Alternatives: Are Pension Funds Taking a Dangerous Leap of Faith?

Last week Bloomberg reported that state pension funds in the U.S. are increasing bets on high-risk alternative investments in an attempt to fill deficits in retirement plans and make up for their worst performance in six years.

Given my thoughts on the markets in general, and on alternatives in particular, I think this is a huge mistake and gross negligence on the part of fiduciaries that are suppose to be prudently managing investment risk.

I quote the following:

"It doesn't come risk-free,'' said Susan Mangiero, president of Pension Governance LLC, a research firm based in Trumbull, Connecticut. "You could end up having a worse performance and the chain of events is lower funding status and increased taxes.''

I would especially heed these warnings:

"Chasing performance, especially in a public fund, can be a dangerous thing,'' said Stan Rupnik, the chief investment officer at the Teachers' Retirement System of the State of Illinois.

...

"The risk is that if there is this rush to get into alternatives, investors could get crowded out,'' losing access to managers, Clark said.

If you ask me, the alternatives space is already too crowded and prospective returns will disappoint many pension funds that are aggressively and blindly throwing money into these investments (at the worst possible time!).

Worse still, this morning I noticed that the U.S. Pension Benefit Guaranty Corp (PBGC), the federal agency charged with backstopping pension benefits for 44 million Americans is being accused of understating the risks of its new investment policy.

I quote the following:

The Government Accountability Office said in a report that the Pension Benefit Guaranty Corp.'s new strategy could significantly boost the PBGC's investment returns, but it "will likely also carry more risk than acknowledged by PBGC's analysis."

The PBGC said earlier this year that it would take a more aggressive investment approach by investing more in stocks and adding new alternative investments, such as real estate and private equity funds.

The agency, which has assets of $68 billion, hopes the strategy will help it close a $14 billion gap between those assets and its liabilities. Otherwise, taxpayers could be called upon to pony up extra funding, the director of the PBGC has warned.

The PBGC has said its new approach will reduce risk because it will result in a more diversified portfolio of 45 percent stocks, 45 percent bonds, and 10 percent in alternative investments.

Previously, its targets were 75 percent to 85 percent bonds and 15 percent to 25 percent in stocks, though the actual figure reached 28 percent last year. The agency is seeking bids from Wall Street firms to help manage the switch.

The GAO, however, said that under certain scenarios the new strategy would have more volatile results than the old approach. The report said that's risky because PBGC pays out more than $4 billion a year to retirees and needs access to cash.

What on earth is the PBGC thinking aggressively allocating to alternative investments at this time? Are they not taking a huge leap of faith? This is unbelievable and extremely irresponsible on their part.

Finally, someone alerted me to another article from Pensions & Investments Online which discusses how the U.S. Department of Labor is now targeting valuations of alternatives.

I quote the following:

The Department of Labor’s regional office in Boston has launched an investigation challenging the way many corporate pension plan fiduciaries value their alternative investments.

The result could be a huge increase in expense and work for plan fiduciaries.

Pension plan executives often rely on the financial statements of the general partners in their alternative investment partnerships to report the value of those investments in the plan’s Form 5500 annual filings with the DOL.

But in a letter to an unidentified pension plan, James Benages, director of the DOL’s Boston regional office, contends that plan fiduciaries need to have a process in place to independently value the alternative assets.

The letter, dated July 1, said that Mr. Benages believed the plan’s “failure to have an established process by which the fair-market value of alternative investments can be determined” violated ERISA and, if not changed, could result in a lawsuit against the plan.

“A process which merely uses the general partner’s established value for all funds without additional analysis may not insure that the alternative assets are valued at fair market value,” according to the letter. (The copy of the letter obtained by Pensions & Investments had all information that could be used to identify the plan sponsor deleted.)

Most pension funds are not aware of the risks involved in alternative investments, especially valuation risk, model risk, operational risk, fraud risk and liquidity risk. It is particularly worrisome that pension funds are forging ahead to increase their allocations in alternatives at this time. Moreover, talk of "diversification" is pure rubbish when all asset classes are overvalued and in an imploding bubble. Finally, in many pension funds, the benchmarks used to evaluate the performance of alternative investments are inadequate and do not reflect the beta or risks of the underlying investments.

Pension fiduciaries need to take a step back and reevaluate their allocations into alternatives, making sure they are properly mitigating risks attached to these investments. Keynes was right, the investment world is nothing more than a beauty contest. If pension funds do not adequately identify, assess and mitigate these risks, another systemic disaster will surely ensue.