Key Takeaways
- • The Reason Foundation argues public pension funds' growing private equity allocations reflect a rational response to institutional constraints, not managerial ignorance, since lawmakers control contributions and benefits, leaving returns as the only lever.
- • The American Investment Council's 2021 Public Pension Study reports a median 10-year annualized net-of-fees private equity return of 12.3%, with the Illinois State Board of Investment cited at an estimated 19.8%.
- • Private equity represented upwards of 13% of pension portfolio assets as of 2022, up from 11% the prior year, and public pensions supply 67% of private equity fund capital.
- • The SEC issued a January 2022 Risk Alert warning that some private equity firms misled investors about performance track records, and has since proposed stricter fee and allocation disclosure rules.
- • A forthcoming Journal of Investing study cited in the article finds U.S. public pensions realized a real negative alpha of about -1.2% per year since 2008, virtually all tied to alternative investment exposure.
Summary
A Reason Foundation commentary examines why public pension systems continue to expand private equity allocations despite significant risks. The piece notes that private equity firms market to pensions by promising returns above traditional assets and local economic benefits. Citing the American Investment Council's 2021 Public Pension Study, the article reports a median 10-year annualized net-of-fees return of 12.3% for private equity, and an estimated 19.8% for the Illinois State Board of Investment. Public pensions account for 31% of private equity investors' funds and 67% of their capital, and private equity now makes up upwards of 13% of pension portfolio assets as of 2022, compared with 11% a year earlier.
The article identifies several risks. Private equity assets are not marked to market, so realized returns remain unknown until fund termination, often years or decades later. The SEC's January 2022 Risk Alert warned that some firms had misled investors about performance, and the agency has since proposed stricter disclosure requirements for fees and allocations. The article also highlights fee burdens, including the traditional 2% management fee plus 20% of gains, and cites Stanford Business School research by Juliane Begenau showing that fees vary with a pension fund's bargaining power. A Journal of Investing study cited by the author estimates a real negative alpha of about -1.2% per year for U.S. public pensions since 2008, largely linked to alternatives exposure.
The author argues that pension allocations nonetheless make structural sense. Accounting standards discount liabilities and project assets based on expected returns, which rewards risk-taking. Unfunded obligations, forecast to reach $1.3 trillion in 2022, following the dot-com bust and Great Recession, leave pension managers with limited levers, since only lawmakers can change contributions or benefits. Private equity offers a high projected return with third-party underwriting that improves accounting optics. The article concludes that this reflects rational institutional incentives rather than managerial ignorance, while acknowledging the risks involved.
The article identifies several risks. Private equity assets are not marked to market, so realized returns remain unknown until fund termination, often years or decades later. The SEC's January 2022 Risk Alert warned that some firms had misled investors about performance, and the agency has since proposed stricter disclosure requirements for fees and allocations. The article also highlights fee burdens, including the traditional 2% management fee plus 20% of gains, and cites Stanford Business School research by Juliane Begenau showing that fees vary with a pension fund's bargaining power. A Journal of Investing study cited by the author estimates a real negative alpha of about -1.2% per year for U.S. public pensions since 2008, largely linked to alternatives exposure.
The author argues that pension allocations nonetheless make structural sense. Accounting standards discount liabilities and project assets based on expected returns, which rewards risk-taking. Unfunded obligations, forecast to reach $1.3 trillion in 2022, following the dot-com bust and Great Recession, leave pension managers with limited levers, since only lawmakers can change contributions or benefits. Private equity offers a high projected return with third-party underwriting that improves accounting optics. The article concludes that this reflects rational institutional incentives rather than managerial ignorance, while acknowledging the risks involved.
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