Public pension fund travails show that risk and fees matter

Some pension funds for state and local employees have sought higher risk investments in order to boost returns and make up for funding shortfalls. Others have stuck to a traditional diversified stock and bond mix. Guess who has done better? (Here’s a hint: it wasn’t the pension plans that took high risks).

Falling tax revenues and rising retirement costs have put some public pension plans on the defensive. In an attempt to make up for shortfalls they began putting some of their assets into hedge funds, direct real estate investments, and private equity arrangements. Hedge funds are investment pools that have no constraints on their strategies: they can short stocks, speculate in currencies, and engage in other risky pursuits. Private equity funds allow large investors to take direct ownership stakes in private businesses, rather than buying publicly-traded stock.

The New York Times recently reported that the Pennsylvania State Employees’ Retirement System has put almost half of its assets into private equity, real estate, and other riskier alternative investments. The pension fund had average returns of only 3.6 percent over the past five years, and it paid $1.35 billion in management fees. Meanwhile, the Georgia municipal retirement system is prohibited by law from using such investments. It invested in a standard diversified mix of stocks and bonds and earned a 5.3 percent annualized return over the same period, while paying about $54 million in management fees.

London-based alternative investment research firm Preqin recently said that Pennsylvania was among a group of pension systems taking the highest risks, while Georgia’s system was in the group taking the lowest risks. Preqin’s study showed that those pension funds that had over one-third of their money in riskier alternative investments earned an average of one percentage point less than pension funds that avoided such investments. Meanwhile the riskier pension funds paid an average of four times more in fees. The results seem to indicate that the returns on alternative investments do not justify their higher fees.