says he won’t invest with hedge funds for this reason.

He also prefers to work with Illinois-based managers. “We have a bias locally, but we are also looking for the best deals. We work with managers in our state, but not exclusively.”

Looking to November he expects greater volatility and the potential for monetary policy to be politicised and a possible impact on the dollar. “The US is looked to globally for stability in monetary policy, but the traditional playbook is being thrown out.”

In our 2024 outlook, we highlight the current macro backdrop, three key questions our clients are asking and investment considerations they may want to make.
(more…)

Geopolitical tension remains elevated, and corporate supply chains and inflation are ongoing risks, but Markus Aho, chief investment officer of Varma, the €57.4 billion ($61 billion) Finnish pension fund, says the portfolio has stood up well to challenges on the investment landscape mostly because of its carefully woven diversification.

The portfolio is divided 50:50 between fully liquid and illiquid assets or, put another way, 50:50 between equity (private and listed) and fixed income, hedge funds and real assets. It wasn’t built for the low interest rate environment of yesteryear and won’t change for today’s higher interest rates.

“There are surprisingly few cracks. We are happy through the cycle,” says Aho.

He is eyeing opportunities in venture and believes alternative credit has further upside because of balance sheet restructuring in coming years, but says neither of these opportunities will show up in any shift in allocations.

One area of concern is growing concentration in the equity portfolio. Slow growth in Europe, a long-term laggard in terms of GDP growth and index returns, means Varma has limited its European weighting in its international portfolio. Geopolitical trends make it difficult for investors to access opportunities in Asia which leaves the US, where performance is concentrated in a few, very large companies.

“It’s become narrower and harder to achieve diversification in US public equity,” he says.

Varma manages everything in its liquid allocation internally, either directly or through ETFs. Aho doesn’t place limits on the team’s ability to seek alpha in listed equity, but strategy must maintain passive exposures and the portfolio also needs to incorporate thematic allocations.

All the illiquid bucket is invested through or with managers, investing in co-mingled funds and tailor-made funds as well as co-investing alongside managers.

Twenty per cent of the total equity portfolio is invested in Finland. Because many of the companies in the allocation are global, he doesn’t worry it has an impact on diversification. The portfolio comprises active and direct exposure, but the focus on public companies also makes it a proxy for Finnish index exposure.

“We are a large owner of a lot of Finnish companies and these tend to be stickier investments. We are a long-term owner and don’t move in and out of the Finnish market,” he says. Mettle that was tested when Finnish equity was hit hard when Russia invaded Ukraine.

Many companies had exposure to Russia which they had to write down. Something he flags as a warning sign to companies with large exposures to China, if the geopolitical situation worsens.

“We haven’t seen negative risk perception of Finland because of the war in Ukraine. People still invest in South Korea and Israel, and they are both in geographically difficult places in the world. Our alliances and alignment with the West is more important than where we are on the map. Financial markets tend to be cold about these things.”

Hedge funds add diversification

An important source of diversification comes from Varma’s 16 per cent allocation to hedge funds, a portfolio that has evolved over the last two decades. It used to comprise mostly traditional allocations to long/short equity but is now also populated by less liquid investments that span different forms of corporate credit, exposure to US real estate and residential markets.

The portfolio’s job is to hedge risk and provide diversification from Varma’s large equity program, fixed income and real assets, he explains.

“We are always trying to look at new uncorrelated strategies in the hedge fund portfolio. In my mind, a hedge fund is a structure where you can put in place different hedges and change the profile and correlation, but you always have underlying risk.”

The qualitative strategy is also combined with human analysis. Aho has introduced quantitative strategies to measure and test diversification, and ensure the team understands the behaviour of the underlying assets in every asset class. “We look at individual assets and try to model behaviour and correlations and pull that to the portfolio level.”

The same qualitative approach has been helpful informing sustainability, as well as diversification, in private equity. “When we want to understand sustainability in private equity or exact industry exposures in private equity, we also need to know the underlying assets in the portfolio and model up from the bottom up.”

Waiting out the downturn in private equity

The private equity portfolio has experienced a sharp drop off in activity. After years of plentiful liquidity, exits and new deals, M&A activity is subdued, the IPO market “shut down” and valuations unknown.

Moreover, he says net cashflows into and out of the portfolio are predictable but gross cashflows can change hugely. It means the team is focused on keeping the allocation steady and a firm eye on open commitments.

“We are investing in fewer new deals to keep more in the portfolio,” he says. “We are less active because we want to wait it out and see what happens. If there is any chance you might be in a hurry to get out of illiquid assets, you don’t want to allocate so much to begin with.”

Varma’s average private equity commitment is around $100 million, and the pension fund rarely introduces new managers. Strategy is focused on a limited number of key managers equally weighted regardless of size. Although they don’t just focus on the mega names, most managers are at the larger end of the market ($1 billion AUM) because of the amount of money the fund invests.

“We look at new names in the lower-mid-sized category to check if they are drifting up.”

He adds that the fund increasingly uses the same “best in class” managers across asset classes, homing in on strong relationships and fee savings. “We can achieve more through the same relationships across different assets classes. We find it’s easier to watch over, negotiate with and partner with fewer relationships,” Aho says.

The impact of pension reform

Varma is also operating against the backdrop of reform to the Finnish pension sector. Negotiations between unions, pension funds and policymakers, seeking to future proof a system facing challenging demographics, are trying to measure how increasing pension fund risk would impact the spectrum of outcomes.

“There is a system level discussion underway to decide how much risk pension funds want to take on,” says Aho “Policy makers don’t want to find out in ten or twenty years-time they made the wrong decision.”

Previous reforms have introduced more risk and flexibility into pension funds’ investment strategies and over time Varma’s portfolio has changed to include a larger allocation to equity and alternatives which is now close to its natural limit. “We shouldn’t just increase equity for the sake of doing so,” he says.

As a long-term investor, Varma has “some room” to extend its equity allocation but many different assets in the portfolio already have equity-like return expectations, he continues.

“If we had a traditional portfolio of listed equity and government bonds, it would be easier to calculate our potential return from adding, say, a 10 per cent allocation to equity.”

Nor does he want to have to sell too many assets to buy equity.

“We still need the diversification benefits we get from hedge funds, real assets and fixed income,” he concludes.

The $260 billion New York State Common Retirement Fund (CRF) will divest and restrict approximately $26.8 million of corporate bonds and actively traded public equities in eight integrated oil and gas companies, including ExxonMobil.

The fund has taken the step of divesting or restricting its investments in companies whose energy transition plans do not measure up to “minimum standards to assess transition readiness and climate-related investment risk”.

The fund’s most recent divestments and restrictions follow similar steps taken in 2023 in 50 companies which it also assessed as not being sufficiently prepared for the energy transition.

As a result of its latest review, the New York fund will restrict or sell down its holdings in Exxon, Guanghui Energy Company, Echo Energy, IOG, Oil and Natural Gas Corporation, Delek Group, Dana Gas, and Unit Corp.

Under New York Comptroller Thomas DiNapoli’s 2019 Climate Action Plan, the CRF aims to transition its investment portfolio to net-zero greenhouse gas emissions by 2040. (See NY State Common’s climate plan).

One of the fund’s core climate-change beliefs is that most of its investments are at some degree of climate change-related risk, but there is still time for those risks to be managed.

The fund plans to conduct analysis on companies in its portfolio that operate in sectors identified by the Taskforce on Climate Financial Disclosure as being high-impact; and on major US-based utilities which it believes are “among the highest emitters of greenhouse gases, but also potential leaders in developing climate solutions”.

The fund believes that some of the companies at greatest climate change risk are also among those best-placed to develop and offer climate change solutions. It says engagement with investee companies is a key component of how it identifies and addresses climate-related risks.

Alternatives build out

Strategy in the next few years will be most focused on growing the allocation to alternatives in line with a target to allocate 25 per cent of AUM to alternatives by 2025. The boosted strategy is a response to market volatility amid macroeconomic and geopolitical uncertainties, and a recognition that the benefits of diversifying between equities and fixed income are becoming less apparent. KIC had previously aimed to raise its alternatives target to 25 per cent by 2027.

KIC’s alternative allocations currently comprise private equity, real estate and infrastructure, and hedge funds. Five year returns in these portfolios came in at 13.5 per cent, 5.5 per cent and 5.7 per cent respectively. KIC will focus particularly on investment opportunities in private credit and will access opportunities both directly and through external fund managers. KIC began making direct private equity investments in 2010 and co-investments with GPs in 2011.

The decision follows other leaps forward in its approach to alternatives that include last year’s acquisition of private debt manager Golub Capital to supports the hunt for stable cash flows via loans to blue chip companies.

In another milestone, KIC opened its Mumbai office in January, its first local presence in emerging markets. The investor said the new office will become an integral part of its sustainable growth by capturing new investment opportunities in the world’s fastest growing economy, primarily in the private equity, venture capital, real estate and infrastructure markets.

Employees will be tasked with research, deal sourcing, and building and managing networks with investment managers in India.

KIC begun investing in hedge funds in 2010 and runs a diversified strategy using multiple approaches. In its latest annual report it states a renewed focus on absolute return strategies that take advantage of arbitrage opportunities such as equity L/S, event-driven and fixed-income arbitrage, seeking to tap the impact of rising interest rates, increased market volatility and other changes in the financial environment.

In 2019, KIC set up an Asset Allocation Forum, charged with adjusting asset class weights and companywide risk management. “We hold an asset allocation forum every quarter to integrate top-down and bottom-up views from various investment departments and formulate a house view to ensure a reliable asset allocation process,” states its annual report.

The equities team also runs a quota program to allocate to domestic securities firms with overseas stock trading orders as part of a continued effort to support growth in the domestic finance industry, a key goal at the fund.

KIC launched the International Finance Academy, an educational program that nurtures overseas investment specialists and supports the development of Korea’s finance industry. The fund has also revamped its compensation system “because we know that if KIC wants to grow excellent talent, they need excellent compensation.”