New York’s public pension funds will have the green light to significantly increase their asset allocations to “alternative investments,” such as private equity and hedge funds, under a bill poised for passage in both houses of the state Legislature.

The bill would increase, to 30 percent from the current 25 percent, the share of pension fund investments that can be allocated in “baskets” of assets not otherwise specifically permitted by law. The last such increase was from 15 percent in 2007. 

The proposed increase — pending, as of this afternoon, with vote-ready “third reading” status on end-of-session Assembly and Senate floor calendars — would affect the New York State and Local Retirement System (NYSLRS) and the New York State Retirement Teachers’ Retirement System (NYSTRS), as well as the five pension funds of the New York City Retirement System (NYCRS). However, the sponsors’ memo submitted with the bill refers only to the New York City system, suggesting that’s where pressure to raise the cap is coming from. (UPDATE: The bill passed in the Assembly late Wednesday afternoon.)

A higher cap on alternatives “will allow for a superior risk-adjusted portfolio and for additional flexibility to reduce portfolio volatility while maintaining superior returns,” the memo says. Unmentioned in the memo: alternative investments also involve more complex risks and are more opaque than traditional stocks and bonds. They often feature higher fees for fund managers, as well.

The move to assets classes offering a combination of higher returns and higher risk has been a long-term trend not limited to New York. As summarized in this recent Pew report:

In a bid to boost investment returns, public pension plans in the past several decades have shifted funds away from fixed-income investments such as government and high-quality corporate bonds. During the 1980s and 1990s, plans significantly increased their reliance on stocks, also known as equities. And during the past decade, funds have increasingly turned to alternative investments such as private equity, hedge funds, real estate, and commodities to achieve their target investment returns.

Picking up from the bill sponsors’ memo:

Under the current 25% cap, most of the investments allocated to the basket are illiquid, long-term private equity partnerships. In addition, NYCRS’ international investments, to the extent they exceed the 5% permitted by the legal list, must be counted against the basket cap. The private equity investments involve a long-term commitment for NYCRS to make additional investments, and the timing of these investments is subject to ever-changing market conditions and is difficult to forecast. NYCRS must account for both the actual value of private equity investments as well as future contractual commitments to provide capital when measuring compliance with the 25% basket clause allocation.

The portion of the NYCRS portfolios allocated to public equities is much more volatile than the investments allocated to the basket. As a result, a swing in public markets can push NYCRS dangerously close to the investment cap with no new investments. Expansion of the basket to 30% is critical in providing public pension advisors and trustees greater ability to mitigate market volatility and structure superior risk-adjusted portfolios. Increasing a fund’s ability to invest according to the expanded standard will result in increased flexibility, thereby enabling trustees to monitor investments closely without restricting their ability to respond effectively to changing market conditions.

In other words, the pension funds would like more cap room to maneuver under. If the limit goes to 30 percent, the actual asset allocation is unlikely to go quite that high. According to its latest financial report, alternatives made up about 19 percent of NYSLRS’ $160 billion in assets in fiscal 2013, although the fund has a stated long-term goal of a 27 percent allocation to  alternatives. The New York City Employee Retirement System, largest of the city funds, had 17.2 percent of its assets invested in alternatives last year. By contrast, the New York City Teachers’ Retirement System reported allocating just 8 percent to the same class, and NYSTRS had just 9 percent invested in alternatives last year.

Assuming the bill leads to a full 5 percent boost in such investments across the board, it would shift at least $21 billion more into alternative investments for all the pension funds combined, based on their 2013 values.

The bill has leadership juice behind it: it’s sponsored in the Assembly by Herman “Denny” Farrell, D-Manhattan, the Assembly Ways & Means chairman, and in the Senate by John DeFrancisco, R-Syracuse, the Finance Committee chairman, and Diane Savino, D-Staten Island, who is both a close ally of labor unions and a leading member of the Independent Democratic Coalition.

Presumably all this means Governor Cuomo is on board, too?  Stay tuned.