Public Pension Funds Continue to Boost Alts Allocations in Search of Higher Returns

Public pension funds have more money in alternative investments than at any point in history, according to a report from the Equable Institute, which warns that “pension funds are addicted to risk.”

The nonprofit organization’s State of Pensions 2023 report identified that the risk profiles of U.S. state and local pension funds have changed significantly in recent years, with pension fund alts allocations ballooning to more than $1.6 trillion in 2022 from approximately $100 billion in 2001.

Although the authors of the Equable report are clearly wary of the increasing amount of alternative investments public pension funds are holding, the report acknowledges that the institutional investors are facing a Catch-22 situation.

“There is no way that pension funds can meet their investment targets using simple stock and bond passive portfolios,” the report stated. “The probability of earning just a 6% return over the next decade is less than 50%.”

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According to Equable, this leaves pension funds with two choices: either increase contributions, which it says are already at “historically high levels,” or take on more risk. “It appears that the ‘take more risk’ route is likely for the major pension funds,” the report concluded.

According to Equable’s research, the share of pension funds’ assets in alternatives has grown to 34% as of 2022, up from an average of 10% between 2001 and 2007. The report found that, as of 2022, there was more than $620 billion from public pension funds invested in private equity, $460 billion in real estate, $310 billion in commodities and other miscellaneous alternative assets and some $240 billion in various hedge fund strategies.

The report noted a wide variance in how much state and local pension funds have invested in alternatives. Although most states have between 21% and 36% of their collective pension fund investments allocated to alts, some public pension funds have more than half of their investments in alts.

For example, the Louisiana School Employees’ Retirement System (59.7%), the Michigan Department of Treasury (58.5%), the San Francisco City and County Employees’ Retirement System (58%), the Washington State Investment Board (57.2%) and the Virginia Retirement System (55.5%) have all allocated more than half of their assets to alternatives, Equable reports.

“The increasing addiction to investment risk has meant exposing public employee retirement assets to the volatility of highly interconnected global markets,” Anthony Randazzo, the Equable Institute’s executive director, said in a release. “Beyond volatility, the heavy expansion into alternative asset classes that don’t have robustly transparent market prices—like private equity and real estate—means that each retirement system needs to start accounting for the amount of ‘valuation risk’ that their portfolio poses.”

Valuation risk arises, according to the report, because the reported value of assets used to determine contribution rates is dependent on the accuracy of “fair price” valuations. According to Equable, approximately one-third of the $4.8 trillion in assets that pension funds reported having in 2022 was “based entirely on nontransparent valuation approaches from asset managers,” as opposed to market-based prices, such as stocks.

“If these valuations are off, then today’s contribution rates have been miscalculated,” the report warned.