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Keep It Simple

Sometimes the best plan is the simplest one. The state of Pennsylvania learned that lesson the hard way.

That lesson was highlighted recently by The New York Times: the Pennsylvania State Employee’s Retirement System, which stands at $26.3 billion, has better than 46% of its holdings in riskier alternative assets, including 400 real estate, private equity and venture capital funds. And over the course of the past five years, the system has spent $1.53 billion in fees, and has seen an annualized return of 3.6%…well below the 8% return it needs to meet its obligations.

Meanwhile, Georgia’s municipal retirement system is prohibited by state law from investing in alternative assets. The system stands at $14.4 billion, and with its less risky portfolio has paid out fees of $54 million over the last five years, and its annualized return has been 5.3%.

These two states represent opposite ends of the pension plan spectrum, but Pennsylvania isn’t the only state moving towards riskier bets. In 2007, pension funds with more than $1 billion in assets held 10.7% in alternatives like real estate, private equity and hedge funds. By 2011, that increased to 19%. The reason is that pension funds are facing serious shortfalls, and they are turning to riskier assets in the hopes of higher returns to close the gaps.

The problem is that while fees have grown, returns have not. According to The New York Times, after looking at a sampling of pension plans: “the funds with a third to more than half of their money in private equity, hedge funds and real estate had returns that were more than a percentage point lower than returns of the funds that largely avoided those assets. They also paid nearly four times as much in fees”.

The trend toward risk prompted a study by the Government Accountability Office.

There are over 3,400 state and local pension systems in the US. And those plans cover over 27 million people. Even after losses due to the recession (which amounted to $672 billion), most state and local plans have sufficient assets to cover their benefit obligations for at least the next ten years. But the reality is that pension funding is a long-term effort…and the long-term is where the problems arise.

There has been a growing gap between pension fund assets and liabilities. Losses from market declines, combined with increased benefits and a failure to keep pace with required contributions, have resulted in funding ratios trending in the wrong direction.

The response has been increased risk. And that added risk has brought with it new problems. Beyond higher fees, some pension plan sponsors have run into reduced liquidity with their hedge fund and private equity investments. Typically, hedge funds will have limits on the timing and size of redemptions, but some have imposed “discretionary gates”, meaning limits on redemptions at the discretion of the hedge fund manager. And that becomes a problem when pension funds are counting on those redemptions to meet their obligations, and a hedge fund manager decides they can’t cash in. The end result is that plans have to sell off other public equity positions to make their benefit payments…during the financial crisis that meant selling at a significant loss.

The lesson is keep it simple. Sometimes the more ‘sophisticated’ investment plan isn’t the most efficient, or the most cost-effective.

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