The public pension hedge fund dodge
A bill awaiting final passage by the New York state legislature would allow public pension funds to put more money into “alternative” asset classes such as hedge funds, private equity and international bonds.
Alternatives may or may not have some role to play as part of public pension funds’ overall portfolio. But, in New York and elsewhere, the main drivers behind ratcheting up exposure to these high-risk investments are politicians’ poor grasp of the risk involved and a willingness to believe anything that would spare them tough decisions that could earn them taxpayers’ and/or unions’ wrath.
The New York bill raises the ceiling on the total alternatives allocation – known euphemistically as assets held under the “prudent investor standard” – from 25 to 35 percent of a fund’s portfolio. In theory, those investments are justified by higher expected returns and/or lower volatility, leading to lower and more predictable costs for taxpayers.
But that’s only if these investments hit their ambitious yield targets. A more certain effect, and one which is no doubt not far from legislators’ minds, is that the new ceiling would temporarily bail out New York’s troubled public pension systems.
Higher expected rates of return make a pension plan appear cheaper and better funded. They reduce both the current cash contribution and the projected cost of benefits. Although the improved funding levels will only be on paper, politically, this is still better than manna from heaven for state leaders who want to avoid painful decisions such as reducing benefits and/or paying more to cover funding shortfalls.
These days, alternative asset classes are so crowded with institutional investors hunting for a higher return that the true opportunities are likely either out of reach or too expensive. According to a recent Pew study, alternative allocations ballooned from 11 to 23 percent of public pension plans’ assets between 2006 and 2012. Many pension funds have been paying high fees for mediocre returns, often increasing rather than reducing their exposure to market risks.
Hedge funds did better than stocks but still took a beating during the financial crisis. Overall, the industry has underperformed broad market indices for over a decade, even before accounting for its rich fees and expenses. Preeminent managers such as George Soros have been closing their funds for new investments.
Most problematically from a public finance perspective, the alternatives space is, in general, opaque and the assets are very hard to value. These features make it easier for both pension funds and their private investment managers to engage in creative accounting.
Over about a decade, the pension plan of metropolitan Boston’s transit authority rapidly expanded its alternatives allocation. This enabled the fund to raise its assumed rate of return by half a percent, but produced no tangible improvement in actual returns. One failed $25 million investment in a hedge fund has prompted investigations by the FBI, SEC and the attorney general of Massachusetts into possible fraud and lack of proper disclosure of the losses by the fund’s trustees.
It’s appropriate to doubt Albany’s motivations here given its other recent moves on pension policy. Last year, Governor Cuomo pushed through a “smoothing” policy that will allow localities to defer some $735 million in pension payments and counting. State leaders say the policy will help avoid steep local tax increases, but it also undermines the security of retiree benefits and will require much higher future contributions to offset the current “savings.”
One need look no further than Illinois’s woefully underfunded state pension systems or the wave of local bankruptcies in California to get an idea of where such “savings” and accounting shenanigans lead. Too often, quick paper gains lead to very real long-term losses. The governor and legislators in Albany should do the right thing and reject the hedge-fund dodge.