Public Pension Shift to Alternatives Results in More Volatility

A shift to more complex investments has significantly increased fees, volatility, and potential losses, according to a report by The Pew Charitable Trusts examining investments by the 73 largest state public pension funds.

The analysis also estimates that $4 billion in investment fees are unreported each year.

The report, “State Public Pension Funds Increase Use of Complex Investments,” finds the funds studied have assets under management of more than $2.8 trillion, making up about 95% of all state pension fund investments.

The use of alternative investments varies widely—from none to more than half of fund portfolios. While examples exist of top performers with long-standing alternative investment programs, the funds with recent and rapid entries into alternative markets—including significant allocations to hedge funds—reported the weakest 10-year returns. Although longer time horizons will allow better evaluation of these investment strategies, funds and policymakers should carefully examine risks, returns, and fees in the meantime, Pew says.

The data do not reveal a best or one-size-fits-all approach to successful investing, but there is a uniform need for full disclosure on investment performance and fees. In 2014, more than one-third of state-sponsored funds reported performance figures before deducting the costs of investment management. In addition, unreported investment fees—primarily performance payments made to private equity managers—totaled more than $4 billion in 2014, or about 40% above the $10 billion in reported investment expenses for that year.

“Public pension funds have increasingly relied on more complex investments in an effort to diversify portfolios and boost annual returns, a shift that can result in greater financial returns but also can increase volatility and the possibility of losses,” says Greg Mennis, director of Pew’s public-sector retirement systems project. “These trends underscore the need for transparency on plan performance and attention to the impact of investment fees on plan health.”

Looking at recent returns across state plans over the past five years, Pew found that funds posted overall fiscal year gains ranging from 17% in 2014 to 1% in 2016.

Government sponsors should consider investment performance both in terms of long-term returns and cost predictability, according to Pew. From this perspective, many fund portfolios are highly correlated with the up-and-down swings of the stock market and expose state budgets to considerable risk and uncertainty.

Investment performance varies widely among public pension funds, with only two of the funds examined exceeding investment return targets over the past 10 years. Although these results reflect the losses that occurred at the onset of the Great Recession, more recent performance, low interest rates, and forward-looking economic forecasts point to the need to closely examine long-term investment return targets.