July 17, 2013

The Interdependence of Pension Security and Private Equity

By Bronwyn Bailey, Ph.D. Vice President, Research, Private Equity Growth Capital Council

In the wake of the financial crisis, American pensions face an unprecedented challenge. Pension funds are struggling to recover large losses suffered during the financial crisis due to declining stock prices. Throughout this period however, private equity remained a bright spot in pension portfolios. Now more than ever, pension funds have an interdependent relationship with the private equity industry. Private equity depends on pension plans for capital commitments, and pensions rely on private equity to provide superior returns to help meet their investment targets.[1]

Private Equity Funds Depend on Pensions for Capital

Pension funds are the largest investors in private equity. According to Preqin, public and private pension funds made up 43% of capital invested by private equity funds during 2001-2011. Public pensions alone make up 30% of the total capital invested. In contrast, foundations and endowments comprise only 19% of total capital invested during this period.

Moreover, pension plans continue to increase their allocations to private equity funds. Wilshire Consulting finds that the percentage of assets allocated to private equity by state pension plans more than doubled from 3.9% in 2001 to 8.2% in 2011.2 Preqin estimates that public plans’ current allocation (8.9%) to private equity is still below their target allocation (9.7%), based on average allocations of US-based pensions with $5bn or more in AUM. In the post-recession economy, public pensions are putting more capital in private equity funds at an increasing rate. Given these trends and the tough fundraising environment, private equity firms have become increasingly dependent on pension plans during fund raises.

Private Equity Provides Higher Returns Compared to Other Asset Classes

Pensions’ rationale for increasing their commitment to private equity is superior returns. A study by the Private Equity Growth Capital Council found that the median US public pension portfolio received an annualized 8.8% return from private equity, compared to 3.7% from public equity and 6.6% from fixed income for the 10 years ending 2011.[2] The median US pension fund portfolio returned an annualized 5.7% the same period. Generating 3.1 percentage points above total portfolio returns on an annual basis, private equity funds are boosting the retirement security of pension members.

Investment performance is important to public pensions because these returns are a major source of revenue. Portfolio returns comprise 61% of all revenues pensions receive. The other sources are contributions by employees, i.e. pension members who pay into the system, and by employers, i.e. state and local governments, which are funded by taxpayers.

Over the past decade, public pensions’ total investment returns have fallen short of their target rate of return. Pension funds have an average target return of 8%. The 8% target return is considerably higher than the 5.7% return received by the median pension plan over the last decade. Consistent underperformance – driven by low equity returns – has reduced the funded status of public pension plans. Based on a study from the Center for Retirement Research at Boston College, the overall ratio of assets to liabilities by public plans fell to 75% in 2011, from 103% in 2000.[3]

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[1] This article is based on a larger study conducted by the Private Equity Growth Capital Council.

[2]  Julia K. Bonafede, Steven J. Foresti and Russell J. Walker. “2012 Report on State Retirement Systems: Funding Levels and Asset Allocation”, Wilshire Consulting, March 2, 2012, p. 14.

[3] Alicia H. Munnell, Jean-Pierre Aubry, Josh Hurwitz, Madeline Medenica and Laura Quinby. “The Funding of State and Local Pensions: 2011-2015”, Center for Retirement Research at Boston College, Number 24, May 2012.