As public pension plans take risks, SEC wants more transparency from private equity funds

State and local government public pension funds have unfunded pension liabilities in the hundreds of billions of dollars. In an effort to reduce pension debt and fund retirement benefits already promised to workers, public pension plans are increasingly turning to alternative investments. So, with the retirement security of public workers increasingly dependent on these types of alternative investments, the Security Exchange Commission is now proposing increased reporting requirements from private equity funds. Although private equity firms are understandably resisting the change and make some good arguments against the regulation, this requirement could potentially help taxpayers who are on the hook for these pension commitments by improving the ability of public pension systems to more fully evaluate the risks of alternative investment options.  

Traditional investments, such as public equities and bonds, are not producing at historically-high investment return levels and many public pension systems have increased their investments in higher risk and potentially higher reward investment options, like private equity.

In the aggregate, for public pension plans, investments in private equity have grown to  represent 8.9% of their total holdings, a notable acceleration since 2018. According to The Wall Street Journal:

Government retirement funds are pumping record sums into private equity, defying concerns about risk and cost as they try to plug pension shortfalls. U.S. pension funds’ private-equity investments swelled to an average 8.9% of holdings in 2021 after three years of straight growth, according to analytics company Preqin. That amounts to roughly $480 billion of state and local pension fund assets tracked by the Federal Reserve, up from about $300 billion in 2018.

Some of the growth comes from blockbuster 2021 returns—54% for private-equity funds tracked by the data analytics firm Burgiss, not including venture capital, for the year ended June 30.

However, return experience from investments in private equity has differed significantly between pension plans. This inconsistency adds to uncertainty over private equity’s suitability for ensuring the security and sustainability of pension plans for teachers, firefighters, and other public sector employees. 

Private equity investments are not easy to value , which can make it difficult for public pension investors to make informed decisions on this key subset of assets. For example, private equity funds only report their results annually, creating a significant lag in information for their shareholders.

Also, since they are not publicly traded, these private equity valuations tend to contain more inaccuracies than other similar investment reports. The Securities Exchange Commission does not require a list of assets to be publicly available, which also makes it difficult for investors and the public to access all relevant information. 

The proposed reporting requirement from the SEC would force private equity funds to report quarterly instead of annually. These reports would require details about fee structure, manager compensation, and performance of securities. These private equity funds would also be subject to annual audits. 

This proposed level of reporting will lend itself to public plans who need to evaluate the risks they are taking on, and it will hopefully help public pension plans reduce situations where they are caught off guard by investment returns coming in way below their expectations. For example, The State Teachers Retirement System of Ohio's holdings in private equity have not met the high expectations set for this classification of investments. The plan’s assets returned an average of 6.7% annually over the past 5 years, lagging well behind the plan’s 10% benchmark.  

Another example is the Pennsylvania Public School Employees Retirement System (PSERS), which allocated more than half of its assets to alternative investments. Critics of PSERS’ investment strategy have suggested that the fund would have been better off investing in index funds or even stocks and bonds. The plan’s private equity return over the last 10 years was 7.7%, which is lower than the S&P 500's return during that period. 

Private equity firms are understandably pushing back on this increased regulation, feeling they're private entities who offer sufficient information to their willing investors and that the government regulations will not improve their sector. Other concerns from private equity firms include the worry that the quarterly reports may also leave less time for companies looking to right the ship, a significant advantage for new companies looking to use private equity funding.  

The stage is set for further discussions on how private equity is monitored and reported. With more and more public pension dollars tied to private equity performance, the increased focus by the SEC is notable.

In the meantime, public pension funds should be careful in developing an over-reliance on private equity, which should not be viewed as the solution to public pension debt and the perpetual underfunding of pension systems.

The race for higher yields and the increased volatility that comes with it can threaten the fiscal health of public pension plans, which puts taxpayers and public workers at risk. The costs of public pensions are rising for most governments and an overreliance on private equity is likely to exacerbate the growing challenges facing government budgets and taxpayers.