Art by Robert Hunt
Matt Clark, chief investment officer of South Dakota Investment Council (SDIC) and Board of Trustee member of the South Dakota Retirement System (SDRS), has long been known as an “investment rock star” to other CIOs. The $12.4 billion SDRS plan managed by the SDIC is always at the top of the funded lists at 100% funded. South Dakota public employees can pretty much bet that their pensions will be solid for them when they retire. But Clark, with his self-depreciating humor, would describe himself as a mere long-distance runner, able to endure the short-term pain to get to the long-term goal. We asked Clark to describe the ingredients of the secret sauce that put the SDRS plan on steroids when it comes to funded levels. He says it has a lot to do with the sustainability of the plan’s design.
Leg 1: Be Religious about Making Regular Contributions
Perhaps it’s most important to start with lessons learned from the pension plans that got in trouble and are now facing credit downgrades and lots of drama. “The most important thing to stay out of trouble and have a sustainable plan is to always put the contributions in, every single year,” he told CIO.
To Clark, whether or not contributions should be made should never be a question: It should be non-negotiable. “You should not look at how much room there is in the budget and then ask I wonder how much we should put in the pension plan this year?” It should be automatic and not subject to discussion or discretion or putting it off or anything like that.”
The contributions should be paid systematically as part of payroll. If the tab is too high, it may mean it’s time to cut salaries or employees, but never skip the contributions. Requiring employees to also contribute can help make this easier.
Clark admits he might have an easier path than others. He says policymakers in South Dakota have been concerned about the long-term and have been willing to listen and make hard decisions. If some places are unwilling to make hard choices, they may risk going bankrupt, he says.
Clark says it’s always tempting to lower the contribution rate during times of financial or budget stress; South Dakota policymakers have resisted the temptation. There was a realization that no one knew where the bottom was, and there was no telling, even during a crash, if things would get worse and how long it might last. The difficulty, he says, was that if contributions aren’t paid when times are tough, double or even triple may need to be contributed later—which may not be feasible if conditions remain challenging. When conditions eventually improve and more resources are available, there will be competing demands for them, and the hole becomes more difficult to escape.
Clark says, “If we don’t have the money to pay the pension, we shouldn’t be promising people they’re going to get a pension.” He suggests that employees monitor the funded status of their pension. He says if he was in a pension that was in trouble, he would want the plan to have the difficult conversation now about putting money into the fund regularly. It would be difficult to depend on a plan if the funding is not happening and there is no realistic path to sustainability.
Leg 2: Set Realistic Goals
“The second-most important thing is to resist the temptation to increase benefits every time markets hit a new peak,” says Clark. If the market is at a peak and the fund appears a little overfunded, it should be considered temporary because bubble valuations are unsustainable. It is better to use a neutral valuation of the markets to judge whether there is extra money to spend, Clark suggests. It is important to use realistic assumed returns. South Dakota uses a 6.5% assumed return but contributions are a bit higher than requirements so just over 6% is needed to maintain full funding.
“We think that’s much more realistic than the traditional 8% assumption from decades past,” says Clark, especially when stocks are high and interest rates are so low. Unrealistic assumptions may be hiding the underfunding problem instead of addressing it. If a plan only earns an average of 6% instead of even 7%, it will become 10% more underfunded every decade.
If extra money is available and the plan can pay extra benefits, Clark suggests paying them as one-time sums. “Don’t say we’ve got a billion dollars extra, so let’s promise $5 billion of extra benefits that maybe only have a present value of $1 billion, assuming we could earn 8%. You’re creating even more of a liability dependent on earning 8% for it to work out when you’re not going to earn 8%, you’re only going to earn 6%,” he says, warning, “if the debt bubble in the country and around the world ever comes home to roost, then 6% might look like an optimistic scenario.”
Leg 3: Account for Longer Lifespans
Clark says people are living longer and pension funds need to recognize that lifespans are continuing to lengthen. “Every year that goes by, the likelihood of someone living to 100 is going to go up,” he says.
He says the South Dakota plan uses fully generational actuarial tables, which also project continued increases in lifespans into the future. Potential for even further longevity increases is another reason to not raise benefits when a fund is temporarily overfunded.
Leg 4: Build Some Flexibility into the Liability
Clark says even fully funded plans need the ability to dial things back if markets turn south, so building flexibility into the benefit structure to handle bad times is key. South Dakota has found that the least painful way to adjust benefits is to trim the rate of cost-of-living adjustments (COLA) increases.
In difficult times, the COLA might be reduced to the floor level of .5%. This can cause benefits to fall behind inflation. When conditions improve, the COLA is automatically restored as the COLA each year is determined by backing into what the plan can afford and still be 100% funded, Clark says.
But what happens if things get so bad, that the plan falls below 100% funded even at the bottom of the .5% to 3.5% range of the COLA adjustment?
If the COLA flexibility isn’t sufficient, South Dakota’s statutes require that other changes be made to promptly get back to 100% funded. A contingency plan for this scenario focuses first on adjustments to benefit features such as early retirement that are more generous than a new plan started a couple years ago for new members. In extreme circumstances, benefit formulas may need to be reduced until conditions improve.
Leg 5: Change Your Laws
The ability to change laws to increase benefit flexibility is also important, says Clark.
Two years ago, South Dakota came up with a new retirement plan design called the “Generational Plan” for new employees. The new plan has a normal retirement age of 67 and does not allow unreduced early retirement. The legacy “Foundation Plan” has a normal retirement age of 65 and allows for unreduced early retirement at age 55 with 30 years of service. To more closely equalize the value of the two plans while still increasing flexibility, the new plan allocates a modest portion of contributions toward defined contribution-style member accounts.
The accounts earn the return of the assets of the defined benefit plan, which helps share investment outcomes with members.
“To build support for increasing flexibility you’ve got to make your contributions, because employees aren’t going to want to adjust their benefits if the only reason you’re in trouble is because the employer didn’t put the money in they were supposed to,” warns Clark.
Leg 6: Have Good Investment Results over Time
South Dakota has had very favorable investment results over the long-term. This has enabled the fund to increase benefits over the decades while still being 100% funded. In fact, returns have ranked at or near the top for the past 10 and 20 years, and for its 45-year history. (Clark has been there for 36 years, beginning as an intern out of business school.)
He suggests a focus on long-term investment value based on discounted cash flows. He says similar guidance could be provided by using a simple PE approach. He says the valuation tools help maintain discipline and help avoid chasing overvalued “hot investment products.” He suggests that if a plan can tolerate a little short-term underperformance pain, it can “lean in a contrarian fashion a little bit to try to add some extra value. He says exposures can be adjusted more significantly to try to add significant extra value but that comes with the risk of severe short-term underperformance. South Dakota has a high-quality investment team with long tenures which helps when focusing on the long-term, he says.
Clark is a former long-distance runner, and likes to equate investing to track sports. To him, fast traders are like sprinters—they get the glory, win quickly, and don’t have to endure much pain. Short-term investors also get to win quickly and do not have to endure pain for long. But successful short-term investors need to be smarter or faster or luckier than others. A long-distance runner is not fast enough to compete at short distances. Success for them depends on discipline and willingness to endure pain. Likewise, success for a long-term contrarian investor depends on discipline and willingness to endure the pain of short-term underperformance.
“You don’t have to be a genius to be a contrarian. You just have to have a strong enough desire to win to endure the pain,” he says.
He jokes, “the pain keeps the smarter people away that don’t think they should have to endure pain… And we have kind of concluded that, well, we’re not smart enough or quick enough or lucky enough to be a successful short-term investor, but we are willing to endure pain.”
That pain created steady results over the long term, and during most multiyear periods, when he lands in the top quartile.
“People here are more used to the pain and more used to the idea that the pain leads to a reward five to 10 years down the road. Sometimes the reward comes much sooner but you have to brace yourself for it to be five to 10 years down the road.”
Related Stories:
CIO Profile: Matt Clark (South Dakota Investment Council)
Tags: funded status, Matt Clark, pension, South Dakota Investment Council, South Dakota Retirement System