Transferring Investment Management from SCERS to WSIB (SB 5116, 2017) SCERS Analysis Background Sen. Reuven Carlyle introduced SB 5116 during the 2017 legislative session. It did not come to a vote in the State Senate. The Bill would have provided an option to Seattle, Tacoma and Spokane, as first-class cities, to irrevocably transfer the management of the assets of their retirement systems to the Washington State Investment Board (WSIB). This transfer would be effectuated by the first-class cities investing in the Commingled Trust Fund (CTF), which WSIB has established to efficiently and collectively manage the assets of the state retirement systems. A sole representative of the first-class cities would be appointed by the Governor as a nonvoting Board member. WSIB has a large internal investment staff who are responsible for making investment recommendations. SCERS’s structure differs from this with a smaller internal investment staff (of four individuals) that is complemented by extensive involvement from its external general investment consultant (NEPC). NEPC is the largest consultant to public pension plans with currently over 250 employees and 350 clients representing total assets over $950 billion. SCERS had no official position on the legislation. Chair Tim Burgess and Executive Director Jeff Davis did request that it be amended so that the boards of the first-class city retirement systems would have responsibility for deciding whether to pursue the option available in the legislation since the boards are the plan fiduciaries. This change was not adopted. SB 5116 would leave this responsibility with each city council and the members of each retirement system. Stated Rationale • SB 5116 contends that SCERS (and the other first-class city systems) is too small and costs too much to administer relative to the WSIB CTF and that the higher administrative costs and the more limited investment opportunities available to SCERS will lead to both less investment return and more risk over time. SCERS response: SCERS and WSIB have similar investment-related expenses as a percentage of their respective asset sizes. For the 2016 fiscal year, expenses for SCERS and WSIB were 0.42% and 0.41%, respectively i. This includes reported expenses attributable to investment managers, consultants, custodians and internal investment staff. SCERS does not have a meaningfully smaller investment opportunity set than WSIB. SCERS allocates to a similar set of asset classes and maintains a diversified portfolio by asset class, geography, sector and issuer. • SB 5116 suggests that WSIB’s outperformance relative to SCERS (and the other firstclass city systems) over the last ten years is evidence that the WSIB will continue to generate higher future returns. SCERS response: Over the last ten years through June 30, 2017, the WSIB CTF has provided a net return of 5.5% as compared to 3.7% for SCERS. However, most of SCERS’s underperformance is due to the WSIB CTF’s strategic asset allocation that has a far greater allocation to the private equity asset class. SCERS has also taken steps over the last many years to improve its investment capabilities and enhance its investment portfolio, including increasing its allocation to private equity. Additionally, a broad analysis of public pension plan performance shows that large plans have generated the same return on average as small plans over the last ten years ii. Further Considerations While WSIB is a well-respected investment organization that has generated strong historical performance, there would be challenges and costs if SCERS were to transfer investment management by investing in the CTF. These include: i • SCERS would no longer have any input into the management of its pension assets, including the strategic asset allocation. This means that SCERS’s portfolio would not reflect its unique funded status, required liquidity and risk tolerance that are universally considered by public pension plans when setting their strategic asset allocation. Instead, SCERS’s pension assets would be invested in a portfolio that has been developed for the state plans that have a far different profile, particularly related to funded status (SCERS: 65%, WSIB: 90%). This could pose a significant issue if WSIB, given its stronger funded status, choose to de-risk the CTF at any point in the future while correspondingly reducing the assumed rate of return. As a result, the City would be forced to materially increase its pension contribution even though it would have otherwise preferred to continue with the prior investment risk and return profile. • SCERS would incur substantial transaction costs or have an imbalanced portfolio for a multi-year period following the transfer. Indications are that WSIB would allow SCERS to transfer cash and public market securities in return for shares in the CTF. There are some limited transaction costs that would result from this activity. However, there is also a meaningful portion of SCERS portfolio (est. 20% including cash reserves to meet contractual commitments) that is in private market investments that are unlikely to be able to be transferred and will therefore remain in the SCERS portfolio. SCERS could decide to sell these private market investments on the secondary market and likely incur substantial discounts to their current valuation. Alternatively, SCERS could continue to hold these private market investments until capital is naturally distributed over a period of up to 15 years. If the latter course is pursued, SCERS would have an imbalanced portfolio for a multi-year period with an excessive allocation to private market investments (incorporating its indirect ownership via the CTF). SCERS would also need to maintain some level of investment staff to monitor these investments. • The challenges listed above are magnified by the fact that a transfer to the WSIB would be irrevocable. WSIB has understandably required this transfer to be irrevocable given their long-term investment strategy and the CTF’s substantial allocation to private market investments. SCERS would therefore have no ability to unwind the transfer or resume responsibility for its investment management, even if there was a compelling reason to do so (e.g. WSIB choosing to de-risk the CTF). Note that investment-related expense comparisons across public pensions are complicated by several factors: (a) certain investment manager expenses may be included as an offset to investment income, rather than reported separately, for various reasons such as when expenses are automatically deducted from an investment product; (b) asset allocation decisions can have a large impact on expense differentials due to the significantly higher cost associated with private fund investments. ii Based on SCERS’s analysis of the Public Plans Data Universe (available at publicplansdata.org) for fiscal year 2016 where the universe is divided in equal parts into large, medium and small plans based on asset size at the beginning of the ten-year period. Raw data has been adjusted for the issues of fiscal year-end differences and multiple counting.