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Pensions Have Tripled Their Investment in High-Risk Assets. Is It Paying Off?

A growing body of evidence shows that "alternative investments" may be lowering returns and costing state and local governments more.

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So-called alternative investments include real estate and hedge funds.
Public pensions are more invested than ever before in high-risk and expensive assets like real estate and hedge funds. Yet research continues to show that this tactic is unlikely to improve their earnings.

According to Fitch Ratings, in the span of a decade, pensions tripled their average investment in these so-called alternative investments. In 2007, they averaged 9 percent of state and local public pension investment portfolios. By 2017, that number had risen to 27 percent. 

During that period, median average returns on overall investments were 6.2 percent, according to Fitch. But during the longer period between 2001 and 2017, reflecting a time of less reliance on alternative investments, they were actually slightly better: 6.4 percent.

“If you look at trends and allocation to riskier assets and the returns we see alongside them, you clearly see that you can’t necessarily say you’re getting the bang for the buck over the last 17 years,” says Fitch analyst Olu Sonola, who authored the report.

The report adds to the growing body of evidence that alternative investments are not worth the extra cost and risk. In fact, they may be lowering pensions' earnings and costing state and local governments more money.

Pensions' average investment returns -- overall, not just on alternatives -- failed to meet expectations between 2001 and 2017, even though those expectations lowered from 8 percent to 7.5 percent. Plans that don’t meet expectations require state or local governments to put more money in pension systems. Even high-performing pension systems like Colorado, Oklahoma, Utah and Wisconsin have had to increase their payments or give up being fully funded for this reason.

Only South Dakota’s retirement system, which is fully funded and relies the least among all 50 states on alternatives and equities, met its own expectations over that time period. Seven states -- Arizona, Connecticut, Hawaii, Maryland, New Hampshire, New Jersey and Rhode Island -- missed theirs by 2 percent or higher, according to Fitch.

The reason alternative investments aren't a safe bet, concludes Fitch, is because they tend to be volatile. But others dispute that idea. Andy Palmer, the chief investment officer for Maryland's pension system, says their strategy of investing more in alternatives is to reduce risk and volatility.

Before the 2008 financial crisis, nearly 70 percent of the Maryland system's portfolio was invested in stocks -- now it's less than 50 percent. Since then, Maryland has invested more in private equity, real estate and hedge funds.

"Reducing our risk in U.S. equities in particular and getting return from other sources, we believe, will protect us from those really sharp downturns," says Palmer.

The system has also slightly lowered its expected rate of return over the years from 8 percent to 7.45 percent.

Palmer points to the average 9.5 percent investment return the system has earned over the last 10 years as of this March. While that exceeded state expectations, it's not as good as some of Maryland's peers. Palmer says that’s the result of unfortunate timing: The system shifted away from stocks at a time when the market went gangbusters.

But Jeff Hooke, a visiting fellow for the right-leaning Maryland Public Policy Institute who has been critical of pension systems that invest heavily in alternatives, argues the real winners in this larger trend are the Wall Street bankers who make money from the high fees associated with these investments.

“You can basically replicate all these alternative investment strategies through the public market and save yourself all the fees,” Hooke says.

Fitch’s report backs up Hooke's claim. Passively managed portfolios (which are low-fee and leave Wall Street out of the equation almost entirely), have performed better than the average pension plan over the last 17 years.

This appears in the Finance newsletter. Subscribe for free.

*CORRECTION: An earlier version of this incorrectly stated that Maryland reduced its assumed rate of return to 7.55 percent. The correct number is 7.45 percent.

Liz Farmer is a former GOVERNING fiscal policy writer.
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