Recently, investors are showing an increasing appetite for risk. To this end, more investors are now moving away from the public markets into alternative investments such as private equity, corporate loans and real estate. This includes retirement plans where there is growing interest in “alternative investments.”
Public Pension Plans Hope to Increase Returns by Taking on More Investment Risk through “Alternative Investments”
· Public pension plans today face a significant funding gap. It is estimated that unfunded liabilities in these plans total almost one trillion dollars. This predicament is due to years of underfunding; overpromising; unrealistic demands from public employee unions; and rich early retirement benefits.
· Demographics are now exacerbating this dilemma. The graying of America is resulting in a cash flow shortfall as the number of retirees is increasing relative to the number of active workers. Benefits paid out by the majority of public pension systems now exceed contributions coming in. Two obvious ways to close the funding gap are reduce benefits and/or raise taxes. These alternatives present obvious political challenges so many plans have chosen instead to try and increase investment returns by taking on more risk.
· Historically, pension plans have been conservative investors allocating their portfolios primarily to publicly traded stocks and investment grade bonds.
· However, in recent years, many public pension plans have allocated a portion of their portfolios to alternative investments such as private equity, corporate loans, and real estate. Alternative investments are relatively expensive, lack liquidity, and can be difficult to evaluate. There are very high minimums and funds are locked up, sometimes for many years. There is concern that because alternative investments tend to be opaque, the risks may not be well understood by many plan fiduciaries.
· To date, these investments appear to be paying off. Alternative investments were a big driver of the returns during 2021 in many public pension plans. The average median return for public pension plans in the 12 months period ending June 30, 2021, was 27 percent. As a result, the funding status of these plans has improved – the ratio of assets to liabilities on average is now about 85 percent. While these returns are impressive, some public pension plans achieved comparable or better returns while maintaining a more traditional portfolio invested in publicly traded stocks and bonds.
· However, the outsized returns that many investors achieved in 2021 are not expected to continue indefinitely. While alternative investments offer the potential of higher returns, this obviously comes with increased risk. This can be especially true in down markets because of the lack of liquidity. A possible omen of things to come may be the Orange County 1994 debacle when significant bets on risky derivatives forced the County into bankruptcy.