U.S. public pension funds face a shortfall in returns due to the continuing depressed level of interest rates, and are increasing their allocations to alternative asset classes to make it up.

“Public pension funds have been steadily increasing their exposure to hedge funds in order to increase the expected return of their portfolio, meet their actuarial return assumptions and reduce their unfunded liability,” said Don Steinbrugge, managing director at Agecroft Partners, a hedge fund consulting and third-party marketing firm. “This trend is expected to continue as long as interest rates remain near historic lows.”

Over the past five years, public pension funds have been driving the growth of the hedge fund industry, noted Steinbrugge.

“Another big trend is that they are moving away from funds-of-funds to investing directly in managers,” he said. “Before 2008 in the U.S., there were only a couple of dozen public pension funds that went direct, while today there are over a hundred and in three years there will be over 300, if not more, going direct.”

Agecroft Partners shares advice regarding hedge fund asset allocation, manager selection, hedge fund industry trends, industry survey results and being the liaison between investors and the select hedge funds that have made it through their due diligence process.

“From our standpoint, value added is communicating what we’re seeing in the marketplace, sharing information on how to do research on hedge funds, which is especially important if going direct for the first time, and sharing information on asset allocation to various hedge fund strategies,” Steinbrugge said. “We also are going to begin surveying the marketplace on issues relative to the hedge industry and share that with public funds, in addition to introducing them to hedge funds that have made it through our institutional due diligence.”

Public pension funds are attempting to improve investment returns by shifting assets into riskier asset classes, and because they are underfunded they face an environment of declining investment returns and they see little hope of cash infusions from struggling municipal and state plan sponsors, according to a study by consultancy Greenwich Associates.

“Results from our study show that from 2011–2012 public funds generally made no progress in closing funding gaps,” said Andrew McCollum, a consultant Greenwich Associates.

Average solvency ratios of U.S. public defined benefit pension plans held steady at 77%, and Greenwich Associates estimates show that nearly three quarters of plans are significantly underfunded. Over that same period, public funds decreased their average actuarial earnings returns on plan assets to 7.5% from 7.9%.

“The simple fact is that public pension funds have an actuarial assumption of 7.5%, and the average public pension fund has 30% allocated to fixed income, and with interest rates at historic lows and tightening of credit spreads, a large portion of assets that are invested with traditional long-only fixed income managers are expected to return in the 2.5% range,” said Steinbrugge at Agecroft Partners. “As a result, you will confine to see money move out of fixed income into alternative allocations as long as interest rates stay at historic lows.”