Bringing Pension Funds into the 21st Century – A Double Sided Opportunity for Alternatives

With the exception of a couple of well-known behemoths, the term “pension fund” often conjures up the image of risk-averse investments created as a necessity for an organization’s workers.  It’s typically a stale subject.  Most prefer to stay quiet, as articles often focus on funds that have issues with the adequacy of investments to compensate retirees.  

Rarely does the word opportunity appear.

However, pension funds across the globe have felt considerable strain during recent years to reevaluate their asset allocation strategies as solvency concerns, stakeholder expectations, interest rate pressure, the cost of equities and other headwinds increase. As a result, many have increasingly diversified into alternative assets. Global pension fund AUM is forecast to grow to $65Tn by 2025. The incremental allocation to illiquid funds signals a significant impact for alternatives. The other side of this strategic coin is the ability of pension funds to use their vast wealth, and ability to diversify, to provide funding for those who would otherwise be left out.

The Path to Diversification

Modern pension funds that arose in the twentieth century focused their investments in fixed income, such as government and high quality corporate bonds, to provide a stable and predictable stream of income for their retiree benefit obligations. In 1952, U.S. state pension funds invested 96% of their assets in fixed income assets and cash. Because their realized rate of return is not likely to be too far above or below expectations, these are generally considered lower-risk investments.  

The relaxation of regulations previously limiting public pension plan investment options and the desire to take advantage of larger gains gave rise to pension fund investment in the equity markets in the 1980’s and 1990’s. The transition was also driven by the popularity of Markowitz’s Modern Portfolio Theory. Aimed at finding an optimal way of allocating assets to investment strategies, it greatly emphasized portfolio diversification.  Pension funds were eager to utilize this theory of optimizing results through an adaptive set of asset classes, particularly a mix of low-risk with riskier investments, which was not expected to increase overall risk. By 1992, pension funds investment in fixed income and cash decreased to 47%, with the allocation shifting to stocks.

Evolution into Alternative Investments

The diversification from fixed income continued beyond public equities, and the past twenty years have seen pension funds slowly increase their allocations to alternatives. Even by 2016, the proportion of pension assets in fixed income investments decreased to 26% and to 48% in equities, shifting more to private assets. Four types of alternative strategies have gained popularity in the past few years: private equity, hedge funds, real estate and infrastructure. The latter two have shown to provide safeguards in the current inflationary environment.  

Trends Across Global Markets

Institutional portfolios like pension funds, sovereign wealth funds, endowments and others have increased their exposure towards alternative investments from around 5% or less in 2000 to over 30% today.  
While North America leads the pension fund movement to alternatives, Europe, Asia and others are moving their allocations as well.  The OECD notes that the “most salient” trend over the last 10 years in response to economic and financial market conditions has been the gradual increase in allocations to alternative investments.  While certain countries have regulatory barriers to investing, return-seeking assets such as alternatives are part of policy targets for countries that consider the long term investment landscape.  Within alternatives, prevalent allocations are to land and buildings, infrastructure, hedge funds, and private equity. Even Japan, with allocations traditionally focused on fixed income, has been investing in internal resources to ramp up its alternative investment capabilities. 

Cross Border and “Green” Investments

Although cross border investments favor emerging markets (“EM”), particularly EM equities, (which while potentially volatile, enhance overall returns), there is also an increase in alternatives including real estate, private equity and infrastructure. For those funds increasing their investments in “green” (environmental causes), allocations have been made to alternatives along with “green” bonds and equities.

 The Current Outlook

“This is your quarterly reminder that the stock market is very expensive”

This cautionary statement, recently repeated by a pension fund analyst, is reflected by the data: according to the Pew foundation, over the last thirty years, equity premium has grown by three percentage points – over fourfold – for the period.  The noticeable rise in volatility and the valuation of the stock market has investors and allocators constantly reevaluating their asset allocation strategies. The P7 (largest pension funds market) have reduced their equities allocation from 60% to 43% over the past two decades.

Well before the COVID-19 pandemic, most financial consultants were projecting a lower-yield investment environment for institutional investors over the next 10-to-15 years. Recent revisions are even less optimistic. For example, JPMorgan recently lowered its return expectations for U.S. stocks over the long-term. Horizon Actuarial Services, which surveys multiple investment advisors, confirms the same pattern. The survey additionally notes that “over the last five years, expected returns have declined for all but a few asset classes.” The steepest of these declines was fixed-income investments—a staple of pension investment strategy—which have dropped more than 100 basis points just in the last two years.
Where institutional investors such as pension funds have an appropriate strategy for asset allocation, alternative investments have proven to be a reliable and a game changing weapon. They add a dual power to a traditional portfolio: the positive diversification property enhances expected portfolio returns, and allows investors to avoid huge losses when there is a setback in the bond and equity markets.  According to a PWC report, “when the time comes to take a decision on asset allocation, returns and diversification are the most eminent criteria taken into account.”  Investors make headway by constantly innovating and evolving their allocation strategies, acknowledging the importance of diversifying asset allocation away from the previously preferred asset classes.

The Future of Allocations to Illiquids

The growth of pension funds’ allocations to alternative assets is expected to continue.  With fixed income benchmarks at historical lows, it puts pressure on the rest of the portfolio, particularly with the recent alpha provided by private markets. Private Credit, increasingly the choice of middle market borrowers, has attractive risk adjusted returns with limited downside and the potential of outperformance to minimize losses, when properly diversified. Real Estate, with the availability of exceptional properties, and the option for greater funding leverage given the current Treasuries market, is also attractive for some funds.  
Aside from managing risk, one of the biggest decisions most funds face when allocating to alternatives is budgetary. Outsourcing investment expertise is expensive, and even a rise of nine or ten basis points of AUM can translate into millions in fees. Co-investment opportunities are also becoming competitive, driving up participation costs.  The challenge will be to find the right mix of expertise for investment strategy and decisions, to maximize returns.  The alternative community can contribute by providing more education on the complex nature, and benefits, of the type of investments offered.  This could also dispel some of the popular myths perpetuated by stories from those who fear the alternatives market because they do not understand it. 

Evolution of Liquidity – Democratization and Thought Leadership Perspectives

As the relationship between alternatives and democratization grows, the increased access to investment is expected to create additional liquidity in the market. Technology is expected to accelerate the shift through increased standardization and infrastructure to tranche up ownership. As with retail investors who have an extended outlook, for pension funds, with their permanent mandates, forgoing liquidity can be a better long-term way to get a return on investments when structured properly. A less liquid vehicle can offer investors higher return over a more liquid vehicle to offset the risk of not being able to get money back in the short term.

Pension funds can also contribute to the democracy of access to funding that illiquid alternatives increasingly provide. They have the opportunity to lead the way for private asset management to influence the future, by channeling capital and targeting investment opportunities to those who otherwise would not have access to fundraising.  For pension funds that are adequately funded to pay future benefits, making strategic choices to include private asset allocations not only assists the fund’s long term returns, but helps to democratize funding for those without other investor resources.