Alternative investments, such as hedge funds, private equity, and real estate, are slowly but surely gaining sway with corporate pension fund managers. A recent survey by J.P. Morgan Asset Management of about 150 corporate pension plans found that alternative investments constitute about 11% of their assets, on average, and that the plans intend to increase that allocation to 14% within the next three years.
A separate survey of about 85 corporate pension managers by SEI Institutional Group found that the percentage of corporate pensions investing in alternatives increased in 2010 for the third consecutive year. Sixty-five percent of pensions in the SEI survey are investing in alternatives this year, up from 53% in 2009. Among larger pensions (those with more than $300 million in assets), the rate jumps to 84%.
In J.P. Morgan’s survey, hedge funds are the largest chunk of the alternatives category, accounting for about 40% of such assets. On average, companies hold 8% of their overall portfolios in hedge funds, and plan to boost that to 10% in the next three years. “Even though people [were wary of hedge funds after 2008], those who were invested want to remain invested,” says Karin Franceries, a vice president in J.P. Morgan’s strategic investment advisory group.
However, more corporate pensions have invested in private equity than in hedge funds — though the average size of the investment is smaller — and are planning to increase investments in that category as well. The largest plans, those exceeding $10 billion in assets, have higher allocations to private equity than to hedge funds. Real estate is also fairly popular, with some increases planned.
Alternative investments are especially attractive to pension plans as the traditional categories of equity and fixed income present investing dilemmas. On one hand, plan sponsors are trying to get away from the volatility associated with equities, in order to remain in compliance with the funding requirements set forth in the Pension Protection Act of 2006 (PPA). Equity investments have declined from 46% to 42% of pension portfolios, according to J.P. Morgan, down from about 60% several years ago.
On the other hand, fixed income doesn’t offer enough return to help companies make up for the investment losses of the past few years, particularly with bond rates dropping. “In my conversations with clients, they usually say they cannot afford to reduce equity allocations any further — they need the return to reduce their deficits,” says Franceries. Hedge funds, in particular, can help companies achieve equity-like returns but with dampened volatility.
Other experts, however, point out that the categorizations of various assets can be fuzzy. A survey of the U.S.’s 100 largest pension plans by Milliman found they had stepped up their allocations to alternative investment categories by an average of 17% at the end of last year, compared with 12% at the end of 2007. However, Paul Morgan, co-author of that report and director of capital markets at Evaluation Associates, a Milliman company, says he believes much of the increase was due to revised FAS 157 guidance that could have led some companies to relabel existing investments, rather than to a true increase in exposure.
Items such as private-equity investments, for example, could potentially be put either in the equity category or the “alternative,” or “other,” category. Investments in real estate could also fall into either bucket, depending on whether the investment was in a REIT or a piece of property.
The J.P. Morgan report notes that while corporate pension plans are increasing their allocations to alternatives, they are doing so at a much slower pace than public pension plans and endowments, which are not bound by the funding requirements of the PPA. In keeping with the constraints of that law, the majority of corporate plan managers (47%) say their top priority is asset-liability management, compared with the 50% to 60% of managers of other types of pension funds who consider return generation their top priority.
Indeed, the SEI survey found similar leanings, with 88% of pension managers citing their plans’ funded status as their top priority, above absolute returns. Under the PPA, companies start to face restrictions on their plans, such as constraints on the ability to offer retirees lump-sum payouts, if their funding level dips below 80%. If their funding level falls below 60%, companies must stop accruing new benefits for the participants until the level improves.