In recent decades, public pension plans in the United States have changed how they take on risk. At the turn of the century, their risky investments were primarily in public equities, whereas alternative assets – like private equity, real estate, and hedge funds – accounted for just 14 percent of all risky investments. By 2021, the share of risky assets in alternatives had grown to 39 percent. Equally interesting, the adoption of alternatives has varied enormously across plans. What has driven public pension plans to actively reallocate towards alternatives? And why have some done so much more than others?

This brief, based on a forthcoming paper, explores potential answers to these questions.1 The portfolio models used by most pensions during their asset allocation decisions point to two potential underlying factors: a change in plans’ beliefs about the future performance of alternatives, and/or a change in plans’ appetite for risk. The analysis attempts to measure the impact of these two effects by looking at factors that: 1) influence plans’ investment beliefs; and 2) motivate or constrain their risk-taking.

The discussion proceeds as follows. The first section describes the increased allocations to alternatives among public plans. The second section explores how three influences on plans’ investment beliefs – investment consultants, peers, and prior investment experience – relate to their holdings of alternatives. The third section examines the extent to which factors other than beliefs, such as structural incentives and constraints related to risk-taking, relate to holdings of alternatives. The fourth section assesses how both risk-seeking and shifting beliefs might affect the allocation to alternatives in the aggregate (rather than across plans). The final section concludes that the primary driver behind the increased allocation to alternatives is the growing belief among plan managers that alternatives will outperform public equities on a risk-adjusted basis. These beliefs are shaped by consultants, peers, and plan experience during the 1990s.

Read more @crr