Could alternative investments bail public pensions out?

Updated on

The crisis affecting public pensions has been widely publicized, and some public pensions are in such dire straits that they’re practically beyond repair. Illinois, New Jersey and Kentucky’s pension systems are less than 40% funded. What makes this difficult situation even worse is that many public pensions are operating on return assumptions that aren’t achievable. However, there could be one way U.S. public pension funds could get closer to those return assumptions, and that’s with alternative investments.

Get The Full Ray Dalio Series in PDF

Get the entire 10-part series on Ray Dalio in PDF. Save it to your desktop, read it on your tablet, or email to your colleagues

Q4 2019 hedge fund letters, conferences and more

Return assumptions for pension funds are too high

Citing data from the National Association of State Retirement Administrators, Nicholas Rabener of FactorResearch said in a post that the return assumption for the average U.S. public pension fund was 7.25% as of December. He also points out that this is too optimistic at a time when interest rates are low. Further, unrealistic return expectations mean the unfunded liabilities are even worse than currently told.

He ran the numbers for a traditional 60/40 portfolio with equities and bonds and found an annualized return of only 3.1% for the next decade. That indicates that pensions must look elsewhere if they're going to achieve the optimistic returns they claim to be targeting.

How alternative investments could boost pension funds

Since the traditional 60/40 portfolio won't get public pension funds anywhere near the 7.25% return they assume, he looked at alternative investments like real estate, hedge funds and private equity. He looked at 10-year return assumptions for a number of asset classes with several major asset managers. Based on the numbers, he found that nearly every asset class is likely to outperform bonds and U.S. stocks.

However, also noted that pensions should approach alternative investments with caution. For example, forecasts for asset prices can be extremely unreliable. He also pointed out that asset managers frequently have conflicts when they are creating forecasts because they offer products for multiple asset classes. Additionally, forecasts on alternative investments come from indices that are prone to data bias and tend to overstate returns.

To get an idea of which asset classes would help pension funds better reach their 7.25% return assumption, he created several sample portfolios. In addition to the 60/40 traditional portfolio, he also built a typical public pension portfolio containing 50% equities, 22% fixed income, 7% real estate and 19% alternative investments. He also looked at equal allocations to each of the seven asset classes and created an optimized portfolio with a maximum allocation of 25% for each asset class.

The only one of his sample portfolios to reach the 7.25% return assumption was his optimized portfolio, which exclusively allocates to international and emerging market stocks, real estate and private equity. It contained no exposure to bonds or U.S. equities. He explained that while some would say this is too risky, it is somewhat similar to the allocation of Yale University's endowment fund.

Studies show pensions have noticed alternative investments

Rabener isn't the only one who has noticed that alternative investments can give pension returns a boost. Citing data from Willis Towers Watson's Thinking Ahead Institute, Julie Segal of Institutional Investor reported just last month that pensions have been significantly increasing their allocations to alternative investments over the last two decades.

The data indicates that pension fund allocations to real estate, private equity and infrastructure climbed from about 6% 20 years ago to nearly 23%. The reason for the significant increase is returns. Alternative investments offer attractive returns compared to other asset classes, just as Rabener has noted.

However, Institutional Investor argues that a "cheap stock and bond allocation" would offer better reasons. The pension funds that were included in the study saw their assets increase an average of 15.2% for 2019. However, a portfolio consisting of 60% global stocks and 40% global debt returned 19.3% in 2019.

A clear difference between Rabener's findings and Institutional Investor's is that Segal used global stocks and bonds for her portfolio, while Rabener focused on U.S. stocks and bonds for his sample portfolios.

Leave a Comment