Financial Methods: Chasing Returns

Business Week reports that Pennsylvania's state pension fund is increasingly moving into alternative investments such as hedge funds and private equity in an effort to boost returns.

There is certainly nothing inherently wrong with hedge funds or other non-traditional investments. They are occasionally excellent investments that have historically been ignored by many pension funds. Many funds could probably benefit from diversifying into a few of these types of investments. However, Pennsylvania's move, which is likely to be imitated, is more about boosting returns than a diversification strategy.

In the Business week article, Nanette Byrnes summarizes the difficult position that pension fund managers (like Pennsylvania's Peter Gilbert) find themselves in:

Like many other public pension plans, including Idaho's and California's, Pennsylvania's is underfunded. Because Pennsylvania's state workforce isn't growing, the plan covers almost as many retirees as it does active employees. It takes in roughly $400 million a year in employee and state contributions but pays out almost $2 billion annually in benefits. The fund's assets are currently $1 billion less than the estimate of what will be needed in coming decades. And that discrepancy assumes that Gilbert's investments pump out returns of 8.5% per year.

Political decisions beyond his control have made Gilbert's job far more challenging. In 2001, Pennsylvania lawmakers increased their pensions by 50% and simultaneously raised other state employees' benefits almost as much. At that time, the pension fund was still comfortably in the black, thanks to generous returns from the long bull market. But big bills are coming due. By 2015, the plan's annual obligations are expected to grow to $4.4 billion. Meanwhile, the state continues to contribute only 2% of workers' annual salaries -- way below the actual cost of benefits.¹

Through the bull market of the 1990's an 8.5% target return was entirely possible. A portfolio that held 60% stocks / 40% bonds would require a 10.2% equity return and a 6% bond return to produce the target return for the portfolio. Pretty routine for the nineties. Since 2000, such returns have been much more difficult to produce. Today we live in a low-return world. Throw in politically-motivated pension benefit increases and today's pension fund managers are in an extremely difficult situation.

In an effort to reduce their funding deficit, pension managers are chasing returns and increasing risk. Managers that allocate too much to alternative investments will have high exposure to risk. Hedge funds sometimes fail, often in spectacular fashion (remember Long Term Capital Management?). Private equity and venture investments are very illiquid. What if you're ready to sell and no one is willing to buy - then you get to hold until a buyer comes along, or you lower your price.

Pennsylvania's pension fund is now almost 25% hedge funds, 12.3% private equity/venture capital, and 20.8% in international stocks.¹ I hope this strategy works out for them, but I see a risky, speculative stretch for higher returns.

Source:

1. Nanette Byrnes. Pensions: Hedging Bets In Harrisburg
Business Week. February 6, 2006.
http://www.businessweek.com/magazine/content/06_06/b3970103.htm