‘Contrarian’ State Pension Plan is One of The Nation’s Best-Funded

South Dakota’s retirement system for public workers is a bright spot in an era when some state and local governments around the U.S. are struggling mightily to cover their pension costs.

The state has one of the nation’s best-funded public pension plans. There are a number of factors that have likely contributed to its good health—like the state’s regimented approach to making payments to the fund, conservative planning and ability to be flexible with benefits.

But the way South Dakota invests its retirement fund assets, which totaled about $12.2 billion last year, has also played a part.

Matt Clark, investment officer for the South Dakota Investment Council, which manages the state’s public retirement system investments, along with other state financial holdings, describes a “contrarian” approach that the state takes when investing.

He explains that this is not always an easy path to go down and that it can sometimes mean passing up near-term profits with the hope of achieving longer-term gains.

“The people most willing to suffer, with the least certainty of an eventual reward, are the people who would naturally be a contrarian,” Clark told Route Fifty recently.

“It works because only a few are doing it,” he added.

Amid the Great Recession, the pension fund plowed money into the banking sector, which Clark characterized as the “cheapest, beaten down, scary thing” at that time.

It then dialed these investments down as the market improved.

“If you bought in ‘09 and the market’s up three to four fold since then, then obviously that was a really good thing,” Clark notes. “So far, bad always got followed by good again.”

He points to the “dot-com” market bubble that burst around 2000 as another time the state adhered to contrarian principles. “We sold out in 1998 and watched everybody else get rich for two more years,” Clark said. “It eventually crashed and then we ended up ahead.”

The retirement fund was also once investing more heavily than it is today using strategies that are often associated with hedge funds, like “convertible arbitrage” and “merger arbitrage.”

“We did it for more than 20 years, very successfully,” Clark said. “We were good at it.”

But as more investors flocked to these types of niche investments, the returns the state could squeeze from them became less lucrative. And in recent years South Dakota backed away. “The flood of money rushing into the area just kind of ruined it,” Clark said.

“We like those categories, but we think you need to move in and out based on when they’re cheap or getting overcrowded,” he added.

These days the fund is holding an outsized share of cash compared to other public pensions. Public Plans Data, which compiles information on the nation’s state and local public pension plans, shows that as of 2018 South Dakota had about 18.7% of its portfolio allocated as cash, compared to a nationwide figure of 1.8%.

One reason for this is that markets are expensive right now. “We’re defensively positioned and we have more cash,” Clark said. “If the market crashes, we’ll load up.”

South Dakota manages many of its retirement system investments internally, but will turn to expensive outside managers at times. “Those real estate managers that we have,” Clark said, “they’ve done so well that they’re worth more than their fees.”

Public pension plans are generally funded by three main sources: contributions to the fund from state and local government employers, contributions from public employees who will eventually receive benefits from the plans, and earnings from the fund’s investments.

Fitch Ratings in a report published in May, which looked at 180 state and local public pension plans in all 50 states, noted that South Dakota was the only state where actual returns did not fall short of investment targets between 2001 and 2017.

Public Plans Data shows that the state retirement plan’s funded ratio, which is a measure of how its assets stack up against the benefits it will owe to retirees in the years ahead, has been at or above 100% every year since 2013 and has stayed above 91% since 2001.

The aggregate national funded ratio for plans Public Plans Data tracks was around 72% last year.

And the picture for some troubled plans is quite bleak. Illinois State Employees’ Retirement System had a funded ratio of just 36.5% last year, while Kentucky’s system for teachers was just 57.7% funded.

Beyond the state’s investment results, Clark points to other reasons why South Dakota’s pension fund is in good shape.

One is that the state, unlike some of those having pension problems, has been diligent about making the annual contributions required to keep its retirement system fully funded. “We never postponed a penny,” Clark emphasized. “We paid 100 percent on time, every time.”

He also highlights that the state currently uses a relatively low 6.5% “assumed rate of return.”

This is one of the key assumptions that pension plan managers make. Setting it too high can overstate how well a retirement plan is funded, and while this lowers the cost burden on a government and its taxpayers in the present, it pushes costs onto future generations.

The National Association of State Retirement Administrators in research updated this year looked at 129 plans and found more than 90 percent reduced their assumed rates of return since fiscal year 2010, resulting in a decline in the average to 7.27% from 7.91%.

South Dakota also varies cost of living adjustments, or COLAs, the retirement plan extends to beneficiaries, keeping the adjustments more conservative in leaner years. “We say: ‘how much COLA can we afford and still be 100 percent funded?” Clark explained.

If ratcheting down the COLA isn’t enough to keep the plan fully funded, the state has identified other benefit reductions that it can carry out as part of what Clark describes as a “disaster plan.”

“We may have to cut benefits to do it,” he added. “But we’re going to be 100 percent funded.”

Benefit cuts may sound ominous. But Clark says state pensioners can take comfort in knowing South Dakota’s retirement system is in sound financial condition and that they’re going to continue getting benefits, rather than worrying whether it could catastrophically fail.

Beneficiaries also get to share in the boom times for the fund as well as the hard times, he noted. “Ultimately, whatever we make, eventually, over the course of time, flows into the hands of our members,” Clark added. “We just want to do the best job for them we can.”