Hawaii Employees’ Retirement System pension fund up 15% for first half of fiscal year

There’s a new president in the White House, vaccines are rolling out across the country and Hawaii’s largest pension fund is on track to achieve its best fiscal year in a decade as it takes aim at whittling away at a $14.6 billion shortfall.

Fueled by a 9% investment increase in the October-December quarter, the state Employees’ Retirement System fund reached the midpoint of its 2021 fiscal year with a 14.8% gain, according to a new report presented to ERS trustees by investment adviser Meketa Investment Group. That number is on pace for the best performance since a 17.4% return in full-year fiscal 2014, and puts the fund on track to eclipse the 20.7% return that it chalked up in fiscal 2011. Assets, which include contributions and disbursements, rose more than $1.5 billion during the quarter to an all-time high of $19.56 billion.

“Our fourth quarter (October-December) investment performance is extraordinarily well received, especially as one looks back to the volatility occurring during the first quarter of (calendar year) 2020 and corresponding double digit declines in value,” ERS Executive Director Thom Williams said via email. “A 14.8% return for the year is remarkable, but reflects not only the general rise in the equity markets, but the expertise of our investment team and its leadership. We accept the arrows when the markets are down, so it’s appropriate that we accept the plaudits when they are up.”

The pension fund, which benefits more than 140,000 members and beneficiaries, still has 26 years to go, or until June 30, 2046, before it is 100% funded, according to the latest annual report by independent auditor Gabriel Roeder Smith, which was presented in draft form to the state Legislature last month. The portfolio’s funded ratio was 55.3% as of June 30, slightly better than the 55.2% it was at a year earlier. The fund’s total shortfall of $14.6 billion was a little wider, as expected, than the $14.08 billion shortfall from the previous year.

Gabriel Roeder Smith calculates that the fund’s shortfall will increase annually until peaking at $15.08 billion in the fiscal year ending June 30, 2026. The actuary says the shortfall subsequently will begin declining in fiscal 2027, assuming all assumptions are met regarding contributions, an average annualized investment return of 7% and mortality expectations.

“It’s at that switch-over point in fiscal 2027 when a larger portion of the monthly contributions will go toward paying principal rather than interest, and that’s when the unfunded accrued liability begins to decline,” Williams said in a phone interview.

Legislation became effective July 1, 2017, to close funding shortfalls by having state and county employers increase their contribution percentage over a phased-in, four-year period for general workers and police and fire employees. The employees’ contributions remained constant. The new, higher employer rates were intended to remain constant once established.

Williams said despite the budget shortfall that the Legislature is going to keep the contribution plan intact to lower the pension fund’s unfunded liability and keep the ERS on track to be fully funded in 26 years.

“Clearly, the COVID-19 pandemic has caused the State to take a hard look at all forms of savings and expenditures, including reducing or deferring contributions to the ERS,” Williams said in an email. “I am pleased to report that to date both the Legislature and the Governor have decided not to lower or defer ERS contributions. Lower pension contributions, despite their short-term attractiveness, lead to higher long-term costs. Each $1 of immediate savings costs the State about $4 to make up later. Though tempting, reduced contributions now don’t create savings but rather added expense.”

Williams said prior deferral of ERS contributions is almost solely responsible for the unfunded liabilities that exist today.

“The specter of short-term savings from the deferral of retirement contributions is illusory at best,” he said.

The ERS pension fund began the current fiscal year, which ends June 30, with a 5.3% return in the July-­September quarter and exceeded that performance in the fiscal second quarter with a 9% return, which easily beat its benchmark of 7.1%. The benchmark is a composite of various market-sector returns that are meant to emulate the investments in the ERS portfolio.

The fund’s return has beaten its benchmark over one year (10.4% versus 8.9%), three years (7.3% versus 6.4%), five years (9.1% versus 8.1%) and 10 years (8.1% versus 7.7%). For the first six months of its fiscal year, the fund’s 14.8% return also beat its benchmark return of 13.4%.

“I am really proud of our team and our performance, particularly considering we had to adjust to a lot of rapidly changing conditions this year,” ERS Chief Investment Officer Elizabeth Burton said via email. “2020 was a strange year — it accounts for 3 of the largest single day S&P losses in history, but also for 2 of the largest gains. It was a highly volatile and stressful time to be in financial markets and yet we beat our benchmark by an extremely wide margin last quarter and increased our assets by $1.5 billion. We are beating our benchmark across all time periods — and are exceeding our 7.0% (targeted) return.”

However, the pension fund’s 9% return trailed the median return of peer funds that have more than $1 billion in total assets. The median return of a peer fund last quarter was 10.5%. In fact, the ERS fund trailed the peer fund return for one-, three- and five-year periods.

Burton said that given the ERS’ risk-averse investing strategy, trailing the peer funds was expected.

“The delta between us and peer funds in the fourth quarter (October-December) is to be expected, given how much we outperformed them in Q1,” she said. “We outperformed peers by over 300 basis points Q1 2020 (-9.5% for ERS versus -12.6% for peers). Our portfolio is designed to protect in falling equity markets. The trade-off … is that we will lag peers in rising/bull equity markets. Thus, our results in the remaining quarters of 2020 performed in line with expec- tations. We are more conservatively positioned (particularly with our allocation to stabilized equity and lower exposure to high yield).”

Burton said when equity markets rally — as they did at the end of 2020 — the ERS fund is expected to lag peers that are less conservatively positioned.

“We are more focused on portfolio protection as compounding positive returns are critical to maintaining and improving our funding ratio,” she said. “That said, I am extremely proud of our 2020 performance.”

Williams said he’s optimistic about the investment outlook now that vaccines are rolling out worldwide.

“I feel significantly better today about the near-term prospects for our domestic and global economies though uncertainties remain,” he said. “New and increasing numbers of COVID vaccines will help societies and consequently businesses, return to a new normal. Questions relative to the effectiveness and speed with which populations can be inoculated combined with the emergence of new variants poses near unfathomable risks. On balance, however, current knowledge of the virus in combination with the new administration’s COVID relief and economic development packages provides near-term hope.”