For decades, pension funds have followed a straightforward playbook: investing the bulk of their capital in traditional asset classes like publicly traded stocks and bonds. These investments have been favored because they offer relatively predictable capital preservation, returns, and liquidity, making it easier for pension funds to meet their primary obligation: generate sufficient long-term returns on invested assets to meet liabilities and pay retirees on time.
But times have changed. Longevity continues to increase, populations are aging, traditional asset classes are yielding less, and episodes of high volatility are becoming more frequent.
To consistently generate enough wealth to meet their liabilities, many pension plans are rethinking this approach, diversifying away from a reliance on stocks and bonds and increasingly steering toward riskier, alternative investments like private equity, infrastructure, real estate, and, to a lesser extent, venture capital.
Interest rates have risen sharply since 2022 to curb inflation, which spiked following the COVID-19 pandemic due to a mix of soaring demand, supply-chain disruptions, and government spending.
The move into these assets is largely driven by the hunt for higher returns than those available in public markets, as well as the need for portfolio diversification to reduce overall risk This trend gained momentum after the 2008-09 financial crisis, which led to a prolonged period of rock-bottom interest rates that made traditional asset classes like bonds less attractive due to their lower yields.
Additionally, stock market volatility during this period pushed pension plans to look for alternatives that could stabilize portfolio volatility while offering higher returns. As a result, asset classes like private equity and real estate have gained favor, as they offer the potential for higher, uncorrelated returns compared to public markets and bondsâ.âŻ
This shift has become especially appealing to pension funds since they need solid long-term returns to ensure they can cover future payouts to retirees.âŻ
However, interest rates have risen sharply since 2022 to curb inflation, which spiked following the COVID-19 pandemic due to a mix of soaring demand, supply-chain disruptions, and government spending. This has prompted further reassessment.
On the one hand, elevated rates lower the valuation of a pension fundâs future liabilities, which in turn lowers the required investment returns needed to maintain or improve financial health. With more breathing room, some funds may choose to increase their allocation to riskier, longer-term investments like private equity or real estate.âŻ
Unfortunately, this logic doesnât apply universally. Pension funds vary greatly in their investment mechanics, driven by who bears the investment risk (defined benefit versus defined contribution), national regulations, and the demographics of their membership.
Some funds â such as those bound by obligations to guarantee investment return and those with high liquidity needs and a low capacity for risk â may continue to favor more conservative strategies, especially given the higher bond yields, which have made fixed-income assets more attractive againâ.âŻ
âWhile Europe hasnât moved as quickly as North America towards alternative assets, the shift is happening there too. Countries like the Netherlands and the UK have started allocating more to infrastructure and private equity, though the pace has been slower.â
There are regional disparities, too, with pension funds in North America spearheading the move into alternative assets. Major players like the California Public Employeesâ Retirement System (CalPERS) and the Canada Pension Plan Investment Board (CPP Investments) have publicly committed to ramping up their investments in private equity, infrastructure, and real estate as part of their strategy to seek higher returns and diversify their portfolios.âŻ
By 2023, US state pension funds alone had allocated 40% of their total assets to alternatives, up from 30% just five years earlier. The largest gains have been in private equity, which grew from 9% to nearly 15% of total assets.
While Europe hasnât moved as quickly as North America towards alternative assets, the shift is happening there too. Countries like the Netherlands and the UK have started allocating more to infrastructure and private equity, though the pace has been slower. In 2023, European pension funds made far fewer investments in private capital, dropping to just 60 commitments compared to 113 the previous year.
In Europe, there is also a growing emphasis on sustainability. According to a 2024 survey by Goldman Sachs Asset Management, nearly two-thirds (63%) of European defined benefit pension funds allocate more than 10% of their portfolios to sustainable investments. The survey also found that 87% of respondents consider sustainable investing either âcriticalâ or âimportantâ to their decision-making processâ.âŻ
This reflects not only regulatory pressure, with many pension funds in Europe now required to disclose how their investments impact sustainability, in line with rules like the Sustainable Finance Disclosure Regulation (SFDR), but also a desire among European pension funds to balance financial returns with broader societal and environmental goals.âŻ
Despite the overall growth of private markets over the past 15 years and the growing interest in alternative assets, pension funds around the world face several challenges when managing their portfolios in search of better risk-adjusted returns.âŻ
One key factor influencing their decisions is demographics. Funds with more retirees than active contributors often have a lower tolerance for risk as they need to generate returns and liquidity to pay out pensions sustainably.âŻ
This is particularly relevant for illiquid investment classes like private equity and venture capital, which can take years to realize returns, are sharply dispersed between top and bottom performers, and have unpredictable exits that are outside of investorsâ control.
A fundâs economic health also plays a crucial role. A fund with a strong funding ratio â where projected assets exceed projected liabilities â can afford to take on more risk in pursuit of higher returns. But underfunded plans may need to prioritize safer, more liquid investments to preserve capital and ensure its obligations are met.
Liquidity concerns are particularly relevant for alternative assets. Unlike stocks or bonds, which can be quickly sold to meet liquidity needs, assets like private equity or venture capital require longer periods to build up activity and deliver returns.âŻ
So, pension funds need to carefully manage their portfolios to ensure they have the liquidity necessary to meet their short-term needs while still investing for long-term growth to meet the fiduciary duties toward their sponsors and members.
Pension funds generally take a long-term investment view, often planning 30 to 50 years into the future. To manage this well, especially in defined benefit or hybrid defined benefit schemes, they conduct regular asset-liability studies that assess demographic and economic trends, expected returns, and market and regulatory conditions. These studies guide their overall investment and asset allocation strategy and help them strike the right balance between risk and return.
However, short-term market conditions may force adjustments. For example, if public markets underperform for a sustained period and arenât generating the returns needed to meet the fundâs required return goals, pension funds may look to alternative investments to fill the gap.âŻAt the same time, growing opportunities in private markets, along with improving expertise in managing complex, illiquid investments, have made alternatives more accessible.
Venture capital, however, is often seen as a niche investment within pension fund portfolios, especially compared to private equity.âŻ
The move toward alternative assets highlights how pension funds are shifting their strategies to boost returns and diversify their portfolios in response to todayâs more complex market conditions.
While VC offers the potential for outsized returns, it also comes with significant risks. Many VC-backed companies are in the early stage and may not be generating revenue or earnings, making them difficult to evaluate. For pension funds, this adds a layer of complexity, as they need specialized expertise to select the right VC funds that can deliver the desired returns.
The venture capital market is relatively small compared to private equity, which can make it challenging for larger pension funds to allocate a meaningful portion of their assets to this class. Despite these challenges, VC remains an attractive option for funds with long investment horizons, particularly those seeking to tap into high-growth sectors.
Applying ESG criteria to VC investments, though, can be difficult, especially since many early-stage companies have yet to produce measurable outcomes in areas like emissions or sustainability.âŻ
However, pension funds are increasingly looking at how their venture capital investments align with their broader ESG goals. For example, funds may choose to invest in clean technology or sustainable agriculture ventures that offer clear environmental benefits, even if the financial returns are harder to quantify.
The move toward alternative assets highlights how pension funds are shifting their strategies to boost returns and diversify their portfolios in response to todayâs more complex market conditions.âŻ
While rising interest rates have prompted some funds to revisit traditional investments, the trend toward alternatives, particularly in North America, remains strong. In Europe, while the shift has been more gradual, pension funds are still increasing their exposure to alternatives, with a particular emphasis on sustainability and ESG factors.âŻ
As these funds adjust to changing economic conditions, they must balance liquidity needs, manage risk, and pursue long-term growth. Striking this balance will require a careful mix of traditional and alternative investments to protect the long-term financial security of the funds and their beneficiaries.
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