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By GRETCHEN MORGENSON
Today’s low-interest-rate environment has made the hunt for investment income tougher than ever. Many overseers of public pension funds, desperate to bolster returns and meet ballooning retiree obligations, have turned from traditional investments like stocks and bonds to hedge funds and private equity.
These so-called alternative investments now account for almost one-quarter of the roughly $2.6 trillion in public pension assets under management nationwide, up from 10 percent in 2006, according to Cliffwater, an adviser to institutional investors. Investments in public companies’ shares, by contrast, fell to 49 percent from 61 percent in the period.
Fans of alternative investments argue that they can generate higher returns. But the increased risks, higher fees and lack of transparency associated with such investments make them problematic. A 2007 paper by Fiona Stewart at the Organization for Economic Cooperation and Development in Paris said that “lack of transparency makes the level of risk and type of exposure hard to gauge” in hedge funds.
Last week, an investigation of the Rhode Island pension system’s recent foray into alternative investments raised fresh questions about the high costs and considerable risks of investing in hedge funds and whether their returns are indeed worth it.
The investigation, by Benchmark Financial Services, a forensic firm hired by a Rhode Island council of the American Federation of State, County and Municipal Employees, concluded that the $7.7 billion Employees’ Retirement System of Rhode Island was at risk because of its increased concentration in high-cost and opaque alternative investments. The union represents workers whose pensions are invested by the state.
In less than two years, the Rhode Island pension system has ramped up its investments in hedge funds, private equity and venture capital from zero to almost $2 billion, or more than one-quarter of its assets under management. But this mix of investments hasn’t outperformed the fund’s peers, the Benchmark report said. For the year ended June 30, 2013, the fund returned 11.07 percent, versus 12.43 percent earned by the median public pension fund.
Generating returns on the Rhode Island pension is a task of Gina M. Raimondo, the state’s general treasurer, who is also chairwoman of its retirement board. A Democrat, she was elected in 2010; previously, she was a partner at Point Judith Capital, a smallish venture capital firm.
As treasurer, Ms. Raimondo has won national praise for her efforts to reform the state’s public pension system.
She published a report on the state’s pension problems in 2011. At the time, the employees’ pension fund was only 57.4 percent funded and had increasing obligations. The legislature passed a law increasing the retirement age for many workers and tying cost-of-living adjustments to actual investment returns. Unions are challenging that law in the courts.
But even as many retirees in the Ocean State have experienced benefit cuts, the Benchmark Financial report contends that hedge fund managers are earning rich fees that could otherwise be used to shore up the state’s pension. A recent report in The Providence Journal said investment expenses at the pension were $70 million for the year that ended June 30. Earlier estimates had investment expenses amounting to around $11.5 million for the period, the Benchmark report said.
It is well known that hedge funds charge much higher fees than other money managers. The alternative investments in the Rhode Island pension charge management fees of as much as 2.5 percent and performance fees of up to 20 percent of profits. Transaction costs are additional.
Unfortunately, the hedge funds held by the state have underperformed the overall stock market so far this year. As of Aug. 31, the most recent data available, the Rhode Island State Investment Commission said its 10 hedge funds investing in stocks returned an average of 8.73 percent, while nine so-called real-return hedge funds generated 3.61 percent. Neither matched the 16.15 percent gains in the Standard & Poor’s 500-stock index during the period.
Asked about the problems highlighted in the Benchmark report, Ms. Raimondo, through a spokeswoman, declined to be interviewed. But in a news release, Ms. Raimondo’s office said the report was motivated by her political enemies.
Edward A. H. Siedle, the president of Benchmark Financial Services in Ocean Ridge, Fla., conducted the investigation into the Rhode Island pension’s investments. A former lawyer at the Securities and Exchange Commission, Mr. Siedle said he found it troubling that state officials won’t require the hedge fund managers they have hired to disclose how they are investing the pension’s money. He also noted conflicts of interest common at hedge funds that may put the Rhode Island pension at a disadvantage to insiders or favored investors.
A review of documents from three of the hedge funds managing money for the Rhode Island pension fund show that some investors are more equal than others. Special treatment includes fee discounts, more frequent redemption rights than those given to other investors and the ability to receive reports including information about the fund’s portfolio that is not provided to other shareholders.
“The hedge fund documents all say that ‘We’re not going to disclose what we are doing with your money,’ ” Mr. Siedle said. “However, they say that certain strategic investors will be told what’s being done with your money and that those strategic investors may use that information to profit at your expense.”
The documents don’t specify who might receive these benefits. Instead, they note that the benefits may be based on the size of an investor’s holdings in the fund or that they may be granted to an investor who agrees to hold an investment for a significant time.
Mr. Siedle questions why any state pension plan would agree to invest under such unequal terms. “The hedge fund industry has maintained that they should be allowed to manage public pension money in secret,” he said. “But now we have evidence that insidious business practices are involved. The performance is bad enough, but when you add in these other features, these investments are inherently unsuitable for public pensions.”
Joy Fox, the Rhode Island treasurer’s spokeswoman, said in a statement: “Strong returns from our investments, including alternative investments, help move the pension fund closer to the 80 percent funded level, where the cost-of-living adjustments come back. We constantly monitor our investment strategy, and make changes when necessary.”
It is clear that public pensions, like many investors, are being hurt by the Federal Reserve’s zero-interest-rate policy. But investors who reach for yield do so at their peril. And when the investments that retirees in any state are relying on involve high costs, opacity and conflicts, that can only increase the hazards.
Today’s low-interest-rate environment has made the hunt for investment income tougher than ever. Many overseers of public pension funds, desperate to bolster returns and meet ballooning retiree obligations, have turned from traditional investments like stocks and bonds to hedge funds and private equity.
These so-called alternative investments now account for almost one-quarter of the roughly $2.6 trillion in public pension assets under management nationwide, up from 10 percent in 2006, according to Cliffwater, an adviser to institutional investors. Investments in public companies’ shares, by contrast, fell to 49 percent from 61 percent in the period.
Fans of alternative investments argue that they can generate higher returns. But the increased risks, higher fees and lack of transparency associated with such investments make them problematic. A 2007 paper by Fiona Stewart at the Organization for Economic Cooperation and Development in Paris said that “lack of transparency makes the level of risk and type of exposure hard to gauge” in hedge funds.
Last week, an investigation of the Rhode Island pension system’s recent foray into alternative investments raised fresh questions about the high costs and considerable risks of investing in hedge funds and whether their returns are indeed worth it.
The investigation, by Benchmark Financial Services, a forensic firm hired by a Rhode Island council of the American Federation of State, County and Municipal Employees, concluded that the $7.7 billion Employees’ Retirement System of Rhode Island was at risk because of its increased concentration in high-cost and opaque alternative investments. The union represents workers whose pensions are invested by the state.
In less than two years, the Rhode Island pension system has ramped up its investments in hedge funds, private equity and venture capital from zero to almost $2 billion, or more than one-quarter of its assets under management. But this mix of investments hasn’t outperformed the fund’s peers, the Benchmark report said. For the year ended June 30, 2013, the fund returned 11.07 percent, versus 12.43 percent earned by the median public pension fund.
Generating returns on the Rhode Island pension is a task of Gina M. Raimondo, the state’s general treasurer, who is also chairwoman of its retirement board. A Democrat, she was elected in 2010; previously, she was a partner at Point Judith Capital, a smallish venture capital firm.
As treasurer, Ms. Raimondo has won national praise for her efforts to reform the state’s public pension system.
She published a report on the state’s pension problems in 2011. At the time, the employees’ pension fund was only 57.4 percent funded and had increasing obligations. The legislature passed a law increasing the retirement age for many workers and tying cost-of-living adjustments to actual investment returns. Unions are challenging that law in the courts.
But even as many retirees in the Ocean State have experienced benefit cuts, the Benchmark Financial report contends that hedge fund managers are earning rich fees that could otherwise be used to shore up the state’s pension. A recent report in The Providence Journal said investment expenses at the pension were $70 million for the year that ended June 30. Earlier estimates had investment expenses amounting to around $11.5 million for the period, the Benchmark report said.
It is well known that hedge funds charge much higher fees than other money managers. The alternative investments in the Rhode Island pension charge management fees of as much as 2.5 percent and performance fees of up to 20 percent of profits. Transaction costs are additional.
Unfortunately, the hedge funds held by the state have underperformed the overall stock market so far this year. As of Aug. 31, the most recent data available, the Rhode Island State Investment Commission said its 10 hedge funds investing in stocks returned an average of 8.73 percent, while nine so-called real-return hedge funds generated 3.61 percent. Neither matched the 16.15 percent gains in the Standard & Poor’s 500-stock index during the period.
Asked about the problems highlighted in the Benchmark report, Ms. Raimondo, through a spokeswoman, declined to be interviewed. But in a news release, Ms. Raimondo’s office said the report was motivated by her political enemies.
Edward A. H. Siedle, the president of Benchmark Financial Services in Ocean Ridge, Fla., conducted the investigation into the Rhode Island pension’s investments. A former lawyer at the Securities and Exchange Commission, Mr. Siedle said he found it troubling that state officials won’t require the hedge fund managers they have hired to disclose how they are investing the pension’s money. He also noted conflicts of interest common at hedge funds that may put the Rhode Island pension at a disadvantage to insiders or favored investors.
A review of documents from three of the hedge funds managing money for the Rhode Island pension fund show that some investors are more equal than others. Special treatment includes fee discounts, more frequent redemption rights than those given to other investors and the ability to receive reports including information about the fund’s portfolio that is not provided to other shareholders.
“The hedge fund documents all say that ‘We’re not going to disclose what we are doing with your money,’ ” Mr. Siedle said. “However, they say that certain strategic investors will be told what’s being done with your money and that those strategic investors may use that information to profit at your expense.”
The documents don’t specify who might receive these benefits. Instead, they note that the benefits may be based on the size of an investor’s holdings in the fund or that they may be granted to an investor who agrees to hold an investment for a significant time.
Mr. Siedle questions why any state pension plan would agree to invest under such unequal terms. “The hedge fund industry has maintained that they should be allowed to manage public pension money in secret,” he said. “But now we have evidence that insidious business practices are involved. The performance is bad enough, but when you add in these other features, these investments are inherently unsuitable for public pensions.”
Joy Fox, the Rhode Island treasurer’s spokeswoman, said in a statement: “Strong returns from our investments, including alternative investments, help move the pension fund closer to the 80 percent funded level, where the cost-of-living adjustments come back. We constantly monitor our investment strategy, and make changes when necessary.”
It is clear that public pensions, like many investors, are being hurt by the Federal Reserve’s zero-interest-rate policy. But investors who reach for yield do so at their peril. And when the investments that retirees in any state are relying on involve high costs, opacity and conflicts, that can only increase the hazards.
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