A recent report from the PEW charitable trusts discusses the degree to which the pension funds of the states of the United States are increasing their use of “complex investments.” It also speaks to the consequences of this move.
The term “complex investments” is used here to describe any departure from the simple-and-safe use of government and high-grade corporate bonds. So equity is “complex,” as are alternative investments, including both private equity and hedge funds.
The majority of public pension funds target a long-term rate of return of between 7% and 8%. Only three of the plans surveyed by PEW fell outside of that range. Two of them are more ambitious than that: the Connecticut Teachers’ Retirement Board seeks a return of 8.5%, and the Minnesota State Retirement System seeks 8.14%. The only system that is less ambitious than 7% is the Indiana Public Retirement System (6.75%). These numbers represent a remarkably narrow range. This shows, the PEW report suggests, that all the funds involved are responding to the same pressures. Investment earnings on the simpler assets just aren’t enough, so some more aggressive strategy has become necessary.
Yield chasing isn’t the only reason for a change in the direction of complexity, though. Complexity also allows for hedging. In particular, “real estate and other real asset investments [in particular] can provide some protection against inflation as asset values tend to capture changes in the price of goods and services throughout the economy.”
Variations from State to State
One important point: the strategies vary wildly from one state to another. Some states make much use of alternatives. The Arizona Public Safety Personnel Retirement System has 30% of its assets in equities, only 13% in fixed income, and the remaining 56% in alternatives. (Rounding-issues prevent those numbers from reaching 100%). Even within the same state, the Arizona State Retirement System isn’t quite so bullish on alternatives as is the APSPRS. The same three numbers at the ASRS are, respectively: 53%; 19%; 28%.
The contrast between Arizona and Georgia is sharp (and it isn’t just dry heat versus humid heat). The Georgia Teachers’ Retirement System has 73% of its assets in equities, 27% in fixed income, and … absolutely nothing in alternatives. The Georgia Employees Retirement System? The numbers are similar there but involve a somewhat greater wariness of equity: 67%, 26%, 0% again for alternatives, and 7% for “others.”
There is also a significant divergence in performance. The best ten-year return in 2015 was that of the Oklahoma Teachers Retirement System (8.3%). The worst was that of the Wyoming Retirement System, at 4.5%.
The shift to more complex investments has had a number of consequences. One of them: public pension funds are paying higher fees than they once would have. State pension funds paid more than $10 billion in fees and investment-related costs in 2014. Such fees have increased by roughly 30% over a decade, “a boost closely correlated,” says the report, “with the rising use of alternative assets, which has more than doubled since 2006.” A related point: those alternative investments cost the pension funds billions of dollars in the performance fees of the alternatives’ managers.
Another consequence: the managers of public pension funds may be less well-informed than they once would have been about how their portfolio is doing. Alternatives managements in particular have different ways of valuing their assets and different norms on reporting on them. This isn’t the consequence of perversity or temperamental opacity on their part. They simply have underlyings that are not traded on open markets, which means one can’t just determine valuation by virtue of one’s facility with the Google search engine!
A Trend the Other Way
Some state pension funds are moving away from hedge funds in particular, if not from “alternatives” more generally. In this context, PEW references CalPERS, which eliminated its $4 billion hedge fund investment program in 2014, and the New York City Employees’ Retirement System, which voted to liquidate its hedge fund holdings in April 2016.
The liquidation of those holdings, in each case, was the occasion for a good deal of wailing and some gnashing of teeth. Some thought this was part of a trend that would pick up steam. It wasn’t, or rather it hasn’t.