No longer are the world’s largest pension funds investing exclusively in the traditional stock and bond market. Fueled by the recent boom in alternative asset investing, pension funds are now rebalancing their portfolios and endowments to reflect a 30 to 50 percent allocation in alternatives.
In particular, the most successful pension funds are reorienting toward private equity.
Funds with hundreds of billions of dollars’ worth of assets under management have seen a recent shift away from the safe-haven assets of yesteryear. For instance, the California Public Employees’ Retirement System (CalPERS) recently closed their $4 billion hedge fund portfolio. Instead, they’re moving to private equity strategies and alternative investing.
Pension fund managers haven’t reoriented their strategy on a whim. Rather, they’re following a basic principle—maximizing their returns. In this article, we’ll discuss why private equity is more profitable for pension funds, and how other alternative assets may provide a safer route forward for investment funds.
Pension Funds 101
Pension plans are a type of defined benefit plan in which employees garner a recurring payout relative to a percentage of their average salary over the length of their employment. Payment terms are defined according to contractual agreements with the labor union or employer in question, and are designed to provide a retirement income to fund members.
There’s an important distinction between private and public pension funds. On the one hand, private plans are regulated by the Employee Retirement Income Security Act of 1974 (ERISA) and sets maximum payout limits for retirees (currently just over $60,000 annually). Public funds are exempt from ERISA and are instead subject to individual statutes.
Pensions plans self-impose mandates regarding their projected returns. In the case of CalPERS, their return benchmark is 7.5 percent. However, stock volatility has prevented large-scale pension funds from reaching their mandated targets.
Moving Away From Stocks
Market uncertainty, economic crises, and asset volatility have caused pension fund managers to rethink their strategy of investing in safe-bet bonds and blue-chip dividend stocks. In October 2017, the S&P 500 dropped nearly seven percent before rebounding up over two percent by the month’s end. Dramatic shifts in the securities market have generated interest among fund managers in alternative investment strategies that present a lower relative risk.
The investing public and financial analysts alike hold great skepticism toward the future performance of the stock market. In the event of another Great Recession-like market downturn, we can expect a long-term bear market in which many pensioners would lose a great share of their investment’s value. To hedge against this risk, assets such as private equity and real estate present a timely alternative.
As fiduciaries, pension fund managers are legally obliged to responsibly invest their members’ money in diverse and prudent investments. To spread their investments’ risk as effectively as possible, fund managers are carving out a greater share of their portfolio for alternative assets, including institutional and boutique private equity funds.
A recent report by Preqin Global Private Equity found that over 870 private equity funds in 2015 raised nearly $500 billion in capital. These figures are the highest they have been since the financial crisis of the late-2000s. In other words, the private equity market is booming while stock market volatility is eroding consumer confidence and the bond market suffers from stagnation.
Private Equity: A Safer Bet?
You don’t have to look very far to notice that managers of some of the largest pension funds in the world are changing their investment strategy to hedge against systemic risk.
The Church of England, whose pension fund, worth over $3.4 billion, is performing well over its mandated target of inflation plus three percent—in fact, the Church’s pension board reported a strong 9.4 percent return for all assets in 2017. The funds’ strongest performer was its global equity and fixed income portfolios.
Japan’s Government Pension Investment Fund has also largely turned its back on traditional index funds, instead opting for hedged foreign bonds and domestic private equity. The Japanese funds’ time horizon of 100 years lends itself well to the stable, long-term performance of the private equity market.
Hedge Funds vs. Private Equity
Whereas hedge funds pool investors’ contributions with the aim of providing the highest return possible over a short-term time horizon, private equity funds focus on playing the long game. As seen during the 2008 financial crisis, hedge funds can suffer catastrophic losses due to their employment of highly leveraged strategies to generate immediate returns.
By contrast, private equity funds minimize risk over a longer period of time by investing directly in private companies with the intention of acquiring a controlling interest. Private equity funds seek out undervalued firms that are struggling financially and reorganize the company internally to accrue value in their investment over multiple years.
Hedges funds tend to invest in highly liquid assets that are meant to be cashed out in the short to medium-term. On the other hand, private equity groups usually require their constituent investors to adhere to a minimum time requirement to allow their investment to accrue value—typically, at least three to five years.
Alternative Assets: The Future of Pension Fund Investing
As institutional investors, pension funds look to private equity to ensure long-term growth and consistent returns in the face of market volatility. It’s no surprise, then, that pension funds represent one of the largest capital sources for private equity groups.
In the years ahead, expect institutional investors to seek out a wider slate of alternative assets, such as stable cryptocurrency IRAs, real estate, real estate investment trusts, and precious metals such as gold and silver. In times of economic unrest, pension funds will look to steady, long-term alternative assets to hedge against losses in the bond and stock market.