In search of higher returns, public pension systems dive deeper into alternative investments

In 2022, many public pension funds reported significant investment losses, primarily caused by plummeting prices of public equities and long-term bonds, which account for nearly 70 percent of asset allocations on average, according to Public Plans Data. The 2023 economic forecast is expected to remain gloomy in the upcoming months as global economic activity faces sharp challenges, highlighted by rising geopolitical tensions in Europe, structural inflation risks, and lingering effects of the COVID-19 pandemic. All these factors raise a critical question of how U.S. public pension funds will allocate their assets to match or beat their often overly aggressive assumed rates of investment return.

Responding to across-the-board investment underperformance relative to their lofty return expectations, some public pension plans have greatly expanded their investments in high-risk, high-reward assets. More and more public pension fund managers have raised their target investment allocations to alternative assets, such as private equity, private credit, and real estate, over the past two decades in search of the greater returns needed to make up for large unfunded liabilities. Developments from the past few years suggest that many public pension plans do not intend to slow or stop this financially risky practice.

In May 2022, the New York state legislature passed a bill that increased its pension funds’ alternative investment ownership limit from 25 percent to 35 percent. Signed into law by New York Gov. Kathy Hochul just last month, the bill allows riskier investment strategies by the state’s three largest pension funds, with a total value of assets under management of approximately $700 billion.

Before that, other major pension plans took similar actions. In 2021, the nation’s largest public pension plan, the California Public Employees’ Retirement System (CalPERS),  announced a new asset allocation mix that increased the upper bounds put on its alternative assets from 22 percent to 33 percent. The new asset allocation boundary took effect on July 1, 2022.

Furthermore, the board of the Texas Employees Retirement System approved a new target asset allocation to be applied this year which lowers the fund’s public equity ownership to 35 percent from 37 percent and simultaneously increases the allocation to private equity from 13 percent to 16 percent. Similar movements have also been recorded in the Ohio Public Employees Retirement System, the Iowa Public Employees’ Retirement System, and the New Mexico Public Employees Retirement Association.

Public Pension Asset Allocation

The drive behind those reallocation decisions comes from tough economic perspectives and the downtrend of investment assets on public markets. The latest world economic outlook published by the International Monetary Fund (IMF) shows that global economic growth is projected to slow to 2.7 percent in 2023, down from 3.2 percent last year, as more than a third of the global economy likely enters contraction in the next 12 months.

In addition, the IMF says global inflation is expected to remain at a high level of 6.5 percent in 2023, after doubling from 4.7% in 2021 to 8.8 percent in 2022. These conditions indicate a macroeconomic transition to an economy struggling with high inflation and slow growth.

On the stock market, the returns of the two most popular investment assets—public equities and long-term bonds—experienced historically painful drawdowns together. For example, the Wisconsin Retirement System returned a net -7.3 percent for the plan’s fiscal year that ended June 30, 2022, as its two largest asset classes, fixed-income bonds and public equities, posted a net return of -12.7 percent and -16 percent, respectively.

Based on poor annual investment returns from the latest fiscal year that had been reported as of July 2022, the Pension Integrity Project projected that the aggregated funded ratio—the ratio of its liabilities to assets—of state government pension funds in the U.S. would fall from 85 percent funded in 2021 to 75 percent funded in 2022. For instance, CalPERS recently reported a major loss of -7.5 percent for its 2022 fiscal year, compared with its annual assumed rate of return of 6.8 percent. The failure to meet its investment expectations dragged down CALPERS’ funded ratio from 81 percent in 2021 to 71 percent in 2022, meaning it has just 71 cents of every dollar needed to pay for pension benefits already promised to workers and retirees.

Due to those ongoing challenges, many public pension plans are hoping that raising exposure in alternative assets will help deliver decent returns to improve their funded status, protect employees’ benefits against structural inflation, and preserve capital to meet legislative requirements.

On the other side of the coin, both policymakers and pension fund managers should be aware of the consequences of further expanding allocation into risky and volatile investments. The decision directly results in a substantial increase in a portfolio’s liquidity risk, which is usually underestimated by long-term investors. Even more pressing, engaging in riskier investments further exposes governments and taxpayers to the potential of even more unexpected costs driven by unfunded pension liabilities, which is already a major challenge at its current magnitude.

With over $1 trillion in public pension debt already and taxpayers ultimately on the hook to pay for these costs, public pension plans should not be taking on more financial risk. Instead, they should reduce their overly optimistic investment assumptions to reflect the consensus investment return forecasts for the next 20 years. Adopting lower investment return assumptions would improve the chances of meeting expectations and reduce the pressures to take on unnecessary risks.