If you judged only from the headlines, you’d think that pension funds were becoming an endangered species in the retirement plan world, increasingly replaced by their defined-contribution cousins. Of course, the shift is very real, as only about 10% of workers are now covered by a defined benefit plan, down from closer to 60% in the 1980s. The private sector in particular has embraced the shift, as nearly 40% of existing corporate pension plans have now frozen their benefit accruals.
That said, to completely discount the role of pension funds—particularly public pension funds—in today’s financial markets would be a grave mistake. If anything, the influence of the largest pension fund players has grown in recent years, with aggregate pension fund assets across all OECD nations now totaling approximately $30 trillion. That $30 trillion figure represents nearly 62% of aggregate GDP for the OECD nations, a figure that has grown from a level of 52% of aggregate GDP just 15 years ago.
So while the pension fund era may have long since passed its peak in the U.S. corporate arena, it’s still alive and well as far as global economies (and financial markets) are concerned. Understanding how those pension funds are invested, then, can be a key component of understanding your own portfolio approach, and how large players are likely to move the markets that determine your long-run investment returns.
Yes, even if you don’t have a pension benefit coming to you over the coming decades (and you probably don’t), your ability to meet your retirement goals may still hinge on the ongoing health of global pension funds, if only indirectly.
Recent pension developments
With global interest rates continuing to sit at or near historic lows (even after the recent post-election spike), pension funds continue to struggle to meet their lofty long-term return assumptions. The longer those return shortfalls persist, the greater the funding gap at those pensions grows, which leaves the managers (and sponsors) of those pensions in a bind.
There are only two primary options for an underperforming pension fund: either increase risk (or extend into alternative asset classes) in order to improve long-run returns, or else lower the plan’s return assumption, a decision that would immediately open up a wide gap in pension funding (a gap that would need to be filled either by increased employee contributions, or in the case of public pensions, higher taxes to help support the promised pension benefits).
Perhaps unsurprisingly, both of those things have happened concurrently in recent years, with funds cutting their return assumptions even as they continually shift into ever riskier (and less liquid) investment vehicles. Most recently, the largest American public pension fund (California’s CalPERS) announced that it is considering a further cut in its return assumption from 7.5% to 6%, a decision that would put significant pressure on other smaller pensions to follow suit.
In the case of CalPERS, the recent pressure stems at least in part from the desire of some of its managers to reduce portfolio risk, particularly as they begin to back away from the private equity investments that they have championed in recent decades. But why would CalPERS want to cut its private equity exposure, and what could private equity market dynamics mean for your portfolio?
The impact of private equity
As mentioned earlier, one response by pension funds to the low-interest-rate environment has been to increase total portfolio risk, and one of the preferred methods has been a growing embrace of alternative investments like hedge funds and private equity. According to a recent Financial Times article, pension funds are expected to increase their allocation to these alternatives from 15% to 19% of assets over the next three years. That increase stems largely from a “desire to be out of public equity markets,” which are widely perceived to be expensive on the heels of a bull market that is now well into its eighth year.
While hedge funds and real assets continue to claim their share of the “alternatives” market, private equity has experienced some of the most robust growth. According to one recent analysis, there are currently 293 total US-based pension funds that hold some level of private equity investments, with an average allocation of 7% of assets (representing a total of $320 billion). Most funds place some sort of limit on their private equity exposure (say 10% or 15% of assets), but allocations in excess of 20% do exist.
For many of these institutional investors, the embrace of private equity is a learned behavior—a 2013 study of 146 public pension funds found that private equity investments had generated a median annual return of 10% over the prior decade, easily outpacing stocks, bonds, and real estate. And in recent years, the outperformance trend has even accelerated, at least in certain sectors. Indeed, as of the end of 2015, there were 146 private technology firms boasting valuations of $1 billion or higher, a number that had doubled year over year.
Notably, there was also considerable evidence that privately held firms enjoyed a valuation premium as compared to their publicly-traded peers—more than 40% of billion-dollar tech IPOs between 2011 and 2015 went public at valuations that were below the level of their last private-market capital raises. The combination of those dynamics has led to widespread concern that we are now experiencing a second tech bubble, only concentrated this time in private firms, rather than in publicly-listed issues.
Unfortunately, for many of us, drawing any meaningful conclusions about the current valuations of private companies is typically a fools’ errand. Unlike public companies, private firms are not required to publish financial statements, and even those financial statements that are circulated privately are not required to be audited, nor do they need to adhere to generally accepted accounting principles (GAAP). Comparing companies with GAAP earnings against those using only non-GAAP metrics is like comparing apples to oranges, so it’s difficult to know whether private companies are fairly valued, overvalued, or in an extreme bubble.
Still, there’s ample reason for concern. A recent analysis of the “ridesharing” app Uber found that the firm is burning cash at a faster rate than any start-up company in history, with little hope of turning an operating profit any time soon. Despite its questionable financial position, though, Uber currently commands a private-market valuation of $69 billion, a price tag that would make the firm worth more than Ford (~$50B), General Motors (~$55B), or Volkswagen (~$66B). For a firm that operates in what has long been considered a low-margin business, that’s certainly lofty company.
Naturally, Uber is not alone in its hefty valuation. Fellow sharing-economy darling Airbnb recently raised money at a valuation of $30 billion, based on estimated revenues somewhere between $1 billion and $2 billion (again, all private company revenue numbers are unreliable, due to the lack of publicly available data). On the surface, Airbnb’s valuation probably isn’t quite as lofty as Uber’s, but given that hospitality giant Marriott boasts a similar enterprise value (~$31B) on $15 billion of revenues, Airbnb has quite a bit of work still to do in order to justify its current valuation.
Does that mean that high investment returns are impossible for these firms over the coming years? Certainly not, although they may struggle to generate much higher valuations in an eventual IPO. But to the degree that Uber and Airbnb are representative of other private equity-owned companies, these lofty valuations should at the very least raise some concern about the asset class more broadly, and of the investment-return prospects for the funds that own the investments.
What does this all mean for me?
If you’re not an angel investor who owns pre-IPO shares in Uber or Airbnb or one of the hundreds of other billion-dollar private tech companies, you might wonder why this all should matter to you. The answer lies in the institutional importance of the pension funds that do have exposure to the asset class.
After all, if the 2008-09 experience taught us anything, it’s that financial markets are more interconnected and vulnerable than ever before—in short, a disruption anywhere is a disruption everywhere, and negative market outcomes rarely exist in isolation. Would a bursting of a private equity bubble mean an imminent global recession? Probably not, since the actual economic impact of these new-age tech giants is fairly limited as compared to their financial market valuation.
But as NBA owner (and former tech CEO) Mark Cuban pointed out years ago, back when valuations in private equity land had just begun to show signs of stretching, “the only thing worse than a market with collapsing valuations is a market with no valuations and no liquidity.” In other words, the danger for pension funds is that if private equity valuations do some day turn lower, those funds may struggle to exit their investments, since liquidity in private equity investments is minimal, if it exists at all.
How a pension fund might then react to such a conundrum is anyone’s guess, but adjustments to their public-market holdings would be a seemingly inevitable result. It’s simply naive to think that a large institutional player would withstand a private equity loss without making any adjustments at all to its public-market holdings. Therefore, even if we’re not directly invested in private equity markets, we’re nevertheless impacted by them indirectly. Remember, very few of us owned mortgage-backed securities in the years leading up to the financial crisis, but we nevertheless felt the effects when the investments started blowing up.
To some degree, investing in the markets always resembles a poker game—understanding what “the other guy” holds (and how he is likely to place his bets going forward) is often at least as important as understanding our own hand and our own betting strategy. In the financial market context, pension funds remain one of the biggest players at the table, and knowing the cards they hold is ultimately of vital importance to all investors.