Working Paper

U.S. Public Pension Funds and Alternative Investments

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In the past decade and a half, state and local public employee retirement systems in the United States have significantly shifted their fund investment strategies toward a greater allocation in alternative investments. Today, roughly $660 billion of public pension funds are invested in hedge funds and private equity funds. These alternative investments typically require new governance structures within the pension funds in order to adequately monitor accompanying risks and returns, management fee arrangements and investment complexity.

With large sums of public money at stake, it is crucial for taxpayers, public employees and policymakers to understand the goals, procedures and standards for public pension fund investment in alternative asset classes. While some governance issues, such as the use of placement agents, have attracted wide public attention, many fundamental concerns are not well covered by the academic literature or popular media. These include the financial training of public pension fund board of trustees, accountability and transparency of relationships between investment managers and the evolving relationship between management fees and overall funding ratios. This in-depth study of U.S. state pension funds reveals a lack of consistent practices or governance structures for pension investments in hedge funds and private equity. Our data show a negative relationship between investment returns and management fees, and suggest that fund size does not predict stronger negotiating power in fees or success in returns. In case studies of four public pension funds, we show that state employee retirement systems display a spectrum of experience in both the institutions meant to guide alternative investments and the portfolio returns.

While the shift to hedge funds and private equity funds is common to almost all institutional investors, public pension funds are unique in their mission and connection to civic functions. The long-term shift into alternative investments requires a parallel adjustment in governance and outlook, yet there is great variation in the degree to which public pension funds have matched the changes in asset allocation with modifications in organization and infrastructure. Developing a set of heuristics to guide the governance of externally managed alternative investment based on valid empirical support is thus elusive. In fact, the study highlights the failure of a number of typically “foolproof” governance and management arrangements to parallel the portfolio shift to alternatives. In particular, the paper shows that (1) transparency is not a sufficient solution to the issues inherent in complex active equity investment; (2) layers of governance-related legislation and/or rules can cause unintended (unwanted) consequences; and (3) it is unclear how to best balance the need for independent and unbiased advice and management with the proper expertise in certain investment strategies.

The study uses data on investment strategies, legislation and monitoring procedures in recent years to provide a review of the population of U.S. state pension funds. It documents the variability in state pension fund investment allocations and examines the reasons behind the recent surge into alternatives. Case studies of four state pension funds highlight the variation in experiences across funds. The paper outlines the implications of the investment portfolio shift in the past decade, noting the different governance, financial and political decisions required of investments in hedge funds and private equity funds.