Can Retirees Afford This Much Risk?

Public pensions may have grown addicted to high-risk alternative investments.

New mexico's public pension plan is sinking deeper and deeper into a hole. Over the past four years, it has accumulated a $937 million deficit. That's bad news for the state workers who are depending on the fund to pay for their golden years. In hopes of boosting returns, last year the state legislature gave managers the authority to put money into alternative investments such as real estate, private equity, and hedge funds. Historically, the state had stuck to safe vanilla assets like stocks and bonds.

But that strategy has been put to the test. Over the past two turbulent months, New Mexico's $13 billion public pension fund has lost more than $350 million, in part because of declines in the $366 million originally invested in hedge funds. Yet New Mexico remains undaunted. "We didn't approve this investment program on a lark, and we don't intend to change the strategy based on what we consider to be a short-term crisis," says Chief Investment Officer Robert Gish. In fact, he plans to put an additional $134 million in hedge funds before the year is over.

Despite the sharp ups and downs of the market lately, public pensions show no sign of abandoning their recent push into hedge funds and other nontraditional investments. They really can't afford to do so. State pension plans have deteriorated from a $20 billion surplus in 2001 to a $381 billion deficit last year, according to the National Association of State Retirement Administrators (NASRA). That underfunding, much of which comes from big stock market losses earlier this decade, means the assets they have in their portfolios today aren't enough to cover the present value of the long-term retirement promises they've made.


To make up that difference, public funds have two options: look for higher contributions from already strapped state and local employers or find a way to juice investment returns. Smaller funds with big holes to fill are among those moving fastest into more esoteric investments, but they are the ones least able to afford big losses. "What's driving the high-risk investment policy is the pension system's deficit," says Michael Aguirre, San Diego's city attorney and a frequent critic of that city's underfunded plan. He says San Diego's plan is "no longer a pension fund, [but] now more of a high-risk fund, backed by the city taxpayers."

It's easy to see what has attracted public funds to these assets. Heady returns at a handful of university endowments that ventured into hedge funds early on were followed by successes at larger public funds like the Pennsylvania State Employees' Retirement System. That provided a model for smaller states and cities to follow. In a survey conducted last year, 42% of public fund managers told consulting firm Greenwich Associates they intended to raise their stake in hedge funds. That's up from 26% the year before.

But they may be too late. This year's volatility presents the first real test of the alternative strategy, and some of the lessons are disconcerting. One of the main arguments Pennsylvania, New Mexico, and many others made for getting into alternative investments was that they would lower volatility by spreading their bets over broader investments. It's a highly appealing idea to a group that still suffers from the dramatic market drops of five years ago. But New Mexico's Gish says in the recent turmoil the state's hedge fund investments didn't move independently from the stock and bond markets, as he'd hoped.

That wouldn't come as a surprise to Peter M. Gilbert, chief investment officer for the Lehigh University Endowment Fund, who ran Pennsylvania's groundbreaking public pension fund for 14 years before leaving in May. Pennsylvania now has more than half its assets in alternative investments. It has earned solid returns, but Gilbert questions whether that kind of record can be replicated broadly. The growing popularity of hedge funds, he says, is reducing the diversification they can provide as managers increasingly compete for the same limited set of investments. That dampens how well they can help a pension fund perform. "In some ways, what you have is almost a commodity," Gilbert says. "Ten years ago fund managers had much more unique insight and strategies."

For public plans, whose boards are generally populated with political appointees, unfamiliar hedge funds pose the added risk of bad headlines. "If the market crashes, people don't say 'Why were you invested in equities?' because people are familiar with it," says Gilbert. "But if a hedge fund blows up, it's a disaster."

That is particularly true for underfunded plans--the ones that are most likely to dabble in riskier investments. Looking at the universe of large public plans surveyed by NASRA, 83% of funds with less than 70% of their liabilities covered had above-average allocations in alternative investments. But the best-funded plans, ones that had savings sufficient to cover 97% or more of their expenses, were far less adventurous. Only 50% are similarly highly invested in alternatives. "We don't need to reach," explains Bob Maynard, chief investment officer for the Public Employee Retirement System of Idaho, which has 105% of its liabilities funded thanks to regular employer contributions and more modest benefits.

The San Diego County Employees Retirement Assn. pension fund got what should have been a wake-up call last September. That's when it lost the $175 million it had invested in Amaranth Advisors, a hedge fund that blew up after a series of bad bets on natural gas prices. San Diego has since recovered about $80 million of that money and is suing the fund for fraud. But it has otherwise made few changes to its broader strategy, despite the losses and an uproar from citizens at the time. Today the fund has $1.5 billion of its $8.5 billion in assets directly invested in a dozen hedge funds. At least two, AQR Capital Management and DE Shaw & Co., had some tough weeks in August. Though it was a topic of conversation at a board meeting on Aug. 16, no change of course was considered.

And plans that directly invest in hedge funds, like San Diego's, can face a greater risk in a downturn than those that invest through more expensive and diversified funds-of-funds. Pennsylvania SERS also suffered losses as an Amaranth investor, but because it invests through funds of hedge funds, it holds more than 250 other funds in its portfolio. In all, it lost about $20 million.

Critics worry most about smaller funds that have gotten into the alternative asset game, and there are a lot of them. According to Greenwich Associates, in 2006 the smallest public pension plans, with $500 million in assets or less, had on average a far higher percentage of their assets in hedge funds than those with $5 billion plus. These funds lack the resources of their larger peers. New Mexico's Gish had to double his investing staff--to four--when he started looking at alternatives. "We're concerned about some of the smaller funds that don't have the internal staff capacity to do the due diligence on the extra risks that are associated with hedge fund investing," says Richard C. Ferlauto, director of pension and benefit policy at the American Federation of State, County & Municipal Employees, the union that represents most public employees.

In contrast to New Mexico, some states have decided to clamp restraints on what their own pension plans can do. In May, the Texas legislature set caps for how much state pensions can invest in hedge funds and required that they seek certain outside advice before doing so. But the new limits did not prevent the Teacher Retirement System of Texas from launching a plan two months later to extend its private equity, hedge fund, and real estate holdings to 24% of its total, up from under 5%. The fund also ventured into some high-risk collateralized debt obligations, one of the investment categories that plunged most sharply this month.

By Nanette Byrnes

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