Yet another study is out showing how public sector pension plans are responding to the new normal for investment returns. As of 2014, 25% of public pension assets are being held in alternative investments — i.e. private equity, real estate, and hedge funds — according to a recently updated study from Pew Charitable Trusts. This number is up from the 23% of assets in alternatives in 2012, and 11% in 2006.
The shift away from bonds and fixed income towards riskier assets is a chase for higher investment yields in the face of increasingly difficult assumed rate of return targets. Since 2001, the average assumed rate of return has fallen from 8.1% to 7.6%, according to the Center for Retirement Research at Boston College. However, most forecasts for the next decades suggest that traditional 60/40 portfolios are only likely to earn 5.5%-6.0%, leaving pension plans with the need to allocate fewer than 40% of assets to bonds and an increasing amount to alternatives.
The updated Pew study covers a sample of the 73 largest state pension funds managing $2.8 trillion of assets. One of the more extreme examples is Arizona’s Public Safety Personnel Retirement System (PSPRS), which has allocated over 80% of its investments to equities and alternatives since 2011. Pew’s report only covers data through 2014, but the most recent data from the pension plan shows that at the end of 2016 PSPRS was holding less than 9% of assets in short-term or fixed income asset classes.
Part of the Pension Integrity Project’s work was to help the Arizona legislature, labor representatives, and plan administrators collectively develop an improved governance structure that creates strong incentives against taking this kind of risk. A new pension board was installed under these new governance terms in early 2017, and it is anticipated that PSPRS will gradually lower its assumed rate of return and reduce the riskiness of its portfolio of assets.
For plans like PSPRS, the shift to alternatives has come at higher costs, as private equity and hedge funds tend to demand higher fees. The Pew study finds that reported management fees was $10 billion in 2014, which was, as a percentage of assets, 30% higher than the fees in 2006. But that’s not the whole picture. If unreported fees (typically carried interest, i.e. performance fees) were counted, an estimated $4 billion would probably be added to the total fees. Ultimately, the performance fees for private equity investments are typically far higher than the ordinary management fees for those assets. Unfortunately, most public pension funds do not report those performance fees.
The additional risk taking—and the consequently higher costs—do not necessarily lead to better results. At the same time they do not always mean failure. As my colleagues have highlighted on this blog before, the relationship between alternative investment and pension plan portfolio performance is not particularly clear. The South Carolina Retirement System and Indiana’s Public Retirement System have poor investment returns and large hedge fund allocations. At the same time Washington’s sprawling retirement plans and the South Dakota Retirement System have achieved excellent investment returns with alternative investment programs established several decades ago. Meanwhile, Oklahoma has seen relatively decent investment returns (compared to its peers) from its Teachers Retirement System (minimal alternatives) and Public Employees Retirement System (no alternative asset exposure).
What is clear, though, is that more equities and alternatives mean more risk, more volatility, and more administrative costs. If market returns were as high for more traditional stock and bond portfolios as they were a few decades ago those risks and fees would not be problems pension plans are facing. If market forecasts were pointing towards a return of that strong return investment environment, then the trend towards more risk and more fees would not be continuing. The new normal is becoming firmly entrenched.