OPERF's balancing act
Oregon Public Employees Retirement Fund (OPERF) is one of the most aggressive and successful US public pension funds. Its performance speaks for itself: 20.6% annual return for the 12 months ending September 30, 2000; 16% annual return for the five years ending the same date.
But its success is also the subject of a big dispute between employers (public administrations contributing to the fund) on the one hand and employees (unions representing members of the fund) on the other hand. The former complain that OPERF benefits employees far more than employers and want a larger portion of the system’s returns; the latter do not want to give up any benefit and threaten to fight back. In the middle, OPERF tries to balance opposing pressures and safeguard its achievements.
As of September 30, 2000, OPERF managed $41.3bn (e44.3bn). The fixed income portfolio is managed internally by the Oregon State Treasury; all equity assets are managed externally, because Oregon law prevents the Treasury from investing directly in single stocks.
“The primary goal of the OPERF investment programme is realisation of long-term earnings in excess of the rate currently_8% assumed by the actuary,” explains Dan Smith, director of the investment division. “To realise this objective, the Oregon Investment Council (OIC) has maintained a strong preference for common stocks. Currently, equities securities comprise approximately 60% of total OPERF assets, measured at market value. The OIC reviews the asset allocation policy on a regular basis and a re-examination of key assumptions is conducted every three years.”
According to the last target allocations decided by the OIC, the fund should be invested 60–70% in equities (30–40% in domestic equities, 15–25% in international equities, 7–13% in alternative equities); 22–32% in fixed income securities; 5–11% in real estate, and 0–3% in cash. The actual allocation, as of September 30, 2000, was: 39.5% in domestic equities, 16.3% international equities, 13% alternative equities, 24.6% fixed income, 6% real estate, 0.6% cash. In other words, OPERF has a preference for domestic and alternative equities, which have in fact contributed the most to the fund’s brilliant performances: respectively 28.6% and 39% for the period here considered.
“The value added in domestic equity performance versus the benchmark can be explained by exceptional returns delivered by active management and the resurgence of small to mid-capitalisation,” comments Smith. “The OPERF portfolio has had a deliberate overweight toward smaller companies, with the expectation that these securities will provide superior, or at least competitive, returns over long periods.”
Around 17% of total OPERF assets or 43% of domestic equities are passively managed by Barclays Global Investors (BGI); 22% of total assets (or 67% of domestic equities) are actively managed by many different firms. The largest mandates are $1,317m to Nicholas Applegate Capital Management and $1,029m to Wanger Asset Management, both specialising in small caps.
“Given the long-term attractiveness of equity holdings, no changes to the current strategy are anticipated or recommended,” says John Fewel, senior investment officer. “We remain optimistic regarding the future, but realise there will be periodic bumps in the road.” So in October 1999 the OIC decided to scale back the small cap weighting to a 40% overweighting relative to the Russell 3000 benchmark.
BGI is also the manager of the $2bn passive international equity portfolio (30% of total international equities). The largest active international managers are Marvin & Palmer Associates (Wilmington, Delaware), Driehaus Capital Management (Chicago, Illinois) and Rowe Price Fleming International (Baltimore, Maryland).
OPERF’s alternative equity investments have won it much headline coverage – most recently last August, when OPERF committed $1bn to Kohlberg Kravis Roberts’ newest fund. This, according to the Wall Street Journal, is the biggest investment by a public pension fund in a private equity fund to date. OPERF’s relationship with the New York buyout firm goes back some time, starting with $200m invested in KKR’s 1986 fund. The realised value (returns of capital plus profit distributions) of that first investment was $832m at the end of 1999. Since then OPERF has committed a further $2.2bn to KKR initiatives, not including last August’s new commitment. The KKR portfolio now represents more than 40% of the $5.4bn OPERF Alternative Equity Program (AEP).
“The internal rate of return since the 1981 inception of AEP has been a very respectable 20.4%,” says Fewel. “The decision by the Oregon OIC to remain an active private equity investor has enhanced returns greatly. While it may be unrealistic to expect these returns every year, over the long term the return characteristics for this asset class continue to be quite compelling.” Talking about the special relationship with KKR, OPERF spokespeople explain: “KKR’s investment funds and related partnership structure is somewhat unique. Investors generally execute commitment letters for a particular KKR fund, which sets out the amount committed to the fund and the relationship between the investors and KKR, including the management fee structure. Individual investments are then separately structured and funded directly to that special purpose limited partnership under the terms of the particular KKR investment fund commitment letter.” OIC likes this structure. But its AEP is invested also into other partnerships (for example, with Texas Pacific Group), reviewed regularly by the consulting firm Pacific Corporate Group.
OPERF employee members can choose whether to contribute to the OPERF general account, which is diversified in equities and bonds, or to a new “variable fund”, a growth-stock fund that invests in the stock market and which totaled $2.1bn assets at September 30, 2000. They can also make voluntary supplementary contributions to the Oregon Savings Growth Plan: a sort of 401(k) plan, which offers an array of nine investment options ranging from lower to higher levels of investment risks. This programme’s consultant is Frank Russell Company. The Growth Plan’s total assets were $605m at September 30, 2000.
Until February 2000, OPERF employer members could only contribute to the general diversified account. After the Oregon Public Employees Retirement System (in which OPERF is by large the biggest fund) discovered in 1998 an unfunded liability of $2.6bn, the average public employer’s contribution was raised to 11.4% of its total payroll, up from 9.4%, starting in July 1999. Some of the biggest municipal and county governments in Oregon had asked the system to close the $2.6bn gap by using the $3.5bn gain-loss reserve, a fund created to make up the shortfall should the investment fund fail to earn at least 8% per year. But the system board maintained that state law prohibits it from doing so. In May 2000 the local governments decided to sue the system claiming – among other things – that the board could have reduced the burden on employers and instead has been acting only on behalf of employees.
The lawsuit was filed even if the system board had decided, in February 2000, to allow employers to start funnelling their pension contributions into the variable fund and to take some of the pension fund’s 22.3% gain for 1999 and use the money to increase to $4.74bn the gain-loss reserve.
The last move upset the unions, because it reduced the 1999 earnings available for distribution to employees, especially the longest-tenured workers who have the biggest accounts in the OPERF fund. “The volatility of markets makes it important for the state to increase reserves,” point out the system’s spokespeople, noting that state law requires that individual pension accounts earn at least 8% annually, even if the stock market falls. If the target is missed, the gap is made up by the gain-loss fund.
Actually the board decision looks very wise, if you look at 2000 performance: at September 30, one-year return was 20.6%, but year to date return (first nine months of 2000) was only 6.1%.