Challenges of Alternative Investments in Public Pension Plans

Public pension funds have become addicted to risk and are investing heavily in alternative assets to potentially achieve higher returns. This is introducing significant risks and challenges for local government employers in public pension multi-agency plans.  

Alternative investments refer to assets outside traditional categories such as stocks, bonds, and cash. These include private equity, hedge funds, real estate, commodities, and infrastructure. In his article published in the 2024 winter edition of the Journal of Government Financial Management, Charles Francis discusses the risk imposed on public sector employers from pension funds’ use of alternative assets, and how public sector employers’ can use IRC Section 115 trusts to mitigate the risks associated with pension fund alternative investments. These trusts offer liquidity, investment flexibility, and can improve credit ratings.

Gerard, in his article published July 16 for Governing Magazine “How ‘Alternative Investments’ Are Dragging Down Pension Performance”, highlights several more drawbacks of alternative investments based on a study by Richard Ennis's study “How Hidden Costs Undermine Public Pensions in the US” published in May, 2024”:

• High Fees: These investments carry high management fees, reducing net returns.
• Underperformance: Alternative investments have not consistently outperformed traditional assets.
• Complexity and Lack of Transparency: Valuing and managing these investments can be challenging due to their complexity and opaque nature.
• Liquidity Issues: Many alternative investments are illiquid, making it difficult to sell them quickly without significant losses.

Ennis's study found that the increased allocation to alternative investments has led to significant performance drag, challenging the assumptions made by pension consultants and calling for greater fee scrutiny and transparency. Gerard Miller describes pension performance drag as the negative impact on overall returns due to the high fees, complexity, and underperformance associated with alternative investments. These factors collectively reduce the net returns of pension funds, making it difficult for them to meet their assumed rates of return. Performance drag can erode the financial stability of pension plans, necessitating higher contributions from employers to cover the shortfall.

Section 115 Trusts for Risk Mitigation

Local governments participating in multi-agency pension plans can use Section 115 trusts to manage and mitigate financial risks associated with their pension plans. These trusts offer several benefits:

1. Pension Rate Stabilization: Section 115 trusts provide a financial buffer that can stabilize employer contributions to public multi-agency pension plans. When the public pension plan's investment returns fall short of the discount rate assumption, the trust can cover the higher contributions required. Conversely, when returns exceed expectations, the trust can be replenished.
2. Investment Flexibility: These trusts can be invested in a more conservative manner compared to the main pension fund, providing a counterbalance to the more aggressive investment strategies of CalPERS.
3. Rainy Day Fund: Trust assets can replace general fund contributions during times of fiscal stress, ensuring that pension obligations are met without overburdening the general fund.
4. Credit Rating Improvement: Setting aside assets in a Section 115 trust can improve the creditworthiness of the local government by demonstrating a proactive approach to managing pension liabilities.
5. Supplemental Funding: Trust assets can be set aside and invested to generate income, which can be used to make additional contributions to CalPERS during periods of financial stress, helping to stabilize employer contribution rates.

Conclusion

Section 115 trusts offer a valuable tool for local governments to stabilize their pension contributions and manage financial risks. This approach not only provides financial security but also instills confidence among stakeholders, contributing to the overall stability and reliability of retirement benefits for public employees. The insights from Gerard Miller's article emphasize the importance of managing fees, enhancing transparency, and scrutinizing investment strategies to safeguard pension performance. Section 115 trusts serve as a practical response to these challenges, helping local governments mitigate risks and stabilize contributions amid fluctuating investment returns.