State and Local Pension Plans Shift Toward ‘Alternative’ Investments

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New research from the Center for Retirement Research at Boston College sheds some light on how that looks and what it means.

State and local government pension systems have over the last decade shifted a greater share of their portfolios toward investments like hedge funds, commodities and real estate.

These types of “alternative” assets are generally considered riskier and more difficult to convert quickly into cash than more traditional investments like stocks and bonds. But this added risk and reduced flexibility can result in higher investment returns.

Earlier this month, the Center for Retirement Research at Boston College released a brief that looks at what types of state and local public pension plans have moved the most toward alternative investments and how such shifts affect investment returns and volatility.

These topics are important because pensions can confront states and localities with substantial costs that must be balanced against other priorities like education, transportation and social services. Pension investment returns and volatility are two factors that affect these costs.

What the authors of the brief found is somewhat nuanced and they emphasize that their analysis was preliminary and narrow in scope.

“Alternatives” are defined in the brief as assets that are not traditional stocks, bonds or cash, which fall into four main categories: private equity, hedge funds, real estate and commodities.

The researchers found limited evidence that pension plan characteristics are related to alternative investment holdings.

A few of the characteristics they considered were plan size, the level of funding or underfunding of a pension system, and whether a plan has an independent board that makes investment decisions and chooses financial advisers and asset managers.

“Plans of all types have been drawn to alternative investments,” the brief says.

Turning to the question of performance, the researchers found a negative relationship between alternatives and overall portfolio returns. In other words, a greater share of alternative investments in a portfolio is estimated to have a detrimental effect on pension fund returns.

But the authors note that this negative relationship is largely driven by hedge funds, which have lagged compared to other types of assets since the Great Recession.

Hedge funds, they add, can also lead to slightly less pension fund volatility—meaning a pension system’s portfolio is less vulnerable to swings up and down.

The brief also points out that “the positive effects of private equity and real estate on portfolio returns are not statistically significant,” suggesting that, at least for the periods examined in the brief, “some plans may have done just as well investing in traditional equities.”

The researchers offered these caveats about their analysis:

“It does not examine the performance of each plan individually, but rather public plans in aggregate. It also does not incorporate the specific role of alternatives in each plan’s investment strategy and therefore cannot determine the extent to which alternatives helped meet a plan’s specific objectives. Finally, the analysis does not address fees, disclosure, or administrative issues. Further research is clearly warranted in this area.”

The brief was authored by Jean-Pierre Aubry, who is the associate director of state and local research at the Center for Retirement Research, Anqi Chen, who is a research associate at the center, and Alicia Munnell, who is the director of the center and a professor at Boston College’s Carroll School of Management. A full copy of the brief can be found here.

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