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Risky investments: No way to save pension funds

The California Public Employees' Retirement System building in Sacramento, California.
The California Public Employees' Retirement System building in Sacramento, California.
Max Whittaker/Getty Images

Last year, I wrote about Calpers, the big California pension fund ($235 billion), and its problems with conventional investment strategies:

The investment environment for pension funds isn't actually very good right now. Bonds are yielding historically low rates and the stock market is bucking around like an old Ford pickup truck on a back road in Texas. The Federal Reserve has done everything it can to push investors into riskier assets, like stocks, but so far, the markets haven't been able to maintain any kind of sustained rally.

This means that pension funds are increasingly diversifying into high-risk/high-return stuff, like hedge funds and private-equity. This is an oversimplification, but hedge funds try to make money even when markets are going south, while private equity invests in startup companies and gets involved in the turnarounds of underperforming established ones. The payoffs can be big. But so can the losses. 

The sustained-stock-market-rally part of the argument I was making then has changed, of course. I was blogging in early September, and since then, the Dow is up substantially, as are the other exchanges. Nevertheless, hitting return targets — and Calpers just knocked 25 basis points off its goal, dropping back from 7.75 percent to 7.50 percent — remains difficult. 

The New York Times tackled the issue yesterday, by looking at the investment strategies of two different state funds, Pennsylvania (risky) and Georgia (not so risky):

The $26.3 billion Pennsylvania State Employees’ Retirement System has more than 46 percent of its assets in riskier alternatives, including nearly 400 private equity, venture capital and real estate funds.

The system paid about $1.35 billion in management fees in the last five years and reported a five-year annualized return of 3.6 percent. That is below the 8 percent target needed to meet its financing requirements, and it also lags behind a 4.9 percent median return among public pension systems.

In Georgia, the $14.4 billion retirement system, which is prohibited by state law from investing in alternative investments [my emphasis], has earned 5.3 percent annually over the same time frame and paid about $54 million total in fees. The two funds represent the extremes, with Pennsylvania in a group of pension systems with some of the highest percentages of investments in alternatives and Georgia in a group of 10 with some of the lowest, according to groupings of funds identified by the London-based research firm Preqin.

So, for starters, both those funds are much, much smaller than Calpers. Difficult to make fair comparisons there, because Calpers has a lot more money available to invest in hedge funds and private-equity firms. Still, you can consider the returns. In Calpers case, it's only ever beaten its target on a 20-year basis, with a return near, but not reaching, 9 percent. But that's over two decades in an era of disproportionately high returns from equities markets.

I suggested back in September that Calpers doesn't have much choice but to engage in a risk-reward strategy — and that was before the return target was cut! But given the way that markets have been performing, even 7.50 might be excessively optimistic. 

But there's another factor that the NYT story makes clear: alternative, high-yield investment are no guarantee of, you know, high yields. But they are very costly in terms of fees. Pennsylvania, at $1.35 billion, paid more than  twice as much in fees as Georgia. Makes sense. Hedge funds, for example, operate on the "2 and 20" model, charging investors a 2 percent fee on funds managed, while gobbling up 20 percent of returns. And that's just the standard hedge fund. Very, very successful hedge funds can charge as much as 5 and 50.

This is great when the market is generating returns sufficient to offset the 20 percent hedge-fund take and make the 2 percent seem like a small price to pay for outsized returns. But when markets are creating rotten spreads between returns and fees, the fees start to seem...well, they become harder to justify. In Pennsylvania's case, that five-year annualized return of 3.6 percent, once you subtract management fees, is banged down to 1.6 percent — well below the rate of inflation, and therefore a negative return. 

I mean, more than 5 percent of Pennsylvania's total fund, over a five-year period, is being eaten up by fees. In Georgia's case, it's 3.75. That's not great — a reminder than investors, even ones running huge pension funds, need to be ever-mindful of fees wiping out returns — but it's better than what Pennsylvania is getting, even though Georgia is also looking challenged in its efforts to beat inflation (which tends to run at about 3.4 percent on an historical average).

Take heart if you're in the Missouri State Employees plan, however. With about $8 billion and $100 million in fees from hedge funds and the like, the five-year return is 6.2 percent!

Bottom line is that pension funds — huge ones like Calpers, small ones like Georgia's — need a serious reality check. We could be entering an period when returns will always significantly lag stated targets, and when even exotic investments will either not deliver the hoped-for results or, on the serious downside, offset returns with excessive fees. Hedge-fund manager get paid. Pensioners...maybe eventually don't.

Sooo...enter Jerry Brown's plan to revamp the whole pension system in the state. I wrote about this in October:

The thinking in Sacramento is that the risky side of the equation can be offloaded to individuals. The state can then focus on a return that's designed to beat the rate of inflation — say, 4-5 percent — and leave individuals to chase 8-10 percent. This could be a viable solution, as long as the state encourages its hires to educate themselves on how retirement planning works, outside defined-benefit traditional pensions. Many participants in 401(k) plans do a lousy jobs of managing them.

Do you feel like chasing down an 8-10 percent return with your self-managed pension plan? It's sobering when you consider that Pennsylvania's "400 private equity, venture capital and real estate funds" can only help the state get to 3.6 percent, annualized over five years. Okay, okay — these past five years have been dreadful for the markets. Maybe things will look up for the rest of the decade!

Or maybe not. Asking individual to target 8-10 percent when the pros estimate that the market will only do 6 is a lot like the pension funds counting on 8 percent when some of the finest investment minds active in the market can only deliver, at a stretch, 4-5 percent. 

What does this mean, long term? Well, it means downgraded expectations, for one thing. But in the case of funds that are going to have more going out then coming in as the Baby Boomers retire in force, it raises the specter of insolvency.

Follow Matthew DeBord and the DeBord Report on Twitter.