Pensions: Hedging Bets In Harrisburg

Underfunded state pensions are taking cues from Peter Gilbert's daring investments

The investments that a parade of Wall Streeters pitched to Pennsylvania's state pension officials one recent morning included some surprisingly exotic and risky offerings. Having traveled from New York, California, and points in between to make 10-minute sales presentations in Harrisburg, the sharp-suited men and women suggested everything from real estate deals to venture capital funds and an early-stage drug development venture.

Their audience: the 11 politically appointed members of the board of the Pennsylvania State Employees' Retirement System who ultimately choose its investments. The man who had orchestrated those sales pitches -- and who has steered the board toward an unusually aggressive investment strategy -- is Peter Gilbert, the $27 billion fund's nonvoting chief investment officer. He is an unlikely star in the traditionally staid world of public pensions.

With a master's degree in social work and with investment savvy gained on the job while overseeing pension funds for New York City in the 1980s, Gilbert, 58, has averaged annual returns of 10% during the past decade. That's better than the Standard & Poor's 500-stock index and the results achieved by most other state pension funds, including CalPERS in California, the nation's largest, with $159 billion in assets. Pennsylvania, which ranks No. 22 in assets among statewide plans, has accumulated this strong record with a complex mix of stocks, bonds, private-equity partnerships, and -- perhaps most eye-catching of all -- hedge funds. Some 23% of Pennsylvania's assets are in hedge funds, a level unmatched among pension plans for state workers.

Gilbert's success has helped stoke a frenzy of interest in hedge funds among public plans that once stuck to safe, plain-vanilla investments. According to consulting firm Greenwich Associates, 14% of public plans are already invested in hedge funds -- lightly regulated and usually secretive investment pools -- and 49% expect to increase their hedge fund holdings in the next three years. J. Tomilson Hill, vice-chairman of Blackstone Group, which runs a fund that invests in hedge funds for clients including Pennsylvania, estimates that within a few years, public pension plans, now the source of 25% of his assets, will account for 40%. It's part of a push by the plans into complex, less-liquid investments, which can also be much riskier, and away from traditional fixed-income and stock investments.

Some observers worry that the pension plans will become more vulnerable to large, unanticipated losses. Even for smart managers who avoid hedge fund debacles such as Bayou Management LLC and Wood River Capital Management, the hefty fees and lack of disclosure make hedge funds a tough investment to win with, says Theodore R. Aronson, a founder of Aronson+Johnson+Ortiz, a Philadelphia institutional investment manager that runs hedge funds as well as traditional investment accounts. "The deck is stacked against you" because of high fees, he argues. While "in the rest of the capital markets [performance] information is verifiable, no one monitors this hedge fund crap."


Gilbert acknowledges there are certain dangers. "You have to first understand why you want to use them," he says, "not get in because it's the next hot thing. I think a lot of people will be disappointed. A lot are coming in who probably shouldn't be."

But Gilbert's admirers, including Aronson, see little reason to worry about his performance. "He knows what the hell he's doing," says Bob Maynard, chief investment officer of Idaho's public pension plan, which is up 9% in the past year.

Gilbert says he has little choice but to search for high returns. 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.

Gilbert isn't one to admit to feeling a great deal of pressure from the shortfall. But when the pension plan's assets dropped with the market downturn of 2001-02, he certainly felt the heat. "It was brutal," he says of the criticism in the press and elsewhere. "They all asked: 'How could you lose all that money?' But no one looks at what happened to the fund before that." Just as frustrating for him has been the myopic tendency of the legislature to shortchange the plan. "You have a lot of politicians and administrators out there who don't plan very well," he complains.

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. In 2012, the state contribution is supposed to jump suddenly to 23.5%, but it's entirely unclear where Pennsylvania will find that huge wad of cash.

These demands almost compel Gilbert to push for results exceeding those of the stock market, which in 2005 returned 5%, using the S&P 500-stock index as a gauge. Gilbert's numbers have been so good that in recent years he has been hailed by industry groups. In October, Institutional Investor magazine named him the nation's top public pension plan manager.

In addition to putting nearly a quarter of the Pennsylvania plan's money into hedge funds, Gilbert has allotted 6.8% for real estate, 12.3% for private equity and venture capital, and 20.8% to international stocks. That mix looks a lot like that of the endowments of Yale and Harvard Universities, which moved toward "alternative" investments, with great success, back in the 1990s. Robert A. Bittenbender, a member of Pennsylvania's board, says, "You have to get comfortable with the fact that our individual working knowledge might not be at the same level it was when we were just talking domestic equities and domestic fixed income."

Gilbert, who has a professional staff of 13, first invested in hedge funds in 1999. By 2002 he had switched strategies. Instead of directly investing in the funds, he increased his hedge fund allocation but began directing money toward funds that invest in multiple hedge funds. This approach provides more diversification and, in theory, more sophisticated monitoring by experts at the funds of funds. He coupled this with the purchase of options on the broader market, a technique that gives him the chance to benefit from a market climb but is less risky in an equity meltdown. Gilbert says that since he took this approach in 2002, the combination has added more than $500 million in earnings to the state plan. In 2005, however, the stars of his portfolio were other alternative investments, particularly real estate and private-equity funds.

All of which is highly expensive. In 2004, Pennsylvania paid $195 million in advisory fees, up from less than $80 million in 1998. Says Gilbert: "Sometimes you have to pay for what you get."

By Nanette Byrnes

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