Shoebox Money

Pension-Gate: Some Good News and Bad News

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Shoebox Money

The recent good news from the Wall Street Journal (summarized here) is that the California Public Employees’ Retirement System (CALPERS) is planning to drop the level of its hedge fund investments this year by 40% to $3 billion. This retreat comes in the aftermath of many state and municipal pensions moving into hedge funds over the last decade in an effort to increase their returns in order to meet their future obligations to employees. Another example of the pullback comes from the Los Angeles Fire and Police Employees’ Pension Fund which has decided to exit hedge funds altogether after an investment of $500 million produced a return of less than 2% over seven years, according to General Manager Ray Ciranna. While the hedge-fund investment was only 4% of the total portfolio, it accounted for 17% of all the portfolio’s expenses at $15 million per year. With the common fee structure of 2% of assets and 20% of profits, hedge fund investors face a strong headwind compared to other investors, as shown below.

Unfortunately, not all California municipalities are following in the footsteps of CALPERS and Los Angeles. The board members of the San Francisco Employees’ Retirement System [SFERS] are currently considering a proposal to invest 15% of their $20 billion of assets into hedge funds for the first time. One of the board members, Herb Meiberger, put the question to Warren Buffett who answered, “I would not go with hedge funds—would prefer index funds.” Mr. Meiberger was kind enough to share with us a letter written in opposition to the proposal by the Protect Our Benefits political action committee which correctly stated:

“Contrary to advice of staff [the consultants to SFERS], we believe hedge funds will not reduce volatility during market downturns, but rather increase risk. Also, a complete analysis of the fees associated with this activity needs to be explored and appear, at this time, to be exorbitant.”

Mr. Meiberger also gave us a copy of the assumptions from the consultant that formed the basis of the recommendation. Essentially, the consultant assumed that hedge funds have a slightly lower (by 1%) expected return than equities but with less than half the risk. One of our favorite authors, Bill Bernstein, often talks about being an “investment adult” which means not believing in a stock picking or market timing fairy that will let you beat the market. This assumption from the consultant looks to us like a belief in the hedge fund fairy, and we are glad that Mr. Meiberger has called them out.

Thankfully, the overall trend of hedge fund investment by pensions has been declining. According to consultant Wilshire Trust Universe Comparison Service, after peaking at 1.81% in 2011, pension allocations to hedge funds dropped to 1.21% of total portfolios as of 3/31/2014. Unfortunately, we cannot say the same thing for private equity which climbed to a ten-year high of 10.5% as of 3/31/2014. This appears to be a classic example of performance-chasing, according to this article in Bloomberg Businessweek. The author of this article also cites the Wilshire data which shows that the three-year return (as of 3/31/2014) received by pension plans from hedge funds was 3.6% compared to 10.9% for private equity and 10.6% for public equities. However, as we noted in this article, the returns reported by private equity funds are tenuous at best. Furthermore, a study of the performance of public pension funds in private equity compared to other investors such as endowments showed that the pension funds fared far worse. One possible reason for this underperformance is the prevalence of “pay-to-play” which we just recently saw with the guilty plea of the ex-CEO of CALPERS to receiving cash kickbacks in paper bags and shoe boxes for placing private equity fund purchases.

As we have repeatedly noted, there is still a great deal of work to do in the reform of the management of public pension funds. IFA will continue to act as an advocate on behalf of both public employees and the taxpayers.