US Economy Public pension plans tilt toward alternatives

While alternative investments are a catch-all phrase for a wide variety of investments, they broadly comprise private equity, hedge funds, real estate, commodities, and private credit. The move toward alternatives picked up pace in the aftermath of the 2008–09 Global Financial Crisis, which saw extreme market volatility. This trend has accelerated over the last two years, as the pandemic took its toll on financial markets in 2020, and the Federal Reserve's aggressive monetary tightening has induced substantial asset price drawdowns and market volatility since the beginning of 2022.

The tilt toward alternatives has shown broad participation among public pension plans over the last two decades. Per estimates from the Center for Retirement Research at Boston College, more than 80 percent of state and local government pension plans allocated 20 percent or more of their assets to alternative investments in 2022. That is a sharp increase from 2001, when only about 10 percent of public pension funds had a similar level of allocation.

Large, prominent public pension funds recently announced significant long-term investments/allocation decisions to alternative investments. On 23 December 2022, New York Governor Kathy Hochul signed into law an expansion of the so-called "basket clause" in the state's Retirement and Social Security law. The basket clause covers non-traditional investments such as hedge funds and private equity. The law's "Legal list" covers traditional asset classes such as public equities and bonds. The expansion will allow the New York State Common Retirement fund, New York City Retirement system, and New York State Teacher's Retirement System to raise their alternative investment allocation from 25% to 35%.

Over on the west coast, the University of California entered into a long-term strategic relationship with Blackstone on 3 January 2023. UC Investments (the entity which manages the university's pension and endowment assets) will invest USD 4 billion in the Blackstone Real Estate Income Trust (BREIT), a USD 68 billion private real estate fund set up in 2017. The university's pension fund had USD 22 billion, (approximately 28% of assets), in alternative investments, prior to this new investment in BREIT.

The key rationale, often cited by pension fund managers, is the attractive risk-return profile of alternatives. They offer diversification benefits, owing to their lower correlation with traditional asset classes. The Center for Retirement Research at Boston College estimates that alternative investments had a small negative impact on returns over the last two decades, but also appear to have meaningfully reduced portfolio volatility. However, they caution that it is difficult to precisely estimate volatility reduction given the intrinsic difficulties in valuing alternative assets as well as the lag in data availability.

While the jury may be out on a precise estimate of the benefit alternative investments provide, one thing is clear: They will play a much more significant role in determining overall public pension portfolio characteristics and performance in the years to come, given their rising allocations. While states have shown resilience in the face of current market volatility, pension dynamics will continue to be an important driver of their long term credit quality.

Main contributor: Sudip Mukherjee

Content is a product of the Chief Investment Office (CIO).

Original report - Public pension plans tilt toward alternatives, 11 January 2023.