The Weekly Reader

Pension Officers Putting Billions Into Hedge Funds
By RIVA D. ATLAS
and MARY WILLIAMS WALSH
NY Times

Published: November 27, 2005

Faced with growing numbers of retirees, pension plans are pouring billions into hedge funds, the secretive and lightly regulated investment partnerships that once managed money only for wealthy investors.

ED NOTE: Continuing pressure is causing even the most conservative classes of investors to move into what was once considered very risky territory.

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The plans and other large institutions are expected to invest as much as $300 billion in hedge funds by 2008, up from just $5 billion a decade ago, according to a study by the Bank of New York and Casey, Quirk & Associates, a consulting firm. Pension funds account for roughly 40 percent of all institutional money.

This month, the investment council that oversees the New Jersey state employees pension fund said it would put some of its money into hedge funds for the first time, investing $600 million over the next several months.

While most pension plans have modest stakes in hedge funds, others have invested more than 20 percent of their assets. Weyerhaeuser, the paper company, has 39 percent of its pension fund's assets in hedge funds. In Congress, there has been a push for amendments that would make it easier for hedge funds to manage even more pension money, without having to comply with the federal law that governs company pensions.

Pension officials who have been shaken by market downturns and persistent deficits are attracted by hedge funds' promise of richer, or more consistent, returns. But the trend has caused some consultants and academics to voice cautions. They question whether hedge funds, with risks that are hard to measure, are appropriate for pension funds, whose sole purpose, by law, is to pay out predetermined benefits to retired workers.

Those benefits are considered so crucial that they are guaranteed: corporate pension failures are covered by the Pension Benefit Guaranty Corporation, a federal agency, while pension failures by state and local governments are covered by taxpayers. Given that the benefits are paid out on a set schedule, critics wonder whether it makes sense to rely on investments whose returns are hard to predict, managed by private partnerships that disclose little about their operations and charge some of the highest fees on Wall Street.

"It's very inappropriate when the company is offering a pension plan that is guaranteed by the federal government," said Zvi Bodie, a professor of finance and economics at Boston University who is enthusiastic about hedge funds in other contexts.

Hedge funds make large, sophisticated investments based on the premise that by swimming outside the currents of the markets, often betting against conventional wisdom, they can outperform other investments. Hedge funds became famous in the 1990's, when managers like Michael Steinhardt and George Soros made huge swashbuckling bets that sometimes produced returns of 30 percent or more.

More recently, hedge funds have made headlines when they ran into trouble: Long-Term Capital Management, a hedge fund whose principals included two Nobel Prize-winning economists, nearly collapsed in 1998; and this summer, Bayou Group, a $450 million hedge fund based in Connecticut, shut down after most of its money disappeared. Its two officers have pleaded guilty to fraud charges. Hedge funds have traditionally been only for wealthy, sophisticated investors so regulators have not monitored them as they have stocks or mutual funds, although they are starting to do so.

The news of splashy gains and scandals may not paint an accurate picture of a business that in many ways has become more conservative as a result of the flood of pension fund money. To attract that money, many hedge fund managers emphasize stability.

Among pension fund managers, however, "the whole mentality has changed," said Jane Buchan, chief executive of Pacific Alternative Asset Management, which manages $7.5 billion in funds that invest in hedge funds, primarily for large pension funds. "They are saying, we need returns and we will be aggressive about getting them. They just don't want any downturns."

One of the first pensions to start working with hedge funds is also the nation's biggest corporate pension fund, the $90 billion General Motors fund. It started with a small test investment in 1999 and increased it to about $2 billion in 2003, said Jerry Dubrowski, a G.M. spokesman.

The company is using hedge funds, along with other unconventional investments, in hopes of getting something close to stock market returns without the market's volatility, Mr. Dubrowski said. To pay out the $6.5 billion G.M. owes to its retirees each year, the pension fund must produce annual returns of a little more than 7 percent. Otherwise, G.M. will have to dip into the fund's principal. At current interest rates, G.M. cannot get those returns with bond investments, and if it tries to juice returns by betting on the stock market, it will have to cope with market swings.

"It's really not helpful to have that up-10, down-10" performance, Mr. Dubrowski said. "You want a return that allows you to cover the benefits payments without attacking the capital." It is that kind of consistency some pension mangers are seeking.

"We are looking for consistently positive returns rather than the absolute highest returns," said Robert Hunkeler, manager of International Paper's $6.8 billion pension plan, which has been invested in hedge funds for around five years.

Most pension funds have modest stakes of less than 5 percent, according to a recent J. P. Morgan survey. Verizon has 3 to 4 percent of its portfolio invested with hedge funds, and is considering adding to its investment, said William F. Heitmann, senior vice president for finance.

Some pension fund managers say that diversifying away from stocks through a modest stake in hedge funds is reasonable, especially as hedge funds offer the promise of returns not linked to stock market performance. In 2000, for example, when the Standard & Poor's 500-stock index fell 9 percent, hedge funds rose 5 percent, according to Hedge Fund Research.

The New Jersey state pension fund's investment of $600 million represents less than 1 percent of its assets, but it hopes eventually to raise the figure to $3 billion as part of a plan to diversify its portfolio, said Orin Kramer, the chairman of the oversight board.

The New Jersey fund has been wrestling with a $30 billion shortfall, after the stock market bubble burst five years ago. "In recent years, conventional stock investments haven't worked," said Mr. Kramer, who is also a hedge fund manager. He said that in general it is good to diversify no matter what the market does.

Other pension plan managers are far more aggressive. Eli Lilly has about 20 percent in hedge funds and the Pennsylvania state employees' pension fund has 22 percent.

Weyerhaeuser's big position has significant benefits for the company. Accounting rules let companies factor expected pension returns into their operating income; Weyerhaeuser's hedge-fund-laden portfolio allows it to claim expected annual returns of 9.5 percent. By comparison, the 100 largest companies that sponsor pension funds predicted last year that their average long-term returns would be 8.5 percent, according to Milliman Inc., an actuarial firm.

For Weyerhaeuser, each 0.5 percent increase in the expected rate of return is worth an additional $21 million to the company's pretax income this year, according to S.E.C. filings. Weyerhaeuser did not respond to phone inquiries about its hedge fund investments, but said in S.E.C. filings that its actual pension investment returns more than justify its assumption of 9.5 percent.

Hedge fund investors place a lot of trust in the funds' managers, giving them great flexibility in how they produce returns. The managers do not need to give investors specifics about trading activities, and there are no daily updates on the value of investors' holdings as there are with mutual funds.

Employees of G.M., Verizon or International Paper, who are involuntary hedge-fund investors through their participation in pension plans, will not find any reference to the funds in those companies' annual reports. In their footnotes, these and other companies drop hints that a sophisticated investor might recognize as a reference to hedge funds, but they do not give the particulars. International Paper's description of its pension asset allocation, for example, breaks it down into "equity securities," "debt securities," "real estate" and "other."

Some companies and governments, like Pennsylvania, make the argument that hedge funds are not really an asset class at all, but an "asset management tool" that does not have to be disclosed as part of the fund's allocation to stocks or bonds.

That lack of disclosure has some regulators and pension specialists worried. Labor Department officials, who regulate pension funds, declined to discuss the hedge fund phenomenon, but referred to a 1996 letter the department wrote to the United States comptroller of the currency.

The letter said that the Labor Department still expected pension officials to exercise prudence when investing in derivatives, a form of trading in which hedge funds often engage. The letter also said pension officials were responsible for understanding and fully vetting their hedge fund investments, and measuring how they might perform - and how they might affect the pension fund - under a variety of conditions.

Susan M. Mangiero, author of "Risk Management," a textbook for pension officials, said she had come across pension executives who had not done that level of analysis. Some did not even know they had derivatives in their portfolios, she said.

Investing: Hedge Funds Work for Yale, but Will They Work for You? (November 27, 2005)
"A lot of well-intentioned people don't know they don't know," she said.

In Washington, despite concerns over the health of the nation's pension system, there has been little discussion of pension plans' growing use of nontraditional investments. Even as Congress has been working to shore up the pension system and strengthen the Pension Benefit Guaranty Corporation, a provision to relax the pension law for hedge funds has been proposed.

The provision would raise the limit on how much pension money a hedge fund can handle before it is deemed a fiduciary under the pension law, which would require it to be more prudent and careful than is required under securities law and would bar some trades entirely. The provision was added to a broad pension bill in the House shortly before the Committee on Education and the Workforce approved the legislation.

Currently a financial institution becomes a pension fiduciary when more than 25 percent of its assets consist of pension money; the bill would raise that to 50 percent. The House bill would also change the definition of "plan assets," so that only corporate pension money would be counted, not pension money from government plans or foreign plans.

These two changes are not in the counterpart Senate pension bill that was recently approved, but they could be added soon during efforts to reconcile the House and Senate bills.

Wall Street's interest in overcoming these legal barriers shows the allure of pension money, which tends to stick with an investment strategy and is far less likely to fly out the door when the markets turn bad.

"Pension money is the stickiest form of capital," Mr. Kramer of the New Jersey pension fund noted.

But the surge of pension money is coming at a time when the returns of many hedge funds have not been as strong as in past years, raising questions about whether pensions are arriving at the party late. Hedge funds actually lost money in four of the first ten months of this year, although they still had an overall average return of 5.7 percent.

Those returns easily beat the stock market: the S.& P. 500 index was up 1 percent in the same period. But as they continue to attract money, hedge funds may start to more closely mimic the performance of plain old stocks and bonds.

"There is no such thing as a free lunch," said Frank Partnoy, a professor at the University of San Diego law school and a former trader at Morgan Stanley whose clients once included large pension funds. "And even if there were, nobody is offering it to pension funds."