South Carolina Pension’s Hedge-Fund Bet Trails as Fees Soar

South Carolina’s $27 billion pension dove into private equity and hedge funds in 2008, hoping to increase returns that were at the bottom tenth of public-employee retirement funds.

Five years and $1.2 billion in fees later, its annualized gain of 1.3 percent still trails the median among public pension-systems, according to data compiled by Wilshire Associates Inc. In neighboring Georgia, the $53.5 billion teachers’ pension buys only stocks and bonds. It paid money managers $119.5 million over the same period and its annualized returns of 2.95 percent were in the top quartile.

U.S. public pensions, confronting an $800 billion funding gap for promises to retirees and chasing 8 percent annual returns amid slow growth and historically low interest rates, have turned to riskier investments in private equity, hedge funds and real estate. If the bets don’t pay off, strapped governments will have to pour cash into pensions instead of hiring teachers or rebuilding crumbling bridges.

“We pay too much in fees and we earn too little,” said South Carolina Treasurer Curtis Loftis, a Republican who sits on the seven-member panel that oversees the fund. “I love alternative investments. I love Wall Street. I don’t mind paying fees. But I want returns.”

Palmetto Portfolio

No state has rushed into the loosely regulated investment pools as South Carolina has. As of June 30, the pension had invested 56 percent of its portfolio with firms including Goldman Sachs Group Inc., Bridgewater Associates LP and Apollo Global Management LLC.

Diversifying the portfolio reduces risk and provides the best opportunity to capture higher returns, wrote Reynolds Williams, chairman of the South Carolina Retirement System Investment Commission, in a Jan. 13 letter accompanying the fund’s annual report.

“We view this as a long-horizon strategy for a fund that has to last a long time,” said Danny Varat, a spokesman for the commission. “There will be fluctuations, but the commission believes that it has the appropriate long-term plan.”

Public Scoldings

The strategy has drawn fire from Loftis, elected in 2010 with Tea Party endorsements. He has pushed the commission to get a handle on management fees, which have soared 143 percent to almost $300 million annually.

Loftis’s persistent and public criticism of the pension fund’s management earned him a censure today from the investment commission “for engaging in false, misleading, and deceitful rhetoric.”

The resolution, which was approved 5 to 1 with Loftis opposed, cites articles, radio interviews and blog posts. In one, he said that some contracts with money managers had fee structures different than those approved by the commission, costing the pension “millions of dollars.”

Loftis responded by saying he will continue to press for transparency and information that the commission majority has denied him.

“The complexity of our portfolio is uncharted in public-pension plans,” said Loftis. “We have structural inadequacies in performing and monitoring and risk analysis. All these things cost us money.”

Key Component

Investment returns are crucial to funding state and local government pensions. From 1982 to 2005, returns provided almost two-thirds of their revenue compared with about a quarter from employer contributions and an eighth from employees, according to a report by the U.S. Government Accountability Office.

Higher fees charged by hedge funds and private equity firms, which often use borrowed money to buy companies, improve operations and then resell them, erode those returns.

Meanwhile, the borrowing exposes pensions to bigger risks.

“If state and local pension plans and their sponsors are unable to properly monitor and manage these new risks, they may exacerbate recent market losses,” the GAO report said.

Public funds with more than $1 billion in assets had a median of 10.29 percent of their assets in so-called alternative investments in the fiscal year ending June 30, according to Wilshire, a Santa Monica, California-based consulting firm. That’s up from 0.62 percent in 2002.

Their Cut

Private equity firms and hedge funds often charge 2 percent of assets under management, plus 20 percent of profits above a certain benchmark, a sum much higher than traditional stock and bond funds.

That “2 and 20” arrangement can reduce a 12 percent investment gain to 7.6 percent after fees are deducted, according to the GAO.

Some public pensions, including the $250 billion California Public Employees’ Retirement System, the biggest U.S. pension, have demanded concessions. The discounts have been marginal because it’s a seller’s market, said Michael Schlachter, a managing director at Wilshire.

States are hard-pressed to resist, he said.

“There’s probably 10 other clients who are willing to take their place, he said.

Over the past three years, South Carolina’s private equity and hedge-fund portfolios returned an annualized 12.3 percent and 7.8 percent respectively.

The Standard & Poor’s 500, a stock index based on leading companies publicly traded in the U.S., returned 16.4 percent.

‘‘You almost didn’t need to be in alternatives the last few years, given how well some of the public stuff has done,” said Schlachter.

Good Decade

Over longer periods, pensions that had more in alternative investments have performed better.

For the 10 years ending June 30, Oregon and Washington state’s pensions, which allocate 30 and 40 percent of assets respectively to alternatives, each returned 7.4 percent. That compared with 6.65 percent for the median pension with assets of more than $5 billion, according to Wilshire.

South Carolina isn’t the only pension that hasn’t seen its bets on alternative assets pay off yet.

Maryland’s $37 billion pension increased its holdings in private equity, hedge funds and real estate to about 29 percent of its portfolio from 14.6 percent in 2008, according to its annual report.

Cellar Dweller

Investment fees rose to $229 million in 2012 from $90 million in 2008, a 155 percent increase. Meanwhile, its five-year annualized returns of 0.8 percent place it in the bottom three-quarters of public pensions, according to Wilshire’s Trust Universe Comparison Service.

The median five-year annualized return of a public pension with more than $5 billion of assets was 1.62 percent, for the period ending June 30, according to Wilshire.

Maryland would be better off investing its assets in index funds, said Jeff Hooke, chairman of the Maryland Tax Education Foundation, a nonprofit formed in 1998 to help residents understand tax and spending policies.

“I don’t think the private equity guys or the hedge fund guys or the developed common stock and bond guys consistently beat their indices,” Hooke said. “I think the fees are generally a waste of money.”

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