Structural Problems Cause Public Pension Systems to Look to Alternative Investments

The largest state-level public pension systems manage hundreds of billions of dollars in assets, rivaling some of the largest private investors on Wall Street. Even smaller municipal pension systems frequently exceed $10 billion in assets. When combined, state and local public pension assets make up a nearly $5 trillion pool of money that millions of retired public servants rely on. Unfortunately, in recent years, unrealistic investment return assumptions and a challenging new investment environment have forced public pension plan managers and policymakers to make difficult decisions that significantly impact taxpayers. In some cases, state leaders have forgone making full pension payments and chosen to address what they view as more immediate budgetary needs rather than fully funding public retirement benefits already promised to workers. At other times, some pension plan managers have decided to make increasingly risky investments in pursuit of higher investment returns.

A state or municipality’s defined benefit public pension fund is often the largest pot of money being managed on behalf of the jurisdiction’s taxpayers each year. Pension funds are comprised of a payment from an employee’s paycheck, an employer contribution from the governing body (i.e. taxpayers), and investment returns earned on existing assets. When one of those three revenue streams is interrupted, the others need to make up the difference.

Over the last 20 years or so, public employee contribution rates into pension systems have increased in a handful of states and municipalities. Most employer contribution rates—or more accurately the rates that actuaries say they need to continue to fully fund the promised benefits—have increased dramatically. But many governments have failed to keep up with these necessary increases in contributions and have not been making the full public pension payments that actuaries suggest are needed to pay for retirement benefits promised to government workers. This, along with muted market results over the mid-term, has left pension fund managers with primary two choices: find ways to boost investment returns or slip further behind in funding.

The traditional blue-chip public equity and bond portfolio strategy sustained public pension systems for decades up until the year 2000 when most public pension plans were still fully funded—they had the money needed to pay for benefits promised. After the 2008 stock market fall and recession, however, low-risk stocks and bonds went from routine double-digit returns to returning far below the 8 to 9 percent expected by pension plan actuaries. The alternative asset market usually made up of actively-managed private equity and hedge fund limited partnerships promised higher returns and some relief for public pension fund managers feeling pressure to address the growing amount of earned—yet unfunded—pension benefits. But so far pensioners and taxpayers have received hard-to-value partnerships that are often expensive and ripe with political influence, manipulation, and corruption from this increased investment in these alternative assets. By expanding a fund’s exposure to alternative assets, public pension plan managers often limit the level of transparency and accountability within their public pension systems.

Public pension members and stakeholders should be aware that alternative assets, like hedge funds and private equity fund limited partnerships, can be effective investment tools, but can also be are very expensive. Pension funds compensate these limited partners based on the “two and 20” model where the limited partner is paid two percent of all assets being managed plus 20 percent of anything above expectations, usually equating to tens of millions of dollars being transferred from the public pension fund directly to private fund managers each year with little excess value to offer over the common, low-risk index fund.

Pension plan members and taxpayers should also know that the investment returns reported by these partners are calculated periodically throughout the life of the partnership, but the asset ultimately does not have an official return until it is liquidated at the end of the partnership, making the process of truly evaluating investment managers’ performance nearly impossible. This means that public pension plan managers will have a very difficult time determining if compensation associated with these investments is above or below their actual value.

As a result, pension fund managers in places like New Mexico began experimenting with a new compensation scheme based on the value generated by limited partners in excess of passive index funds, but limited partners willing to accept such compensation are hard to come by.

These issues have had a direct impact on retirees, especially the last few years. The reality is when public pension investments don’t perform as expected, more often than not, the difference is made up by taxpayers making increased contribution increases into the systems. And with inflation currently a growing concern, retirees are sure to voice concerns about higher prices and inflation shaving valuable dollars from their pension checks each month. Even career-long members of pension systems that enjoyed full funding for decades have not escaped the shifting global investment markets. So, what policies can realistically address the issues posed by alternative investments in public pension plans?

Policymakers need to address the underlying factors that put public pension plans in this difficult situation. Lawmakers have an opportunity to adjust their pension systems’ investment return expectations downward to set more realistic investment return expectations, which would help unearth the long-term benefit costs hiding in overly optimistic return rate assumptions.

Stakeholders and policymakers should understand that public pension system managers’ increased reliance on alternative investments is a mostly rational choice that is made because they are reacting to lower long-term market yields and employee contributions that have not kept up with actuarial needs. Many public pension systems looking to increase investment returns through making more investments in riskier, high-fee alternative assets are doing exactly what legislators set them up to do by failing to properly fund the pension systems.

If policymakers can understand why plan managers are taking this route with alternative assets, they can effectively address the underlying causes. Pension systems should ensure employee and employer contributions are at the proper levels and their investment return rate assumptions reflect the realistic long-term market and economic conditions. Doing so would better protect taxpayers and public retirement funds against a potentially volatile and unpredictable future.