Public pension funds have been steadily adding alternative investments to their portfolios for years – but the managers they’re choosing aren’t delivering the returns they expect.
According to Kroll Bond Rating Agency, not all pension funds have the internal staff, governance, and oversight capabilities to manage the complexity inherent in portfolios with large allocations to alternatives such as private equity and hedge funds.
“Pension fund managers’ due diligence of their outside investment managers, the selection of the right manager for the right strategy, and a thorough understanding of fees are key for a pension fund becoming a top performer,” the rating agency said in a research report titled “The Big Shift: Did Public Pension Bets Pay Off?”
According to the report, public pension funds tripled their alternative investments from 10 percent of their portfolios to approximately 30 percent between 2001 and 2016, driven by a desire for better returns. The pension funds that got manager selection and other decisions right significantly outperformed their peers, with the top quartile of pension fund performers delivering an average annualized return of 6.3 percent over the 15-year time period.
Funds in the bottom quartile of performers had increased their alternatives allocations even more, from 7 percent of their portfolios in 2001 to 33 percent in 2016. These funds earned annualized returns of 4.6 percent on average over the time period, according to data gathered by Kroll.
Public pension funds aren’t the only institutions to fail to benefit from the heady promise of alternatives. The performance of Ivy League endowments has trailed a passive portfolio of 60 percent U.S. stocks and 40 percent bonds over the past ten years — and has been more volatile to boot, according to a report from research and analytics provider Markov Processes International.
Pension funds, both public and corporate, are underfunded for a myriad of reasons, including insufficient contributions, rising longevity, and unrealistic promises to retirees. But investment performance is a significant contributor. According to Kroll, the pensions in the bottom quartile of returns averaged a 63 percent funded ratio – in other words, just under two-thirds of the funds needed to meet payout obligations. The top quartile, in comparison, had an average funded ratio of 80 percent.
“If the bottom quartile had achieved the top quartile’s performance, the bottom quartile’s funded ratio would be 25 points higher,” the rating agency said in the report.
For large plans in particular, Kroll said it can be difficult to recover from consecutive years of underperformance. “The larger the plan, the less likely that subtle changes in allocations can make an appreciable difference in overall performance,” the report stated. “Attempting to compensate for low returns with dramatic and aggressive shifts in allocation toward sectors such as alternatives, especially the wrong ones, can exacerbate the problem.”
Beyond the main categories of alternatives – including hedge funds, private equity, commodities, and real estate – Kroll noted that pensions have to be able to evaluate how and when to use a wide array of investment subcategories. “Private equity can be further segmented into private equity buyout, private equity growth, private equity real estate and private credit, to name a few,” the report stated. “Each subcategory introduces different levels of risk and potential returns, and at different points in the market cycle will enjoy varying levels of success.”
Kroll advised pension funds seeking better returns to stick to traditional publicly traded equities and fixed income, citing evidence from Boston College’s Center for Retirement Research, which shows that smaller plans which mainly employ traditional asset classes outperform their larger brethren.
“Allocations to traditional asset classes combined with consistent contributions is the most reliable formula to ensure sufficient funding to meet future obligations,” the report concluded.