How Do Alternative Investments Stack up in State Pensions?

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There are numerous expert opinion on the proper investment strategy for public pension funds. In 2012, the Pioneer Institute’s Ilya Atanasov cited concerns about risk and subpar returns in recommending that public pension funds divest from certain complex alternative including private equity and hedge funds. Instead, Atanasov suggested funds invest in safer, more stable assets such as fixed income securities and even holding some portion of assets in gold and cash-equivalents as a hedge against market volatility.

Today, private equity and other alternative investments constitute an ever-larger portion of asset portfolios. Hedge funds and private equity as of March 2017 make up 19.2% of the Pension Reserves Investment Trust (PRIT), which manages assets for Massachusetts state pensions. This is a huge increase from the 5.5% of their asset portfolio PRIT had in these alternative investments back in 2005.

Hedge Funds

Hedge funds fill their portfolios with a diverse set of assets designed to reduce risk by minimizing exposure in any single market. Hedge funds, unlike mutual or index funds, have access to specialized financial instruments, or derivatives, in order to shield themselves from market volatility.

The problem is that all of this comes at a cost. According to Bloomberg, the average hedge fund charges about 1.48% of assets in fees and an additional premium on returns over a certain threshold. Because of the high fees, in order for hedge funds to be a worthwhile investment, they must offer either higher returns or lower risk than other asset classes.

Unfortunately, the returns on hedge fund investments have not been stellar. The average hedge fund performance lagged behind the S&P 500 by about 3% annually over the last 10 years. This is consistent with PRIT’s first quarter 2017 report, which shows that over the last decade, hedge funds have returned only 3.1% annually net of fees, significantly lower than the fund’s average return of 5.2%.

Long-term predictions don’t paint a much brighter picture. Actuarial assumptions are a prediction of future returns based on future expectations for the market, current market fundamentals, past history, and professional judgement.

According to Horizon Actuarial Services, a company that provides actuarial services to pension funds, in 2016 the expected 20 year return for hedge fund assets was 6.1%. This is 1.4% lower than the 7.6% 20-year return that was predicted in 2012. To put this difference in context: $1 invested at a rate of 7.6% in 20 years it would be worth $4.33, but only $3.27 at a rate of 6.1%. Horizon’s assumptions decreased by .8% or less for every other asset class. This means that actuaries have been consistently revising down how well they think hedge funds will do in the future, a trend that makes hedge fund investments seem like an increasingly unattractive choice.

Hedge funds do have an advantage in that they tend to be very stable. Volatility measures how much returns can fluctuate year to year. Hedge funds have a standard deviation of returns of only 8.7%. This is very low when compared to riskier assets like private equity which has a volatility of 23.9%.

Private Equity

The bulk of private equity funds invest in private companies or buy out public companies, attempt to improve their operations, and resell them for a profit.  Although the funds purchase many companies to diversify and limit risks, the underlying investments may fail or sell at a loss. A high payout on a successful investment may more than offset many failures.

Private equity has seen very high returns over the past three decades. PRIT’s private equity investments have returned 14.1% over the past 10 years, significantly higher than any of their other asset classes. Assets can earn outsized returns in one of two ways. Either they exploit inefficiencies in the market’s valuation or they incur additional risk. For the last three decades, private equity has fallen into the former category but nowadays it is moving towards the latter.

Forbes reports that in 1992 there was only about $30 billion invested worldwide in private equity. As of 2015, the total was $4.3 trillion. In the past, private equity firms have been able to make outsized returns since there were only a few investors and each could pick the most profitable buyouts. Yet, according to the same CEPR report, “Capital flows into private equity have grown much faster than attractive target companies for [private equity] acquisition.” This is why the last 10 years have seen a steady decline in private equity returns. Horizon projects a 20-year return of 10.2%, which although lower than historical returns, is still the highest projection of any asset class.

While returns in private equity have been going down, risk has been consistently high. According to a paper published by the Center for Economic and Policy Research, “today, past performance of a fund managed by a particular [fund] is no longer a good predictor of how that [fund] will perform in the future.”

Horizon’s survey agrees with this assessment. They show a 23.9% standard deviation (SD) in returns. Standard deviation measures how far the results are likely to be from the average. To put this in perspective, this means that 68% of all private equity investments will have returns between (13.7%) and 34.1% or one SD from the mean, and 95% of all funds will have returns between (37.6%) and 60%, or two SD from the mean. By comparison with a mean of 4.5% and a SD of 5.9%, 68% of all U.S. core bonds will have yields between (1.4%) and 10.4%, with 95% having yields between (7.3%) and 16.3%.

While the “average” private equity investment will be a pretty good deal, results are wildly inconsistent.  Private equity tends to have a lot of stellar performers and a lot of losers that perform disastrously. It is nearly impossible for investors to predict where their investments will fall within this range. This could spell bad news for taxpayers who are responsible for a defined amount of benefits regardless of asset performance.

This is not necessarily a reason to avoid investing in private equity. Despite the high risk, private equity is projected to have the highest returns for the next 20 years of any asset class and high returns mean less of a financial burden on cash-strapped state budgets to pay back unfunded liabilities. As of March 2017, PRIT has 10.7% of its assets in private equity.


So what is the correct asset allocation for public pension funds to pursue? Joshua Rauh and Robert Novy-Marx argue that unlike someone with a personal retirement fund who may be willing to take a risk in order to hopefully earn more in retirement, pension funds need a specific amount of money to pay a defined benefit to retirees regardless of market activity. Therefore, it might be wise to invest only in assets that guarantee a specific payout: bonds and treasuries.

Pension funds set their expected rate of return based on average asset class performance and don’t factor risk into their calculations. By taking on additional risk, funds can theoretically lower their unfunded liabilities by driving up assumed returns. However, if these investments go south, as risky investments are prone to do in events such as the Great Recession, then taxpayers could be responsible for an even larger portion of the underfunded pension system. Under this line of thinking, pension funds should begin to divest private equity holding.

Not everyone agrees however. While researching for this blog, I met with Mr. James Lamenzo. Lamenzo is an actuary for the Public Employee Retirement Administration Commission (PERAC), the regulatory agency that oversees Massachusetts’ retirement boards. He argues that it is important for funds to generate rates of return that are much higher than fixed income securities. If pension funds invest in low-yield assets, then taxpayers are forced to cover an even larger portion of unfunded liabilities. According to Lamenzo, decreasing the assumed rate of return by .25% increases liabilities by about 2.5%.

By my own calculations using data from MassPensions, with $50 billion in unfunded liabilities, if every board across the Massachusetts state retirement system were to revise their expectation down just .25%, taxpayers would be on the hook for an additional $1.25 billion. Lowering expectations to those of safe, fixed-income securities would lower the assumed rate of return by at least 2%, increasing actuarial liability by about $10.9 billion.

In contrast to the lower rate proposed by Rauh and Novy-Marx, Lamenzo believes that an assumed rate of return of 6% is likely “too conservative” for a long-term assumption and generally recommends that the Massachusetts boards use assumed rate of returns in the 7.25%-7.5% range for PRIT systems in 2017. He recommends assumed rates of return about .25% lower for systems not invested in PRIT. To get these returns however, funds must partially invest in assets that at least take on some additional volatility, which may include private equity. Rate of return assumptions in Massachusetts are ultimately decided by the boards themselves and not PERAC.

For better or worse, many pension funds across the country have decided to shed their hedge fund investments in the wake of declining returns and high fees. According to Institutional Investor, some of the biggest pension funds including the New York City, New Jersey State, California State, Rhode Island State, and Kentucky State Retirement Systems have greatly reduced or eliminated hedge fund assets. Private equity, however, has not seen such a decrease. In the end, it comes down to the question of whether or not taxpayers should be made to underwrite additional risk in the hopes of reducing the total tax burden. However, as long as private equity returns stay high enough, we are likely to see continued investment in the foreseeable future.

Joshua Beck is a Roger Perry Transparency Intern focusing on public finance. He is currently studying computer science and economics at Brown University.