Pension funds, the silent guardians of people's retirements, manage a staggering $76 trillion globally, with a whopping $4.6 trillion entrusted to them in the UK alone. How these vast sums are invested impacts the comfort and security of retirees.

In this context, we drive into two key questions that shape pension investment strategies:

Should pension funds prioritize local economic growth, or focus solely on maximizing returns?
And how do alternative investments like private equity stack up against traditional investment options?

Balancing Returns and Local Impact

Let's start with the basics. The fiduciary duty of a pension fund is to generate the best possible returns to ensure retirees can maintain a comfortable standard of living after they stop working. Governments may advocate for investing in local economies, citing tax breaks offered to pension funds. However, when it comes to investment decisions, maximizing returns for pensioners must be the top priority. Without delving into the politics of it, local investments are attractive if they deliver strong growth potential. There are arguments put-forward by entrepreneurs that pension funds must invest locally, most recently by the founder of Graphcore. This distills down to: Should the responsibility of driving economic growth fall on the shoulders of pensioners through their investments, or should retirees simply benefit from the economic growth generated by the broader economy?

Exploring Alternatives

UK FTSE 100 has historically delivered around 7% nominal returns compared that of 16.5% 5-year annualized returns of S&P 500. UK Equities barely keeps pace with inflation, essentially eroding the purchasing power of retirees' savings. Pension funds are said to have averaged under 7%. Alternative investments such as private equity (PE) has traditionally been generating 15-24% annualized returns historically. Added to that the tailwind behind alternative investing makes it almost mandatory to have strong alternatives exposure.

A breakdown of key advantages to add alternatives exposure:

Diversification: Traditional equity markets are consolidating, meaning there are fewer publicly traded companies to invest in (listed equities have come down from 8000 in 1990s to less than 3700 today). Alternatives offer diversification, spreading risk and providing access to value creation in the private sector. Companies are staying private for longer periods, and a lot of the value creation is happening in private markets.

Riding the Digital Wave: Many industries are undergoing a digital transformation, and a significant portion of the value generated from this shift resides in private markets. By incorporating alternatives, pension funds can gain exposure to these high-growth areas.

Non-Correlation: Studies suggest that alternative asset classes have a low correlation with traditional investments.. This means that when traditional markets experience a downturn, alternatives may hold steady, further enhancing the overall resilience of a pension fund's portfolio. There is an alternative argument however that the private markets simply delay downsizing their valuations. But what matters ultimately is the returns upon exit, something to watch out for.

Learning from the Pack:

North American pension funds have been at the forefront of incorporating alternatives into their investment strategies. European funds are slowly opening up and developing expertise in selecting skilled fund managers and accessing the most promising markets for alternative investments.

While maximizing returns remains paramount, strategically incorporating alternatives offers pension funds a powerful tool to fulfill their core mission: securing a comfortable future for retirees.

However, navigating the alternatives industry is no easy task. There is much work to be done both from pensions funds and the alternatives industry overall. Alternative industry is famously complex, lacks transparency, has high fees, boasts of limited liquidity, and is ridden with regulatory restrictions. In addition, market timing is crucial as performance can vary significantly with economic conditions.

By carefully selecting managers and diversifying with alternatives, pension funds can unlock higher returns, achieve better portfolio balance, and tap into the growth potential of the private sector. This, in turn, can translate to a better financial future for generations of retirees.

References:

Talent drain in the UK if pension funds don't invest locally

How pension interest rates work?

An aerial view of major alternative asset classes

The case for UK pensions review

Should pension funds invest in UK growth?

Staying private longer leads to opportunity

2024 pension updates from UK Spring budget