Public Sector Pensions Investing in Hedge Funds

In less than five years California will have over 10 million residents who are over the age of 55 (ref. U.S. Census, California Demographics). If every one of these people were to receive a pension equivalent to what the average public employee in California can now expect after working full-time for no more than 30 years, it would cost taxpayers nearly $700 billion per year. To put this in perspective, $700 billion is 40% of California’s entire gross domestic product.

When spokespersons for California’s public sector unions claim that pension reformers are “trying to destroy the middle class,” they should be asked this question: How on earth can any system of retirement security – not even including health insurance benefits – possibly expect to consume 40% of the entire economic output of the state or nation in which such benefits are being provided, and yet remain financially sustainable? Universal and equitable retirement security in America will never be realized by offering everyone the deal that public sector employees currently receive. Their benefits must be reduced. But instead, government worker pension funds are making riskier investments.

Public sector pension funds rely on investment returns to make up for the shortfalls in taxpayer revenues. But can investment returns really hope to sustain public sector pensions when there are as many people drawing pensions out of the fund as there are people (and taxpayers) contributing money into the fund? That tipping point, where there is as much money going out as there is going in, has not yet been reached, since most pensioners in the system currently are drawing benefits that were calculated when pensions formulas were far less generous. For example, a teacher who retired in 1985 and is still alive will receive today a pension of barely $30,000 per year. A teacher of the same seniority retiring in 2010 after a 30 year career will receive a pension on average of $70,000 per year. This same sort of disparity applies across all public sector disciplines, and is the reason there is still more money going into public sector pensions than is being paid out. Once these pension funds start selling as many securities as they are buying, even more downward pressure will apply to stock prices than already applies.

As we documented in “What Payroll Contribution Will Keep Pensions Solvent?,” for every 1.0% that the rate of return for a pension fund falls, the required contribution into the pension fund must increase by about 10% of payroll. This means, for example, that if CalPERS lowers their projected rate of return from 7.75% per year down to 6.75%, the contributions their members (or taxpayers) will have to invest in CalPERS every year will rise from (for example) 20% of payroll to 30% of payroll. It is difficult to overstate just how dire the pressure is on public sector pension funds to claim they can continue to earn 7.75% per year.

One way that public sector pension funds are trying to maintain their rate of return is by investing in hedge funds. These virtually unregulated funds utilize manipulative tactics to extract larger than market returns – often at great risk. But to beat the market, someone else has to lose. Public sector pension funds investing in hedge funds are encouraging a phenomenon – market manipulation – that is driving value investors and small private investors out of the market altogether. As reported in the Wall Street Journal on October 18th in an article entitled “Traders Warn of Market Cracks,” the dominance of program trading and other manipulative tactics is taking taking liquidity out of a market that is already in trouble:

“One surprising element of the fall-off in liquidity is that one key set of players actually appears to be more active in recent months: so-called high-frequency traders. These hedge funds use computer models to trade at a rapid pace. In recent years they have replaced brokerage firms as the go-betweens when investors trade stocks. But with so many other players stepping back from the market, the liquidity that high frequency traders are providing isn’t creating much of a cushion, traders say. In fact, some say they may be making matters worse.”

Yet public sector pension funds have to invest in hedge funds. They have to be high-risk players, exploiting the tactics that value investors would never consider and small investors could never afford – and THIS is the reason they claim they can outperform the small investors – because without these high-risk, manipulative, barely-legal, market-killing, short-term acts of desperation, they would already have to admit they cannot possibly earn 7.75% per year. And their actions only postpone that admission.

Here are some examples of how much money is now being poured into hedge funds by public sector pension funds, as documented in Pensions & Investments (online):

“The New Jersey Division of Investment, which manages the state’s $71.6 billion in public pension assets, could put as much as $10.7 billion in hedge funds if it moves to a full 15% allocation. That would make the New Jersey fund the second largest hedge fund investor among P&I’s top 200 pension funds.

Another large pension fund looking to increase its hedge fund limit is the $108 billion Texas Teacher Retirement System, Austin.

Another Lone Star State fund, the $18 billion Texas County & District Retirement System, Austin, in March increased its target allocation to hedge fund as part of a new asset mix, confirmed Paul J. Williams, investment officer.

After two years of study, Connecticut Retirement Plans & Trust Funds, Hartford, finally moved its first $200 million into hedge funds, investing $100 million each in funds of funds with Prisma Capital Partners and Rock Creek Group.

The State of Wisconsin Investment Board, Madison, which oversees $83.3 billion, last year began to search for single and multistrategy hedge fund managers to run a total of $1.4 billion, as part of the rollout of its new hedge fund allocation;

The $154.7 billion Florida State Board of Investment, Tallahassee, early last year invested $250 million each directly in three activist hedge funds, but did not create a dedicated hedge fund allocation with a 6% target until June. Investment staff is at work getting the first 2% or $2.2 billion invested directly in single and multistrategy funds.

Colorado Fire & Police Pension Association, Greenwood Village, took its absolute-return investments down to zero in 2009 from 5%. The fund set a new 11% absolute-target and restructured the allocation to invest about 70% in hedge funds and 30% in commodities.

After nearly six years of study, three of the five pension fund systems within the $113.4 billion New York City Retirement Systems finally made large first-time hedge fund investments last month.”

Distilling all this arcana yields chilling realities. The public sector unions who claim Wall Street is to blame for our economic challenges are actually collection agents for Wall Street, at the same time as they are a corrupting influence on Wall Street. Year after year, they pour hundreds of billions of dollars of taxpayer’s money into some of the seamiest investment vehicles ever invented, bankrupting our cities and states to collect their tithe. At a time when assets are deflating everywhere, when the federal government is issuing 10 year notes at under 3%, the public employee pension funds are claiming they will continue to earn 7.75% on their money. They are essentially lending money at 7.75%, a grossly over-market rate, and forcing the smaller, private investors in the market to cover the difference.

If the market crashes again, and it might, look no further than your local public employee pension fund campus, that beachhead of Wall Street at its worst, to find an avid culprit. Public sector pensions are not sustainable, and the notion that they are is Wall Street’s last, biggest con.

3 replies
  1. horn says:

    Your concerns about unsustainable pensions are all good ones. However this article is badly in need of several corrections.

    Long/short investing strategies are not ‘highly risky,’ they are much safer than 100% long-only traditional strategies as A.W. Jones showed 50+ years ago. Hedge Funds are a type of legal structure, not an investing strategy. In fact, many large and famous funds are known for being extremely low-risk when compared to the markets: 4-5% vol is not uncommon.

    Secondly, calling HFs ‘virtually unregulated’ is completely laughable in November 2011. Highly regulated, just not as very highly regulated as banks is more accurate. If you think they are ‘unregulated,’ try starting one and see what happens if you ignore the various laws, regulators and bureaucracies.

    Thirdly, calling investment techniques that have been prima facie legal and well-known for decades [if not centuries] ‘barely legal’ is fairly dishonest analysis. Program trading/HFT has been around since the OEX and index futures were invented decades ago. HFT has been responsible for 40-60%+ of NYSE trading since before 1987, mostly via index arbitrage.

    Also, it’s not ‘Private Investor Online,’ at least read the link you gave. You’d think a pension article could at least get that right.

  2. Editor says:

    horn: Thank you for your thoughtful and informed comment. The link referenced in the post was “pionline” which is what prompted the name used in the link – it is now corrected.

    I would agree that “long/short” hedging strategies can reduce the volatility of a portfolio. But the meaning of “hedge fund” has changed in recent years, as I’m sure you know. Here’s the definition from Investopedia.com:

    “The name is mostly historical, as the first hedge funds tried to hedge against the downside risk of a bear market by shorting the market (mutual funds generally can’t enter into short positions as one of their primary goals). Nowadays, hedge funds use dozens of different strategies, so it isn’t accurate to say that hedge funds just “hedge risk”. In fact, because hedge fund managers make speculative investments, these funds can carry more risk than the overall market.”

    Also, as you know, most hedge funds cater to “sophisticated investors” and as such are not subject to the same regulations as banks. We can discuss what regulations might be appropriate for banks and we’d probably agree that many regulations are either unnecessary or, worse, doing more harm than good. But we might have different perspectives regarding program trading and other manipulative techniques used with increasing frequency and effectiveness – as you correctly state – since the 1980’s. These techniques have nothing to do with value investing, they are primarily speculative, and whether or not they add value by making the market more efficient is highly debatable. It is fair to characterize these practices, if not as “barely legal,” then as private gain and socialized loss, a phenomenon that exists, quite legally, in many realms. That doesn’t make it right. As Bridgewater Associates CEO Ray Dalio states, quoted in the New Yorker article “Mastering the Machine,” “In order to earn more than the market return, you have to take money from somebody else.”

    In any case, apparently we agree on the core point of this post, which is that America’s public sector worker pension funds, which now have roughly $4.0 trillion in assets under management, cannot rely on hedge fund investing to beat the market. When you manage $4.0 trillion in assets, you are the market.

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