Retirement: Your Pension Plan Has a Big Hedge Fund Problem

If you’re one of the 25% of non-retirees who are still lucky enough to look forward to a pension, congratulations. But don’t get too comfortable, because there’s a good chance your pension plan is taking on a questionable investing strategy.

Since 2005, state and local pension plans have sharply increased their exposure to alternative investments, including private equity, real estate and hedge funds, from 9% of portfolios, on average, to 24%. That was an understandable reaction to scary declines in the stock market. But it has turned out to be a poor decision, especially where hedge funds are concerned.

Looking at the results of this shift, researchers at the Center for Retirement Research at Boston College found that plans that increased their exposure to any alternative investment to at least 10% of the portfolio between 2005 and 2015 saw annual returns that were 0.32 percentage points below plans that had less than 10% in alternative investments. From 2010-2015, the annual gap was 0.44 percentage points.

When breaking out the different alternative investments – and returns – the researchers found a statistical link between investments in hedge funds and an even sharper decline in the portfolio returns. Among plans that increased their exposure to hedge funds to at least 10% of their portfolio, the average plan performed annually 0.48 percentage points worse from 2005 to 2015, and lagged by 0.75 percentage points from 2010 to 2015, when compared to average pension plan returns.

The average pension plan returned 6.5% annually from 2005 to 2015, and 9.8% annually from 2010 to 2015. Underperforming by less than a percentage point may not sound like a lot, but it effectively means millions or billions of dollars left on the table for the huge pension plans. And of course, hedge funds are also known for charging relatively high fees, which makes that underperformance more galling.

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“Most of the shift into alternatives is really about…reducing volatility and diversifying the portfolio,” says Jean-Pierre Aubry, an author of the report and an associate director of research at the Center for Retirement Research. “Some have done well and others have not.”

Overall, though, the move into alternatives didn’t help volatility, either, according to the preliminary findings.

The authors didn’t look into the impact that fees have on the returns or how plans use different types of investments. They did find that smaller pension plans were more likely to invest in hedge funds, over private equity investments, which they theorize has to do with the lower cost of entry.

Hedge funds as an investment have been under attack for years due to the high fees and poor investing results. Most notably, Warren Buffett bet that his S&P 500 index fund could outperform a group of hedge funds over a decade. His total returns, which he shared in February, were 85.4% compared to 22% for the group of hedge funds.

Plans began moving into alternatives in 2005, in part as a reaction to the Internet bubble that burst in 2001. By 2005, hedge funds (and real estate) were performing better than equities. That held true through 2008. But by 2010, stock portfolios far outperformed, rising 14.9% annually, compared to 1.3% for hedge funds.

It’s not just hedge funds, however, that have enticed plans. Aubry and his team found that certain pension plans have gotten particularly hooked on the alternative investment strategy. The Dallas Police and Fire plan held 68% of its assets in alternative investments, most notably real estate. The fund nearly went bankrupt last year after a run on the plan by savers who feared it would no longer be solvent. Texas had to pass a $ 2.1 billion rescue bill in June to keep the plan funded.

Texas isn’t alone; 31% of plans had at least 30% of assets in alternative investments by 2015.

“The data is pretty clear, looking at overall returns and volatility,” says Aubry: The investments did not improve things on either front. All the more reason for retirement savers to look at the fine print.