Monday, May 6, 2013

Increasing alternative investments in public pension plans

The NC State legislature is considering increasing the pension fund's allocation to alternatives to 40%. As reported in Pension and Investments magazine, the state is also looking to allow the fund to hold on to assets if they exceed the allocation target.  The idea here is to avoid selling assets whose weights have increased because of high performance.

As Andrew Stilton (in his blog) notes, increasing the allocation to alternatives may not be such a great idea.

The problems are pretty simple:
1. Alternatives are very expensive - they have fees that can easily exceed 2%
2. The fee structure is such that you pay higher fees when performance is good, but you don't get a fee refund when performance is bad.   From the manager's point of view this is "heads I win, tails you lose".
3. Alternatives are very illiquid.
4. There is no free lunch in terms of performance.  To think that you will get higher performance from alternatives without some additional risk is pure folly.
5. Did I mention that these investments are expensive?

I personally think that relying more on alternatives is the wrong approach - a more conservative approach that focuses on traditional assets while paying the lowest fees possible makes more sense.

Underlying this move is a problem that plagues all state pension plans - that the expected return is set too high.   Given that long term bond rates are less than 2%, there is little chance that most funds will achieve their return objectives which are typically in the 7-8% range.   Of course the other options (higher taxes, higher payroll contributions, lower benefits) are all politically unacceptable.  (I've blogged on return assumptions in the past here.)

Incidentally - Stilton's blog "Meditations on Money Management" is excellent - highly recommended.

5/7/13:edited - to note that the legislation hasn't passed the house yet.