United States Government Accountability Office

GAO Report to Congressional Requesters

DEFINED BENEFIT 

PENSION PLANS 

Guidance Needed to 

Better Inform Plans of 

the Challenges and 

Risks of Investing in 

Hedge Funds and 

Private Equity 

August 2008 

 

GAO-08-692 
What GAO Found

United States Government Accountability Office

Why GAO Did This Study

Highlights

Accountability Integrity Reliability

August 2008

DEFINED BENEFIT PENSION PLANS

Guidance Needed to Better Inform Plans of the 

Challenges and Risks of Investing in Hedge Funds

Highlights of GAO-08-692, a report to and Private Equity 

congressional requesters 

Millions of retired Americans rely

on defined benefit pension plans 

for their financial well-being. 

Recent reports have noted that

some plans are investing in 

‘alternative’ investments such as

hedge funds and private equity

funds. This has raised concerns, 

given that these two types of 

investments have qualified for 

exemptions from federal 

regulations, and could present 

more risk to retirement assets than

traditional investments. 

 

To better understand this trend and

its implications, GAO was asked to 

examine (1) the extent to which

plans invest in hedge funds and 

private equity; (2) the potential

benefits and challenges of hedge 

fund investments; (3) the potential 

benefits and challenges of private 

equity investments; and (4) what 

mechanisms regulate and monitor

pension plan investments in hedge 

funds and private equity.

To answer these questions GAO

interviewed relevant federal 

agencies, public and private

pension plans, industry groups and

investment professionals, and 

analyzed available survey data. 

What GAO Recommends

GAO recommends that the

Secretary of Labor provide 

guidance on investing in hedge 

funds and private equity that

describes steps plans should take 

to address the challenges and risks

of these investments. Labor 

generally agreed with our findings

and recommendation. 

According to several recent surveys of private and public sector plans, 

investments in hedge funds and private equity generally comprise a small 

share of total plan assets, but a considerable and growing number of plans 

have such investments. Available survey data of mid to large-size plans

indicate that between 21 and 27 percent invest in hedge funds while over 40 

percent invest in private equity; such investments are more prevalent among 

larger plans, as shown below. The extent of investment in hedge funds and 

private equity by plans with less than $200 million in total assets is unknown. 

Pension plans invest in hedge funds to obtain a number of potential benefits, 

such as returns greater than the stock market and stable returns on 

investment. However, hedge funds also pose challenges and risks beyond 

those posed by traditional investments. For example, some investors may

have little information on funds’ underlying assets and their values, which 

limits the opportunity for oversight. Plan representatives said they take steps 

to mitigate these and other challenges, but doing so requires resources beyond 

the means of some plans. 

Pension plans primarily invest in private equity funds to attain returns 

superior to the stock market. Pension plan officials GAO spoke with generally 

had a long history of investing in private equity and said such investments 

have met expectations for returns. However, these investments present 

several challenges, such as wide variation in performance among funds, and 

the resources required to mitigate these challenges may be too substantial for 

some plans. 

The federal government does not specifically limit or monitor private sector 

plan investment in hedge funds or private equity, and state approaches to 

public plans vary. Under federal law, fiduciaries must comply with a standard

of prudence, but no explicit restrictions on hedge funds or private equity exist.

Although a federal advisory council recommended that the Department of 

Labor (Labor) develop guidance for plans to use in investing in hedge funds, 

Labor has not yet done so. While most states also rely on a standard of 

investor prudence, some also have legislation that restricts or prohibits plan 

investment in hedge funds or private equity. For example, one state prohibits 

plans below a certain size from investing directly in hedge funds. 

Share of Large Plans Investing in Hedge Funds and Private Equity 

Share of plans

Source: Pensions & Investments’ 2007 annual survey.

Year

11%

47%

80%

71%

0

10

20

30

40

50

60

70

80

Private equity

Hedge funds

2001 2002 2003 2002 2004 2006 2007

To view the full product, including the scope 

and methodology, click on GAO-08-692. 

For more information, contact Barbara 

Bovbjerg at (202) 512-7215 or 

bovbjergb@gao.gov, or Orice Williams at 

(202) 512-8678 or williamso@gao.gov. 
Contents 

Letter 1

Results in Brief 3

Background 6

A Growing Number of Pension Plans Are Investing in Hedge Funds 

or Private Equity, but Such Investments Are Generally a Small 

Portion of Plan Assets 13 

Pension Plans Seek Various Investment Objectives through Hedge 

Funds, and Such Investments Pose Challenges That Require 

Considerable Effort and Expertise to Address 20 

Private Equity Investments May Provide Important Benefits, but 

Pension Plans Face Limited Access to Top-Performing Funds 

and Other Challenges 31 

The Federal Government Does Not Specifically Limit or Monitor 

Private Sector Plans’ Investments in Hedge Funds and Private 

Equity, but Some States Do So for Public Sector Plans through 

Various Approaches 40 

Conclusions 48

Recommendation for Executive Action 49 

Agency Comments and Our Evaluation 49 

Appendix I Objectives, Scope, and Methodology 53 

Appendix II Government Agencies, Industry Organizations, 

Investment Consulting Firms, and Other 

Organizations Interviewed 59 

Appendix III Comments from the Department of Labor 61 

Appendix IV Comments from the Pension Benefit Guaranty 

Corporation 63 

Appendix V GAO Contacts and Staff Acknowledgments 65

Page i GAO-08-692 Defined Benefit Pension Plans
Tables 

Table 1: Extent of DB Plan Investments in Hedge Funds and 

Private Equity 16 

Table 2: Restrictions on Pension Investments in Hedge Funds and 

Private Equity Identified by Plan Officials in 11 Selected

States 44 

Table 3: Massachusetts Policies on Public Plan Investments in 

Hedge Funds 46 

Table 4: Number and Size of DB Plans Observed in Recent Surveys 54 

Table 5: List of DB Plans for In-Depth Interviews 55 

Table 6: Criteria Used in Selection of Plans for In-Depth Interviews 56 

Table 7: Ten States with the Largest Total Public DB Pension Plan 

Assets 57 

Figures 

Figure 1: Structure of Private Equity Investing 12 

Figure 2: The Number of Plans with Investments in Hedge Funds or 

Private Equity by Size of Investment as a Share of Total 

Plan Assets 14 

Figure 3: Share of Large DB Plans Investing in Hedge Funds and 

Private Equity 17 

Figure 4: Pension Plans with Investments in Hedge Funds and 

Private Equity by Size of Total Plan Assets 19 

Figure 5: Effect of Hedge Fund Fee Structure on the Returns of an 

Investment of $50 Million 25 

Figure 6: Returns from a Private Equity Fund Generally Follow a JCurve Trend over the 10-Year Fund Cycle 36 

Page ii GAO-08-692 Defined Benefit Pension Plans
Abbreviations 

DB defined benefit 

DC defined contribution 

EBSA Employee Benefits Security Administration 

ERISA Employee Retirement Income Security Act of 1974

NASRA National Association of State Retirement Administrators 

PBGC Pension Benefit Guaranty Corporation 

PERAC Public Employee Retirement Administration Commission 

SEC U.S. Securities and Exchange Commission 

SFAS Statement of Financial Accounting Standards 

S&P Standard and Poor’s 

TRS Teacher Retirement System of Texas 

This is a work of the U.S. government and is not subject to copyright protection in the 

United States. The published product may be reproduced and distributed in its entirety 

without further permission from GAO. However, because this work may contain 

copyrighted images or other material, permission from the copyright holder may be 

necessary if you wish to reproduce this material separately. 

Page iii GAO-08-692 Defined Benefit Pension Plans
United States Government Accountability Office

Washington, DC 20548 

August 14, 2008 

Congressional Requesters

Millions of Americans rely on defined benefit pension plans for their 

financial well-being after their working years.1

 In order to pay promised 

retirement benefits when due at an acceptable cost, employers must make 

adequate contributions to these funds and plan fiduciaries must invest the 

fund balance in assets that yield an adequate rate of return over time. 

Historically, public and private sector pension plans have primarily 

invested in traditional investments such as stocks and bonds; however, 

recent press reports indicate that plans are increasingly investing in 

“alternative” investments such as hedge funds and private equity funds. 

While there is no statutory definition of hedge funds, the phrase “hedge 

fund” is commonly used to refer to a pooled investment vehicle that is 

privately organized and administered by professional managers, and that 

often engages in active trading of various types of securities and 

commodity futures and options contracts.2 Similarly, private equity funds 

are not statutorily defined, but are generally considered privately managed

investment pools administered by professional managers, who typically

make long-term investments in private companies, taking a controlling 

interest with the aim of increasing the value of these companies through 

such strategies as improved operations or developing new products. Both 

hedge funds and private equity funds may be managed so as to be exempt 

from certain aspects of federal securities law and regulation that apply to 

other investment pools such as mutual funds. 

Pension plan investments in hedge funds and private equity have been 

controversial for a number of reasons. While hedge funds investments are 

made mainly by relatively wealthy individuals and institutional investors, 

the recent increase in pension plan investments in hedge funds indirectly

 1

A defined benefit (DB) pension plan generally provides benefits in the form of a

guaranteed retirement benefit, the value of which is typically determined by a formula 

based on salary and years of service. 

2

A futures contract is an agreement to buy or sell a specific amount of a commodity or

financial instrument at a particular price on a stipulated future date. An option is a

securities transaction agreement tied to stocks, commodities, or stock indexes. 

Page 1 GAO-08-692 Defined Benefit Pension Plans
exposes people of modest incomes to the risks of hedge fund investing. 

This has been cited as a concern because a pension plan that experiences 

substantial losses as a result of a hedge fund investment may be unable to

meet its obligations to pensioners. The perceived riskiness of hedge funds 

and the collapse of some of these funds in recent years have led some 

industry experts and union officials to express concern about plan 

investments in such vehicles, including the appropriate steps plan officials 

should take in conducting proper due diligence. A further cause for their 

concern is the ability of hedge funds and private equity funds to qualify for 

exemptions from certain aspects of federal securities law and regulations 

that apply to other investment pools. 

In order to better understand the extent to which defined benefit pension 

plans invest in hedge funds and private equity and the implications of such 

investments for the security of pension plan assets, you asked us to 

examine the extent and nature of defined benefit pension plans’ 

investments in these alternative investments. Specifically, you asked us to 

address the following questions: 

1. To what extent do public and private sector pension plans invest in 

hedge funds and private equity funds? 

2. What are the potential benefits, risks, and challenges pension plans 

face in making hedge fund investments, and how do plans address the 

risks and challenges? 

3. What are the potential benefits, risks, and challenges pension plans 

face in making private equity fund investments, and how do plans 

address the risks and challenges? 

4. What mechanisms regulate and monitor pension plan investments in 

hedge funds and private equity funds? 

To answer these questions, we reviewed relevant literature and survey 

data and conducted in-depth interviews with pension plan representatives 

and industry experts. We obtained and analyzed data on the extent of 

pension plan investments in hedge funds and private equity from private 

organizations such as Greenwich Associates, Pensions & Investments, 

and Pyramis Global Advisors. Although these surveys had several 

limitations— for example, the survey data generally represent the holdings 

of larger pension plans—we determined they were sufficiently reliable for 

purposes of our study. To answer the second and third questions, we 

conducted in-depth interviews with representatives of 26 public and 

Page 2 GAO-08-692 Defined Benefit Pension Plans
private sector DB pension plans and, where possible, obtained and 

reviewed supporting documentation. These plans were selected based on

several criteria, including the range of investment in hedge funds and 

private equity and the amount of total plan assets. We also interviewed 

officials of regulatory agencies, relevant industry organizations, 

investment consulting firms, and other national experts. To identify state 

and federal regulatory and monitoring policies, we interviewed officials at

the Department of Labor (Labor) and representatives of relevant agencies 

in selected states, and reviewed relevant policy documents. We contacted 

regulators in 11 states, including the 10 states with the largest amount of 

public pension assets according to the National Association of State 

Retirement Administrators (NASRA) Public Funds Survey data.3

We conducted this performance audit from June 2007 to July 2008, in 

accordance with generally accepted government auditing standards. Those 

standards require that we plan and perform the audit to obtain sufficient, 

appropriate evidence to provide a reasonable basis for our findings and 

conclusions based on our audit objectives. We believe that the evidence 

obtained provides a reasonable basis for our findings and conclusions 

based on our audit objectives. 

While hedge fund and private equity fund investments generally comprise 

a limited share of total plan assets, a considerable and growing number of 

private and public DB plans make such investments. According to 

available survey data, which generally reflect the holdings of larger DB 

plans, average allocations to hedge funds and private equity in 2007 were 

around 4 percent and 5 percent of total plan assets, respectively. However,

according to one survey, a few pension plans had relatively large 

allocations of about 30 percent to hedge funds, while one public plan had 

an allocation of about 20 percent to private equity. Available survey data 

indicate that from about 21 to 27 percent of mid- to large-size pension 

plans invested in hedge funds in 2006, while just over 40 percent invested 

in private equity. Although investments in private equity remain more 

prevalent than hedge fund investments among both private and public 

pension plans surveyed, the number of plans investing in hedge funds has 

increased in recent years more than for private equity funds. Investments 

in hedge funds and private equity are more common among large pension 

Results in Brief 

 3

We contacted the following states: California, Florida, Illinois, Massachusetts, New Jersey, 

New York, North Carolina, Pennsylvania, Ohio, Texas, and Wisconsin. 

Page 3 GAO-08-692 Defined Benefit Pension Plans
plans, measured by assets under management, compared to mid-size plans. 

For example, about 16 percent of plans with $250 to $500 million were 

invested in hedge funds, while 29 percent of plans with $1 billion or more 

had such investments, according to a 2006 survey. Similarly, for private 

equity, 16 percent of plans with $250 - $500 million had such investments 

compared to 77 percent of plans with $1 billion or more in 2006. Survey 

data on plans with less than $200 million in assets are unavailable and, in 

their absence, the extent to which these plans invest in hedge funds or 

private equity is unknown. 

Pension plans invest in hedge funds to obtain various benefits, but some 

characteristics of hedge funds also pose challenges that demand greater 

expertise and effort than more traditional investments, which some plans 

may not be able to fully address. Pension plans told us that they invest in 

hedge funds in order to achieve one or more of several goals, including 

steadier, less volatile returns, obtaining returns greater than those 

expected in the stock market, or diversification of portfolio investments. 

Pension plan officials we spoke with about hedge fund investments all said 

these investments had generally met or exceeded expectations. However, 

at the time of our contact in 2007, several plan officials noted that their 

hedge fund investments had not yet been tested under stressful economic 

conditions, such as a significant stock market decline. Further, some 

indicated mixed experiences with hedge fund investments. At the time of 

our discussions, however, officials of each plan interviewed indicated that 

they expected to maintain or increase the share of assets invested in hedge 

funds. Nonetheless, hedge fund investments pose investment challenges 

beyond those posed by traditional investments in stocks and bonds. These 

additional challenges include: (1) the inherent risks of relying on the skill 

and techniques of the hedge fund manager; (2) limited information on a 

hedge fund’s underlying assets and valuation (limited transparency); (3) 

contract provisions which limit an investor’s ability to redeem an 

investment in a hedge fund for a defined period of time (limited liquidity);

and 4) the possibility that a hedge fund’s active or risky trading activity 

will result in losses due to operational failure such as trading errors or 

outright fraud (operational risk). Although there are challenges of hedge 

fund investing, plan officials and others described steps to address these 

and other challenges. For example, plan officials and others told us that it

is important to negotiate key investment terms and conduct a thorough 

“due diligence” review of prospective hedge funds, including review of a 

hedge fund’s operational structure. Further, pension plans can invest in 

funds of hedge funds, which charge additional fees but provide 

diversification and the additional skill of the fund of funds manager. 

According to plan officials and others, some of these steps require 

Page 4 GAO-08-692 Defined Benefit Pension Plans
considerably greater effort and expertise from fiduciaries than is required

for more traditional investments, and such steps may be beyond the 

capabilities of some pension plans, particularly smaller ones. 

Pension plans invest in private equity primarily in expectation of higher 

rates of return than traditional investments, but these investments too 

pose challenges that require substantial effort and expertise to address. 

The major benefits pension plans seek from private equity investments are 

long-term returns in excess of stocks and, to a lesser degree, to further 

diversify the plan’s portfolio. Pension plan officials we spoke with 

generally had longer experience investing in private equity than in hedge 

funds—in some cases over 20 years—and each plan’s representatives 

indicated these investments have met expectations and most expressed 

plans to maintain or increase their allocations. Nevertheless, investments 

in private equity present distinct challenges and risks beyond those faced 

with traditional investments. These include: (1) the variation of

performance among private equity funds, which is greater than for other 

asset classes, and the difficulty of gaining access to recognized topperforming funds; (2) longer-term commitments of 10 years or more, 

during which the pension plan may not be able to redeem its investment; 

and (3) valuation of the investment, which is difficult to assess prior to the 

sale of underlying holdings. As with hedge funds, taking steps to mitigate 

the challenges of investing in private equity funds requires greater 

expertise and effort than making traditional investments. Plans told us 

that, as a part of their due diligence and ongoing monitoring efforts, they 

regularly reviewed reports on the performance of the underlying 

investments of the private equity fund and held periodic meetings with 

fund managers. As with hedge funds, the extensive amount of monitoring 

required for private equity investments may be impractical for pension 

plans that have more limited resources, such as smaller plans. 

The federal government does not specifically limit or monitor private 

sector pension investment in hedge funds or private equity and, while 

some states do so for public plans, their approaches vary. Under the 

Employee Retirement and Income Security Act (ERISA), plan fiduciaries

are expected to meet general standards of prudent investing and no 

specific restrictions on investments in hedge funds or private equity have

been established. Labor is tasked with helping to ensure plan sponsors 

meet their fiduciary duties; however, it does not currently provide any 

guidance specific to pension plan investments in hedge funds or private 

equity. Conversely, some states do specifically regulate and monitor public 

sector pension investment in hedge funds and private equity, but these 

approaches vary from state to state. While states generally have adopted a 

Page 5 GAO-08-692 Defined Benefit Pension Plans
“prudent man” standard similar to that in ERISA, some states also 

explicitly restrict or prohibit pension plan investment in hedge funds or 

private equity. For instance, in Massachusetts, the agency overseeing 

public plans will not permit plans with less than $250 million in total assets

to invest directly in hedge funds. Some states have detailed lists of 

authorized investments that exclude hedge funds and/or private equity. 

Other states may limit investment in certain investment vehicles or trading 

strategies employed by hedge fund or private equity fund managers. While 

some guidance exists for hedge fund investors, specific guidance aimed at

pension plans could serve as an additional tool for plan fiduciaries when 

assessing whether and to what degree hedge funds would be a prudent 

investment. 

To ensure that all plan fiduciaries can better assess their ability to invest in

hedge funds and private equity, and to ensure that those that choose to 

make such investments are better prepared to meet these challenges, we

recommend that the Secretary of Labor provide guidance on investing in 

hedge funds and private equity specifically designed for qualified plans 

under ERISA. In responding to a draft of this report, Labor generally 

agreed with our findings and recommendation. 

Labor and other federal agencies also provided technical comments on the 

draft report, which we have incorporated where appropriate.

Millions of current and future retirees rely on private or public DB pension 

plans, which promise to pay retirement benefits that are generally based 

on an employee’s salary and years of service. The financial condition of 

these plans—and hence their ability to pay promised retirement benefits 

when such benefits are due—depends on adequate contributions from 

employers and, in some cases, employees, as well as prudent investments 

that preserve principal and yield an adequate rate of return over time. The 

plan sponsor must make required contributions to the plan that are 

intended to ensure it is adequately funded to pay promised benefits. To 

maintain and increase plan assets, fiduciaries of public and private sector

pension plans invest in assets that are expected to grow in value or yield

income. In making investments, DB plan managers consider a plan’s 

benefit payment requirements and balance the desire to maximize return 

on investment and the desire to limit the overall risk to the investment 

portfolio to an acceptable level. In doing so, plan fiduciaries invest in 

various categories of assets classes, which traditionally have consisted 

mainly of stocks and bonds. Stocks offer relatively high expected longterm returns at the risk of considerable volatility, that is, the likelihood of 

Background 

Page 6 GAO-08-692 Defined Benefit Pension Plans
significant short-term losses or gains. On the other hand, bonds and other

fixed income investments offer a steady income stream and relatively low 

volatility, but lower expected long-term returns. Different proportions of 

these two asset classes will, therefore, provide different degrees of risk 

and expected return on investment. Pension fiduciaries may also invest in

other asset classes or trading strategies, such as hedge funds and private 

equity, which are generally considered to be riskier investments, so long as 

such investments are prudent. 

Private sector pension plan investment decisions must comply with the 

provisions of ERISA, which stipulates fiduciary standards based on the 

principle of a prudent man standard. Under ERISA, plan sponsors and 

other fiduciaries must (1) act solely in the interest of the plan participants 

and beneficiaries and in accordance with plan documents; (2) invest with 

the care, skill, and diligence of a prudent person with knowledge of such 

matters; and (3) diversify plan investments to minimize the risk of large 

losses. Under ERISA, the prudence of any individual investment is 

considered in the context of the total plan portfolio, rather than in 

isolation.4

 Hence, a relatively risky investment may be considered prudent,

if it is part of a broader strategy to balance the risk and expected return to

the portfolio. In addition to plan sponsors, under the ERISA definition of a 

fiduciary, any other person that has discretionary authority or control over 

a plan asset is subject to ERISA’s fiduciary standards.5

 The Employee 

Benefit Security Administration (EBSA) at Labor is responsible for 

enforcing these provisions of ERISA, as well as educating and assisting 

retired workers and plan sponsors. Another federal agency, the Pension 

Benefit Guaranty Corporation (PBGC), collects premiums from federally

insured plans in order to insure the benefits of retirees if a plan terminates 

without sufficient assets to pay promised benefits. 

 4

ERISA’s prudent man standard is satisfied if the fiduciary has given appropriate 

consideration to the following factors (1) the composition of the plan portfolio with regard

to diversification of risk; (2) the volatility of the plan investment portfolio with regard to 

general movements of investment prices; (3) the liquidity of the plan investment portfolio 

relative to the funding objectives of the plan; (4) the projected return of the plan 

investment portfolio relative to the funding objectives of the plan; and (5) the prevailing 

and projected economic conditions of the entities in which the plan has invested and

proposes to invest. 29 C.F.R. § 2550.404a-1(b) (2007). 

5

Under ERISA, a fiduciary is a person who (1) exercises discretionary authority or control 

over plan management or any authority or control over plan assets; (2) renders investment 

advice regarding plan moneys or property for direct or indirect compensation; or (3) has 

discretionary authority or responsibility for plan administration. 29 U.S.C. §1002(21). 

Page 7 GAO-08-692 Defined Benefit Pension Plans
In the public sector, governments have established pension plans at state, 

county, and municipal levels, as well as for particular categories of 

employees, such as police officers, fire fighters, and teachers. The 

structure of public pension plan systems can differ considerably from state 

to state. In some states, most or all public employees are covered by a 

single consolidated DB retirement plan, while in other states many 

retirement plans exist for various units of government and employee 

groups. Public sector DB plans are not subject to funding, vesting and 

most other requirements applicable to private sector DB plans under 

ERISA, but must follow requirements established for them under 

applicable state law. While states generally have adopted standards 

essentially identical to the ERISA prudent man standard, specific 

provisions of law and regulation vary from state to state. Public plans are 

also not insured by the PBGC, but could call upon state or local taxpayers 

in the event of a funding shortfall. 

Hedge Funds Use Broad 

Range of Investment 

Strategies to Achieve 

Desired Return 

Although there is no statutory or universally accepted definition of hedge 

funds, the term is commonly used to describe pooled investment vehicles 

that are privately organized and administered by professional managers 

and that often engage in active trading of various types of securities, 

commodity futures, options contracts, and other investment vehicles. In 

recent years, hedge funds have grown rapidly. As we reported in January 

2008, according to industry estimates, from 1998 to early 2007, the number 

of funds grew from more than 3,000 to more than 9,000 and assets under 

management from more than $200 billion to more than $2 trillion globally.6

Hedge funds also have received considerable media attention as a result of

the high-profile collapse of several hedge funds, and consequent losses 

suffered by investors in these funds. Although hedge funds have the 

reputation of being risky investment vehicles that seek exceptional returns 

on investment, this was not their original purpose, and is not true of all 

hedge funds today. Founded in the 1940s, one of the first hedge funds 

invested in equities and used leverage and short selling to protect or 

“hedge” the portfolio from its exposure to movements in the stock 

 6

For additional information about hedge funds, see GAO, Hedge Funds: Regulators and

Market Participants Are Taking Steps to Strengthen Market Discipline, but Continued

Attention Is Needed, GAO-08-200 (Washington, D.C.: Jan. 24, 2008). 

Page 8 GAO-08-692 Defined Benefit Pension Plans
market.7

 Over time, hedge funds diversified their investment portfolios and 

engaged in a wider variety of investment strategies. Because hedge funds 

are typically exempt from registration under the Investment Company Act 

of 1940, they are generally not subject to the same federal securities 

regulations as mutual funds. They may invest in a wide variety of financial 

instruments, including stocks and bonds, currencies, futures contracts, 

and other assets. Hedge funds tend to be opportunistic in seeking positive 

returns while avoiding loss of principal, and retaining considerable 

strategic flexibility. Unlike a mutual fund, which must strictly abide by the 

detailed investment policy and other limitations specified in its 

prospectus, most hedge funds specify broad objectives and authorize 

multiple strategies. As a result, most hedge fund trading strategies are 

dynamic, often changing rapidly to adjust to market conditions. 

Hedge funds are typically structured and operated as limited partnerships 

or limited liability companies exempt from certain registration, disclosure 

and other requirements under the Securities Act of 1933,8

 Securities 

Exchange Act of 1934,9

 Investment Company Act of 1940,10 and Investment 

Advisers Act of 194011 that apply in connection to other investment pools, 

such as mutual funds. For example, to allow them to qualify for various 

exemptions under such laws, hedge funds usually limit the number of 

investors, refrain from advertising to the general public, and solicit fund 

participation only from large institutions and wealthy individuals. The 

presumption is that investors in hedge funds have the sophistication to 

understand the risks involved in investing in them and the resources to 

absorb any losses they may suffer. Although many workers may be 

impacted by any losses resulting from pension fund investment in hedge 

funds, a pension plan counts as a single investor that does not prevent a 

hedge fund from qualifying for the various statutory exemptions. 

 7

Leverage involves the use of borrowed money or other techniques to potentially increase 

an investment’s value or return without increasing the amount invested. A short sale is the

sale of a security that the seller does not own or a sale that is consummated by the delivery 

of a security borrowed by, or for, the account of the seller. Short selling is used to profit by

a decline in the price of the security. 

8

Ch. 38, tit. I, 48 Stat. 74 (codified at 15 U.S.C. § 77a et seq.). 

9

Ch. 404, 48 Stat. 881 (codified at 15 U.S.C. § 78a et seq.). 

10Ch. 686, tit. I, 54 Stat. 797 (codified as amended at 15 U.S.C. § 80a-1 et seq.). 

11Ch. 686, tit. II, 54 Stat. 847 (codified as amended at 15 U.S.C. § 80b-1 et seq.). 

Page 9 GAO-08-692 Defined Benefit Pension Plans
Individuals and institutions may also invest in hedge funds through funds 

of hedge funds, which are investment funds that buy shares of multiple 

underlying hedge funds. Fund of funds managers invest in other hedge 

funds rather than trade directly in the financial markets, and thus offer 

investors broader exposure to different hedge fund managers and 

strategies. Like hedge funds, funds of funds may be exempt from various 

aspects of federal securities and investment law and regulation. 

Private Equity Funds 

Obtain Returns from 

Manager Skill and 

Investing Capital in a 

Limited Number of Private 

Firms 

Like hedge funds, there is no legal or commonly accepted definition of 

private equity funds, but the term generally includes privately managed 

pools of capital that invest in companies, many of which are not listed on a 

stock exchange. Although there are some similarities in the structure of 

hedge funds and private equity funds, the investment strategies employed 

are different. Unlike many hedge funds, private equity funds typically

make longer-term investments in private companies and seek to obtain 

financial returns not through particular trading strategies and techniques, 

but through long-term appreciation based on corporate stewardship, 

improved operating processes and financial restructuring of those 

companies, which may involve a merger or acquisition of companies. 

Private equity is generally considered to involve a substantially higher 

degree of risk than traditional investments, such as stocks and bonds, for a 

higher return.12

While strategies of private equity funds vary, most funds target either 

venture capital or buy-out opportunities. Venture capital funds invest in 

young companies often developing a new product or technology. Private 

equity fund managers may provide expertise to a fledgling company to 

help it advance toward a position suitable for an initial public offering. 

Buyout funds generally invest in larger established companies in order to 

add value, in part, by increasing efficiencies and, in some cases, 

consolidating resources by merging complementary businesses or 

technologies. For both venture capital and buy-out strategies, investors 

hope to profit when the company is eventually sold, either when offered to 

the public or when sold to another investor or company. Each private 

equity fund generally focuses on only one type of investment opportunity, 

usually specializing in either venture capital or buyout and often 

 12GAO is issuing a forthcoming report on leveraged buyouts by private equity funds. 

Page 10 GAO-08-692 Defined Benefit Pension Plans
specializing further in terms of industry or geographical area.13 Investment 

in private equity has grown considerably over recent decades. According

to a venture capital industry organization, the amount of capital raised by 

private equity funds grew from just over $2 billion in 1980 to about $207 

billion in 2007; while the number of private equity funds grew from 56 to 

432 funds over the same time period. 

As with hedge funds, private equity funds operate as privately managed 

investment pools and have generally not been subject to Securities and 

Exchange Commission (SEC) examinations. Pension plans typically invest 

in private equity through limited partnerships in which the general partner 

develops an investment strategy and limited partners provide the large 

majority of the capital. After creating a new fund and raising capital from 

the limited partners, the general partner begins to invest in companies that 

will make up the fund portfolio (see fig. 1). Limited partners have both

limited control over the underlying investments and also limited liability 

for potential debts incurred by the general partners through the fund. 

 13Other less common types of private equity include mezzanine financing, in which 

investors provide a final round of financing to help carry the company through its initial 

public offering, and distressed debt investments, in which firms buy companies that have

filed for bankruptcy or may do so and then typically liquidate the company.

Page 11 GAO-08-692 Defined Benefit Pension Plans
Figure 1: Structure of Private Equity Investing

Portfolio Company

GP

Portfolio Company Portfolio Company

Private Equity

Fund

Investors

Portfolio Company

General Partner GP 

controls investment 

decision

Investors contribute 

capital to private 

equity fund

Source: New York State Common Retirement Fund Division of Pension Investment and Case Management.

Similar to hedge funds, private equity funds may be structured to qualify 

for exemptions from certain registration and disclosure requirements of 

federal securities laws; for example, by refraining from advertising to the 

general public. The majority of investments in private equity funds come 

from wealthy individuals and institutional investors, such as endowments, 

banks, corporations, and pension plans. 

Page 12 GAO-08-692 Defined Benefit Pension Plans
According to several recent surveys, investments in hedge funds and 

private equity are typically a small portion of total plan assets—about 4 to

5 percent on average—but a considerable and growing number of plans 

invest in them. While investment in hedge funds is less common than 

private equity, the number of plans with investments in hedge funds has 

experienced greater growth in recent years. Furthermore, survey data

show that larger plans, measured by total plan assets, are more likely to

invest in hedge funds and private equity compared to mid-size plans. 

Survey data on plans with less than $200 million in assets are unavailable 

and, thus, the extent to which small plans invest in hedge funds and 

private equity is unknown. 

Individual plans’ hedge fund or private equity investments typically 

comprise a small share of total plan assets. According to a Pensions & 

Investments survey of large plans (as measured by total plan assets), the 

average allocation to hedge funds among plans with such investments was 

about 4 percent in 2007.14 Similarly, among plans with investments in 

private equity, the average allocation was about 5 percent. An earlier 

survey by Pyramis Global Advisors, which included mid- to large-size 

plans, found an average allocation of 7 percent for hedge funds and 5 

percent for private equity in 2006. 

A Growing Number of 

Pension Plans Are 

Investing in Hedge 

Funds or Private 

Equity, but Such 

Investments Are 

Generally a Small 

Portion of Plan Assets 

Investments in Hedge 

Funds and Private Equity 

Typically Comprise a Small 

Share of Total Plan Assets 

Although the majority of plans with investments in hedge funds or private 

equity have small allocations to these assets, a few plans have relatively 

large allocations, according to the Pensions & Investments survey (see fig. 

2).15 Of the 62 plans that reported investments in hedge funds in 2007, 12 

plans had allocations of 10 percent or more and, of those, 3 plans had 

 14We reviewed data from surveys of DB pension plans conducted by three organizations—

Greenwich Associates (covering mid- to large-size pension plans, with $250 million or more

in total assets), Pyramis Global Advisors (covering mid- to large-size pension plans, with 

$200 million or more in total assets), and Pensions & Investments (limited to large plans, 

which generally had $1 billion or more in total assets). Greenwich Associates is an 

institutional financial services consulting and research firm; Pyramis Global Advisors, a 

division of Fidelity Investments, is an institutional asset management firm; and Pensions &

Investments is a money management industry publication. These data cannot be

generalized to all plans. See appendix I for more information on these surveys. 

15Pensions & Investments was the only survey we reviewed that reported the allocations of

individual plans to hedge funds and private equity. Among the top 200 pension plans,

ranked by combined assets in DB and defined contribution plans, 133 were DB plans that 

completed the survey and provided asset allocation information in 2007. 

Page 13 GAO-08-692 Defined Benefit Pension Plans
allocations of 20 percent or more. The highest reported hedge fund 

allocation was 30 percent of total assets. Large allocations to private 

equity were even less common. A total of 106 surveyed plans reported 

investments in private equity in 2007, of which 11 plans had allocations of 

10 percent or more and, of those, 1 plan had an allocation of about 20 

percent. 

Figure 2: The Number of Plans with Investments in Hedge Funds or Private Equity 

by Size of Investment as a Share of Total Plan Assets 

0

10

20

30

40

50

60

70

80

90

100

110

Plans investing less than 10 percent of total assets

Plans investing 10 percent or more of total assets

Number of plans

Source: GAO analysis of Pensions & Investments 2007 annual survey data.

Pension plans

62

50

12 11

95

106

Private equity funds

Hedge funds

Page 14 GAO-08-692 Defined Benefit Pension Plans
Two recent surveys of pension plans indicate that a considerable number 

of plans invest in hedge funds or private equity. As seen in table 1, from 

about 21 to 27 percent of all plans surveyed, which included mid- to largesize plans, held investments in hedge funds as of 2006, according to data 

from Greenwich Associates and Pyramis.16 Both surveys reveal that a 

greater share of private sector plans invested in hedge funds compared to 

public sector plans. The Greenwich survey also found that hedge fund 

investment was most common among collectively bargained plans, 

although the number of these plans surveyed was substantially smaller as 

there are relatively few of these plans in operation.

17 Nearly half—8 out of 

17—of collectively bargained plans surveyed invested in hedge funds. 

While More Pension Plans 

Invest in Private Equity, 

the Number of Plans with 

Investments in Hedge 

Funds Has Experienced 

Greater Growth in Recent 

Years 

 16The figures reported by these surveys differ somewhat because, as described in table 1,

they are based on different samples. Comprehensive data on plan investments in hedge 

funds and private equity are not available. The federal government collects information on

investment allocations but does not require plan sponsors to report information on hedge

funds or private equity as separate asset classes. Existing data may not include plans that

engage in hedge fund-like activities outside of a formal hedge fund partnership structure. 

17Collectively bargained plans are arrangements between a labor union and an employer. 

These plans may cover workers at a single employer or multiple employers and are jointly 

governed by management and labor representatives. 

Page 15 GAO-08-692 Defined Benefit Pension Plans
Table 1: Extent of DB Plan Investments in Hedge Funds and Private Equity 

Greenwich Associates 

(2006) 

Pyramis Global Advisors 

(2006) 

Sample 164 public sector plans; 

420 private sector plans, 

including 17 collectively 

bargained plans 

(all plans had $250 million or 

more in total assets) 

90 public sector plans; 

124 private sector plans 

(all plans had greater than 

$200 million in total assets) 

Share of plans that invest in hedge funds: 

All plans 27% 21% 

Public sector 24% 17% 

Private sector 28% 25% 

Private sector: collectively 

bargained 

47% n/a

Share of plans that invest in private equity: 

All plans 43% 41% 

Public sector 51% 44% 

Private sector 40% 38% 

Private sector: collectively 

bargained 

71% n/a

Source: Greenwich Associates and Pyramis Global Advisors, 2006.

Note: The total assets of plans surveyed by Greenwich Associates was $3.6 trillion. 

Investment in private equity is much more prevalent than investment in 

hedge funds, among plans surveyed. The Greenwich survey found that 

about 43 percent of plans held investments in private equity in 2006, while 

the Pyramis survey found that 41 percent of plans had such investments. 

Both surveys also show that a larger percentage of public sector plans are 

invested in private equity compared to private sector plans. As with hedge 

funds, the Greenwich survey found that investment in private equity was 

most common among collectively bargained plans. More than two-thirds—

12 out of 17—of collectively bargained plans surveyed invested in private

equity. 

While pension plan investment in hedge funds is less prevalent than 

investment in private equity, hedge fund investment has increased much 

more in recent years. According to Greenwich Associates, from 2004 to 

2006, the percent of plans with investments in hedge funds grew from just 

under 20 percent to almost 27 percent. Meanwhile, the percent of plans 

with investments in private equity increased at a lesser rate, from about 39 

Page 16 GAO-08-692 Defined Benefit Pension Plans
percent in 2004 to 43 percent in 2006. A survey by Pensions & Investments

found that this comparison was more pronounced over a 6-year period 

(see fig. 3). Among larger plans surveyed by Pensions & Investments, the 

percent of plans with investments in hedge funds grew from about 11 

percent in 2001 to nearly 47 percent in 2007. Over the same time period, 

investments in private equity remained more prevalent, but grew much 

more slowly. 

Figure 3: Share of Large DB Plans Investing in Hedge Funds and Private Equity 

0

10

20

30

40

50

60

70

80

Private equity

Hedge funds

2001 2002 2003 2002 2004 2006 2007

Share of plans

Source: Pensions & Investments’ 2007 annual survey.

Year

11%

47%

80%

71%

While pension plan investment in hedge funds has experienced greater 

growth in recent years, pension plan investment in private equity 

increased markedly following a 1979 Labor clarification that plans may 

make some investments in riskier assets, such as venture capital and 

buyout funds.18 Prior to 1979, such investments were generally viewed as a 

potential violation of ERISA. Labor clarified that ERISA’s prudent man 

standard applies to investment decisions in the context of the entire 

 1844 Fed. Reg. 37, 221. 

Page 17 GAO-08-692 Defined Benefit Pension Plans
portfolio rather than in isolation. Following the Labor guidance, pension 

plan investments in venture capital and buy-out funds experienced rapid 

growth. One study reported that pension plans’ share of venture capital

investments grew from 15 percent in 1978 to 50 percent in 1986, during 

which time overall investment in venture capital increased more than 10-

fold from $427 million to $4.4 billion.19 More recently, the National Venture 

Capital Association estimates that pension plans held 42 percent of the 

approximately $20 billion invested in domestic venture capital funds in 

2004. 

Investments in Hedge 

Funds and Private Equity 

Are More Commonplace 

among Larger Pension 

Plans 

Survey data show that larger plans, measured by total plan assets, are 

more likely to invest in hedge funds and private equity compared to midsize plans. Greenwich found that only 16 percent of mid-size plans—those 

with $250 to $500 million in total assets—were invested in hedge funds, 

compared to about 31 percent of the largest plans—those with $5 billion 

or more in assets (see fig. 4). Similarly, only about 16 percent of mid-size 

plans held investments in private equity, whereas slightly over 71 percent 

of the largest plans held such investments. Pensions & Investments

survey of large plans corroborates this pattern—about 47 percent of plans 

held investments in hedge funds and nearly 80 percent held investments in 

private equity in 2007 (see fig. 3). 

 19Paul Gompers, J. Lerner. M. M. Blair, and T. Hellmann, “What Drives Venture Capital 

Fundraising,” Brookings Papers: Microeconomics, pp. 149–204 (1998). 

Page 18 GAO-08-692 Defined Benefit Pension Plans
Figure 4: Pension Plans with Investments in Hedge Funds and Private Equity by

Size of Total Plan Assets 

0

10

20

30

40

50

60

70

80

Private equity

Hedge funds

>$1 - Over $5 billion

$5 billion

>$500 million

- $1 billion

$250 - $500

million

Share of plans

Source: Greenwich Associates, 2006.

Size of plans

16%

29%

43%

16%

24%

28%

71%

31%

Note: The figures above include public and private sector plans (excluding collectively bargained 

plans). Information on the investments of collectively bargained plans by size of total assets was not

available. Data reported in figures 3 and 4 differ because these data are based on different surveys.

Survey data on plans with less than $200 million in assets are unavailable 

and, in the absence of this information, it is unclear to what extent these

plans invest in hedge funds and private equity.20 Representatives of 

investment consulting firms and industry experts told us that they suspect 

few small plans have such investments, but they could not provide data to

confirm this. A representative of a large investment consulting firm 

explained that smaller plans face inherent restrictions on investing in 

hedge funds and private equity funds because the required minimum 

investments for these funds are often too high to allow small plans to 

make such investments while remaining sufficiently diversified. 

 20According to the PBGC, individual DB plans with less than $200 million in total assets 

comprised about 15 percent of the total assets of all DB plans in 2005. 

Page 19 GAO-08-692 Defined Benefit Pension Plans
While pension plans seek important benefits through investments in hedge 

funds, hedge funds also pose challenges that demand greater expertise and

effort than investments in more traditional assets. Pension plans told us 

that they invest in hedge funds to achieve one or more of several goals, 

including lessening the volatility of returns, obtaining returns greater than 

those expected in the stock market, and/or diversifying the portfolio by 

investing in a vehicle that will not be correlated with other asset classes in 

the portfolio. While all the pension plans we contacted that had invested in

hedge funds expressed general satisfaction with these investments, hedge 

fund investments nonetheless pose significant challenges to pension plan 

fiduciaries, beyond the inherent challenges of investing in more familiar 

asset classes such as stocks and bonds. Plan officials and others outlined 

steps to limit these and other challenges, such as conducting in-depth due 

diligence reviews or investing through funds of funds, which can mitigate 

some of the main difficulties of hedge funds. Such steps entail greater 

expense, effort, or expertise than is required for more traditional 

investments, and some pension plans may not be equipped to meet these 

demands. 

Pension plans’ investments in hedge funds resulted in part from stock 

market declines and disenchantment with traditional investment 

management in recent years. Most pension plan officials we contacted

cited the steep declines in the public equity market early in this decade as 

a reason for initiating or expanding hedge fund investments. From August 

2000 to February 2003, the stock market, as measured by the Standard and 

Poor’s 500 index, declined in value by about 45 percent, and according to

plan sponsors and others, this massive market decline severely affected 

pension plans that were deeply invested in the U.S. stock market. For 

example, representatives of one public pension plan told us that this 

market decline led to largest annual loss in its history and resulted in the 

plan’s first hedge fund investments 2003. A representative of another large 

public pension plan told us that the main motive for initially investing in 

hedge funds was the weak equity markets early in this decade, and the 

perceived need for greater exposure to alternative assets that relied less 

on the stock market for returns. At the same time, some plan officials also 

cited disenchantment with traditional “long-only” investment managers, 

Pension Plans Seek 

Various Investment 

Objectives through 

Hedge Funds, and 

Such Investments 

Pose Challenges That 

Require Considerable 

Effort and Expertise 

to Address 

Broad Market Events and a 

Desire for Specific 

Benefits Have Driven 

Pension Plans’ Allocations 

to Hedge Funds 

Page 20 GAO-08-692 Defined Benefit Pension Plans
and questioned whether such managers delivered returns that justified the 

fees the managers’ charge.

21

Officials with most of the plans we contacted indicated that they invested

in hedge funds, at least in part, to reduce the volatility of returns.22

According to a representative of an investment consulting firm, this is a 

common objective of pension plans that invest in hedge funds. One plan 

official explained the importance of reducing volatility by noting that even 

in periods of relatively good stock returns, volatility can eat away at the 

compounding effect of returns over time, and substantially reduce longterm growth. Another plan official said that in trying to reduce volatility 

through hedge funds, the plan expected that certain hedge fund returns 

may lag behind stock market indices during bull (rising) markets, but also 

expected that it would not suffer nearly the same declines during bear 

(falling) markets. 

Officials of several pension plans told us that they sought to obtain returns 

greater than the returns of the overall stock market through at least some 

of their hedge fund investments. For example, officials of one pension plan 

explained that one of the overall goals of its hedge fund portfolio strategy 

was to obtain an annual return of 2.5 percentage points greater than 

returns in the stock market, as measured by the S&P 500 stock index. 

Officials of pension plans that we contacted also stated that hedge funds 

are used to help diversify their overall portfolio and provide a vehicle that

will, to some degree, be uncorrelated with the other investments in their 

portfolio. This reduced correlation has a number of benefits, including 

reduction in overall portfolio volatility and risk. For example, officials of 

one pension plan told us that hedge funds are attractive because they are 

not solely dependent on equity and fixed income markets for their returns, 

thus reduce the overall risk of the investment portfolio. 

At the time of our contacts with pension plans in 2007, the 15 pension 

plans with hedge fund investments indicated mixed but generally positive 

 21“Long only” investment managers can generally be defined as those whose strategies are 

limited to buying assets whose value is expected to increase. That is, they cannot “short” or 

sell borrowed securities. 

22Volatility refers to the propensity of a security to move up or down over time; if a security 

moves up or down rapidly over a short period of time, it is considered to have high 

volatility. 

Page 21 GAO-08-692 Defined Benefit Pension Plans
results.23 Among officials of these plans, all said that their hedge fund 

investments had generally met or exceeded expectations, although some 

noted mixed experiences. For example, one plan explained that it had 

dropped some hedge fund investments because they had not performed at 

or above the S&P 500 benchmark. Also, this plan redeemed its investment 

from other funds because they began to deviate from their initial trading 

strategy. Further, officials of several plans noted that their venture into 

hedge funds was only a few years old, and, at the time of our contact, their 

investment had not yet been tested by trying economic conditions or 

financial events, such as a significant stock market decline. Nonetheless, 

representatives of all of the plans with hedge fund investments indicated 

that they planned to maintain or increase their portfolio allocation to 

hedge funds in the foreseeable future.

Hedge Funds Pose 

Significant Challenges and 

Risks, Beyond Those 

Posed by Traditional 

Investments 

Pension plans face a number of challenges in hedge fund investing beyond

those of more traditional investing, including specific investment risks, 

limited transparency and liquidity, and risks related to the operations of 

the hedge fund. 

While any plan investment may fail to deliver expected returns over time, 

hedge fund investments pose investment challenges beyond those posed

by traditional investments. These include (1) reliance on the skill of hedge 

fund managers, who often have broad latitude to engage in complex 

investment techniques that can involve various financial instruments in 

various financial markets; (2) use of leverage, which amplifies both 

potential gains and losses; and (3) higher fees, which require a plan to earn 

a higher gross return to achieve a higher net return. 

Investment Risks 

Hedge funds are among the most actively managed investments, and thus 

returns are often dependent not on broad market movements, but on 

smaller moves in the markets they invest in and the skills and abilities of 

the hedge fund manager.24 For example, hedge fund managers may seek to 

 23Our discussions with pension plan officials about their hedge fund investments occurred

in 2007. Consequently, we have no information about how their investments might have 

been affected by the financial market turbulence that occurred since that time. 

24In contrast, mutual fund managers must comply with various aspects of federal securities 

law, and operate in a much more constrained manner. 

Page 22 GAO-08-692 Defined Benefit Pension Plans
profit through complex and simultaneous positions in stocks, bonds, 

options contracts, futures contracts, currencies, and other vehicles, and 

can abruptly change their positions and trading tactics in order to achieve 

desired return as changing market conditions warrant. Representatives of 

some pension plans that had not invested in hedge funds, cited concerns 

about the ability of hedge fund managers to accomplish this over the longterm. One plan official said the plan had avoided hedge funds in part 

because of doubt that the managers’ skills could generate an acceptable 

return over time. Instead, this plan seeks to capture the increase in the 

overall stock market. Regulatory officials and plan sponsors also said that, 

given the growth of the hedge fund industry in recent years, the market 

inefficiencies from which hedge funds profit may diminish. For example, 

SEC noted in a 2004 regulatory proposal that the capacity of hedge fund

advisers to generate large returns is limited because the use of similar 

financial strategies by other hedge funds narrows spreads and decreases 

profitability.25

Hedge fund managers may use leverage—that is, use borrowed money or

other techniques—to potentially increase an investments value or return 

without increasing the amount invested.26 While registered investment 

companies are subject to leverage limits, hedge funds can make relatively 

unrestricted use of leverage to magnify the expected returns of an 

investment.27 At the same time that leverage can magnify profits, it can also

magnify losses to the hedge fund if the market goes against the fund’s 

expectations.

28 Concerns about leverage were cited by several pension 

 2569 Fed. Reg. 45,172, 45,178. 

26Historically, leverage is the use of various financial instruments or borrowed capital to

increase the potential return of an investment. As we reported in January 2008 

(GAO-08-200), since the near collapse of the Long Term Capital Management fund in 1998,

investors, creditors, and counterparties have increased efforts to impose market discipline 

on hedge funds, including tightening credit standards for hedge funds. However, we also

noted that no one entity may have all the necessary data to assess the total leverage used 

by a hedge fund. 

27According to the SEC, a hedge fund’s use of leverage is limited by margin or collateral 

requirements imposed by lenders and others. In contrast, registered investment companies

are subject to specific statutory limitations. 

28For example, a 15 percent decline in an investment of $50 with no leverage is exactly a 15 

percent loss—a loss of $7.50—and the investor still has $42.50 and can hope for a rebound.

On the other hand, an investment of $50 leveraged 10 times exposes the investor to an

investment of $500, and a 15 percent decline in value will result in a loss of $75. The added 

risk of leverage can be seen in the fact that this 15 percent decline in such a leveraged 

position leads to not only a total loss of the original $50 investment, but a remaining debt of

$25—half of the initial investment. 

Page 23 GAO-08-692 Defined Benefit Pension Plans
plans either as an important consideration in selecting a hedge fund, or as

a reason for avoiding them altogether. For example, one public pension 

plan told us that it has avoided hedge funds because when hedge funds hit 

“potholes,” the potholes are deep because of high amounts of leverage 

used. 

The challenge of relying on manager skill for a desired rate of return is 

compounded by the costly fee structure that is typical of the hedge fund

industry. Whereas mutual fund managers reportedly charge a fee of about 

1 percent of assets under management, hedge fund managers often charge 

a flat fee of 2 percent of total assets under management, plus a 

performance fee, of about 20 percent of the fund’s annual profits.29

The impact of such fees can be considerable. As figure 5 illustrates, an 

annual return of 12 percent falls to about 7.6 percent after fees are 

deducted. Several pension plans cited the costly fee structure fees as a 

major drawback to hedge fund investing. For example, representatives of

one plan that had not invested in hedge funds said that they are focused on

minimizing transaction costs of their investment program, and the hedge 

fund fee structure would likely not be worth the expense. On the other 

hand, an official of another plan noted that, as long as hedge funds add 

value net of fees, they found the higher fees acceptable. 

 29Fees can vary somewhat among hedge funds. 

Page 24 GAO-08-692 Defined Benefit Pension Plans
Figure 5: Effect of Hedge Fund Fee Structure on the Returns of an Investment of 

$50 Million 

0

1

2

3

4

5

6

 

Gross returns

$6 million

Net return

Performance

fee

Flat

fee

Dollars (in millions)

Source: GAO analysis.

$1.2m

$3.8m

$1.0m

Gross return = 12%

Net return = 7.6%

Figures are based on a $50 million

investment.

Note: This example assumes a fee structure of 2 percent of assets under management and 20 

percent of profits. 

Because many hedge funds may own thinly traded securities and 

derivatives whose valuation can be complex, and in some cases subjective, 

a plan may not be able to obtain timely information on the value of assets 

owned by a hedge fund.

30 Further, hedge fund managers may decline to

disclose information on asset holdings and the net value of individual 

assets largely because release of such information could compromise their 

trading advantage. In addition, even if hedge fund managers were to 

provide detailed positions, plan sponsors might be unable to fully analyze 

and assess the prospective return and risk of a hedge fund. As a 

consequence, a plan may not be able to independently ascertain the value 

of its hedge fund investment or fully assess the degree of investment risk 

posed by its hedge fund investment. Although we noted in January 2008 

that hedge funds have improved disclosure and transparency about their 

operations due to the demands of institutional investors, several pension

plans cited limited transparency as a prime reason they had chosen not to

Lack of Transparency

 30A security is described as thinly traded when traded infrequently and/or in low volumes. 

Page 25 GAO-08-692 Defined Benefit Pension Plans
invest in hedge funds.31 For example, representatives of one plan told us 

that they had considered investing in hedge funds several years ago, but 

that most of the hedge funds it contacted would not provide position-level 

information, and that they were reluctant to make such an investment 

without this information. 

Hedge funds offer investors relatively limited liquidity, that is, investors 

may not be able to redeem a hedge fund investment on demand because of 

a hedge fund’s redemption policy. Hedge funds often require an initial 

“lockup” of a year or more, during which an investor cannot cash out of 

the hedge fund. After the initial lockup period, hedge funds offer only 

occasional liquidity, sometimes with a pre-notification requirement.32

Liquidity Limitations 

While some pension plans told us that liquidity limitations are not a 

significant concern because the plan has other liquid assets to pay 

benefits, they nonetheless can pose certain disadvantages. For example, 

liquidity limitations can inhibit a plan’s ability to minimize a hedge fund 

investment loss. As one state official noted after a state fund had suffered

losses in the wake of the 2006 collapse of Amaranth, even when a plan 

learns that a hedge fund is losing value, various lockup provisions often 

make it difficult to promptly withdraw from the investment.33 Further, an 

investor’s rights with regard to cashing out may not be entirely clear from 

the written contract. According to an investigative study by a Grand Jury 

of one pension plan’s experience with a failed hedge fund, the contracts 

can be dense with legal language, which may make understanding of basic 

terms and conditions difficult, especially with regard to withdrawal 

provisions.34 Further, the study noted that contracts can delegate immense 

discretionary authority to the hedge fund manager to change conditions 

and rules. 

 31See GAO-08-200. 

32Lock-ups can be important to hedge funds because sudden liquidations could disrupt a

carefully calibrated investment strategy and because some of the hedge fund’s underlying 

assets may themselves be illiquid.

33The $9 billion fund operated by Amaranth Advisors, LLC, collapsed in the fall of 2006 as a

result of natural gas derivatives trading. 

34“San Diego County Employees Retirement Association - The Quest for ‘Alpha,’” San Diego

County Grand Jury 2006-2007, Online: http://www.co.sandiego.ca.us/grandjury/report06_07.html, accessed June 18, 2008. 

Page 26 GAO-08-692 Defined Benefit Pension Plans
Pension plans investing in hedge funds are also exposed to operational 

risk—that is, the risk of investment loss due not to a faulty investment 

strategy, but from inadequate or failed internal processes, people, and 

systems, or problems with external service providers. Operational 

problems can arise from a number of sources, including inexperienced 

operations personnel, inadequate internal controls, lack of compliance 

standards and enforcement, errors in analyzing, trading, or recording 

positions, or outright fraud. According to a report by an investment 

consulting firm, because many hedge funds engage in active, complex, and

sometimes heavily leveraged trading, a failure of operational functions 

such as processing or clearing one or more trades may have grave 

consequences for the overall position of the hedge fund. Concerns about 

some operational issues were noted by SEC in a 2003 report on the 

implications of the growth of hedge funds. For example, the 2003 report 

noted that SEC had instituted a significant and growing number of 

enforcement actions involving hedge fund fraud in the preceding 5 years.35

Further, SEC noted that while some hedge funds had adopted sound 

internal controls and compliance practices, in many other cases, controls 

may be very informal, and may not be adequate for the amount of assets 

under management. Similarly, a recent Bank of New York paper noted that 

the type and quality of operational environments can vary widely among 

hedge funds, and investors cannot simply assume that a hedge fund has an 

operational infrastructure sufficient to protect shareholder assets.36

Operational Risk 

Several pension plans we contacted also expressed concerns about 

operational risk. For example, one plan official noted that the 

consequences of operational failure are larger in hedge fund investing than

in conventional investing. For example, the official said a failed long trade 

in conventional investing has relatively limited consequences, but a failed 

trade that is leveraged five times is much more consequential. 

Representatives of another plan noted that back office and operational 

issues became deal breakers in some cases. For example, they said one 

fund of funds looked like a very good investment, but concerns were 

raised during the due diligence process. These officials noted, for example, 

 35Implication of the Growth of Hedge Funds, Staff Report to the United States Securities 

and Exchange Commission, September 2003. Although hedge funds are substantially 

unregulated, they are nonetheless subject to anti-fraud, and some other provisions of 

federal securities law. 

36Hedge Fund Operational Risk: Meeting the Demand for Higher Transparency and Best 

Practice, Bank of New York/Amber Partners White Paper, June 2006. 

Page 27 GAO-08-692 Defined Benefit Pension Plans
the importance of a clear separation of the investment functions and the 

operations and compliance functions of the fund. One official added that

some hedge funds and funds of funds are focused on investment ideas at 

the expense of important operations components of the fund.

Addressing the Challenges 

and Risks of Hedge Fund 

Investing Requires 

Considerable Effort and 

Expertise 

Pension plans that invest in hedge funds take various steps to mitigate the 

risks and challenges posed by hedge fund investing, including developing a 

specific investment purpose and strategy, negotiating important 

investment terms, conducting due diligence, and investing through funds 

of funds. Such steps require greater effort, expertise and expense than 

required for more traditional investments. As a result, some plans, 

especially smaller plans, may not have the resources to take the steps 

necessary to address these challenges. 

Discussions with pension plan officials revealed the importance of 

defining a clear purpose and strategy for their hedge fund investments. As 

one pension fiduciary noted, plan managers should define exactly why 

they want to invest in hedge funds. He added that there are many different

possible hedge fund strategies, and wanting to invest in hedge funds to 

obtain the large returns that other investors have reportedly obtained is 

not a sufficient reason. Most of the 15 pension plans with hedge fund 

investments that we contacted described one or more strategies for their 

hedge funds investments. For example, an official of one state plan told us

that the plan invested only in long-short hedge fund strategies while other 

plans use multiple strategies.37

Clear Investment Purpose and 

Strategy 

Our contacts with plan officials and others also highlighted the importance 

of diversification. All of the plans having hedge fund investments that we 

contacted invested in either multiple individual hedge funds, or through 

funds of funds, which are designed to provide diversification across many 

underlying funds. Some plans described specific diversification 

requirements, and spread their hedge fund investment across many funds 

to limit exposure to one or a small number of hedge funds. For example, 

one plan determined that no more than 15 percent of its hedge fund 

portfolio would be with a single hedge fund manager and that no more 

than 40 percent in a particular hedge fund investment strategy. 

 37A long-short strategy exploits perceived anomalies in the price of securities. For example, 

a hedge fund may buy bonds that it believes to be under-priced, and sell short bonds that it 

believes to be overpriced. 

Page 28 GAO-08-692 Defined Benefit Pension Plans
Our contacts with plan officials and others also highlighted the importance 

of identifying specific investment terms to guide hedge fund investing and

ensuring that the hedge fund investment contract complies with these 

criteria. These can include fee structure and conditions, degree of 

transparency, valuation procedures, redemption provisions, and degree of

leverage employed. For example, pension plans may want to ensure that 

they will not pay a performance fee unless the value of the investment 

passes a previous peak value of the fund shares—known as a high water

mark. Some plans we contacted also specified leverage limits for their 

hedge funds. For example, one public plan that we contacted has 

established specific leverage limits for each of 10 hedge fund strategies 

employed by its funds of funds—ranging from an upper limit of 2 times 

invested capital for one strategy, to 20 times invested capital for another. 

Once decided upon, these and other terms of the investment can be used 

as criteria in the hedge fund search, and if necessary, negotiated with the 

hedge fund or fund of funds manager. 

Identification and Negotiation 

of Important Investment Terms 

Pension plans take steps to mitigate the challenges of hedge fund investing

through an in-depth due diligence and ongoing monitoring process. While 

plans conduct due diligence reviews of other investments as well, such 

reviews are especially important when making hedge fund investments, 

because of hedge funds’ complex investment strategies, the often small 

size of hedge funds, and their more lightly regulated nature, among other 

reasons. Due diligence can be a wide-ranging process that includes a 

review and study of the hedge fund’s investment process, valuation, and 

risk management. The due diligence process can also include a review of 

back office operations, including a review of key staff roles and 

responsibilities, the background of operations staff, the adequacy of 

computer and telecommunications systems, and a review of compliance 

policies and procedures. 

Due Diligence and Monitoring 

Representatives of several plans told us they mitigate several of the major 

hedge fund challenges by investing through funds of funds, which are 

investment funds that buy shares of multiple underlying hedge funds. 

Funds of hedge funds provide plan investors diversification across 

multiple hedge funds, thereby having the potential to mitigate investment

risk. For example, one plan fiduciary told us the plan reduces investment 

risk by investing in a fund of funds that diversifies their hedge fund 

investments into at least 40 underlying hedge funds. Further, by investing 

in a fund of funds, a pension plan relies on the fund of funds’ manager to 

conduct negotiations, due diligence, and monitoring of the underlying 

hedge funds. According to pension plan officials, funds of funds can be 

appropriate if a plan does not have the necessary skills to manage its own 

Investing Via Funds of Hedge 

Funds 

Page 29 GAO-08-692 Defined Benefit Pension Plans
portfolio of hedge funds. According to a hedge fund industry organization,

investing through a fund of funds may provide a plan better access to 

hedge funds than a plan would be able to obtain directly.38 Nonetheless, 

investing through funds of funds has some drawbacks. Funds of funds’ 

managers also charge fees—for example, they may charge a 1 percent flat 

fee and a performance fee of between 5 and 10 percent of profits—on top 

of the substantial fees that the fund of funds manager pays to the 

underlying hedge funds. Funds of funds also pose some of the same 

challenges as hedge funds, such as limited transparency and liquidity, and

the need for a due diligence review of the fund of funds firm. 

Some Pension Plans May 

Not Be Able to Meet the 

Demands of Hedge Fund 

Investing 

According to plan officials, state and federal regulators, and others, some 

pension plans, especially smaller plans, may not be equipped to address 

the various demands of hedge fund investing. For example, an official of a 

national organization representing state securities regulators told us that 

medium- and small-size plans are probably not equipped with the expertise 

to oversee the trading and investment practices of hedge funds. This 

official said that smaller plans may have only one or two person staff, or 

may lack the resources to hire outside consulting expertise. A labor union 

official made similar comments, noting that smaller pension plans lack the 

internal capacity to assess hedge fund investments, and noted that such 

plans may be locked out of top-performing hedge funds. 

Some plans may also lack the ability to conduct the necessary due 

diligence and monitoring of hedge fund investments. One hedge fund 

consultant told us that certain types of plans, such as plans that are not 

actively overseen by an investment committee and plans that do not have a 

sufficient in-house dedicated staff, should not invest in hedge funds. 

Similarly, a representative of a firm specializing in fiduciary education and 

support noted the special relationship of trust and legal responsibility that 

plan fiduciaries carry and concluded that the challenges of hedge fund 

investing are too high for most pension plans. While such plans might 

often be smaller plans, larger plans may also lack sufficient expertise. A 

representative of one pension plan with more than $32 billion in total 

assets noted that before investing in hedge funds, the plan would have to 

build up its staff in order to conduct the necessary due diligence during 

the fund selection process. 

 38“Funds of Hedge Funds FAQs: MFA’s Concise Guide to Hedge Funds,” Managed Funds

Association. 

Page 30 GAO-08-692 Defined Benefit Pension Plans
According to plan representatives, investment consultants, and other 

experts we interviewed, pension plans invest in private equity primarily to 

attain returns superior to those attained in the stock market in exchange 

for greater risk, but such investments pose several distinct challenges. 

Generally, these plan representatives based their comments on significant 

experience investing in private equity—in some cases over 20 years—and 

said they had experienced returns in excess of the stock market. 

Nonetheless, private equity funds can require longer-term commitments of 

10 years or more, and during that time, a plan may not be able to redeem 

its investments. In addition, plan representatives described extensive and

ongoing management of private equity investments beyond that required 

for traditional investments and that, like hedge fund investments, may be 

difficult for plans with relatively limited resources. 

Unlike hedge funds, pension plan investment in private equity is not a 

recent phenomenon. The majority of plans included in our review began 

investing in private equity more than 5 years before the economic 

downturn of 2000 to 2001, and some of these plans have been investing in

private equity for 20 years or more.39 According to a pension investment 

consultant we interviewed, due to the longer history of pensions’ 

investment in private equity, it is generally regarded as a more wellestablished and proven asset class compared to other alternative 

investments, such as hedge funds. 

Private Equity 

Investments May 

Provide Important 

Benefits, but Pension 

Plans Face Limited 

Access to TopPerforming Funds and 

Other Challenges 

Plans Have Long 

Investment History in 

Private Equity and 

Primarily Seek Returns 

Superior to Those Attained 

in the Stock Market 

Pension plans invest in private equity primarily to attain returns in excess 

of returns from the stock market over time in exchange for the greater risk 

associated with these investments. Officials of each plan we interviewed 

said these investments had provided the expected returns. Plan 

representatives and investment consultants said that attaining returns 

superior to stocks was a primary reason for investing in private equity.40

 39As described in the first section, pension investment in private equity increased markedly 

following publication of guidance by Labor in 1979 clarifying that private sector plans may 

make some investments in riskier assets, such as venture capital and buy-out funds. 

40Several plans cited research which shows that the average performance of top-quartile 

private equity funds exceeds the stock market. See, for example: Steven Kaplan and

Antoinette Schoar, “PE Performance: Returns, Persistence, and Capital Flows,” Journal of

Finance, VOL. LX, No.4, (August 2005); Alexander Ljungquist and Matthew Richardson,

“The Cash Flow, Return and Risk Characteristics of Private Equity.” National Bureau

Economic Research, Working Paper, #9454, (January 2003); and David Swensen, 

Pioneering Portfolio Management: An Unconventional Approach to Institutional 

Investment. The Free Press: New York (2000).

Page 31 GAO-08-692 Defined Benefit Pension Plans
Among the plan representatives we interviewed the most commonly 

reported benchmark for private equity funds ranged from 3 to 5 

percentage points above the S&P 500 stock index, net of fees. At the time 

of our interviews with plans about private equity investments, between 

October 2007 and January 2008, plan representatives indicated their 

private equity investments had met their expectations for relatively high 

returns and many said they planned to maintain or increase their 

allocation in the future.41 Further, representatives of some plans told us 

that private equity has been their best performing asset class over time 

despite some individual investments that resulted in considerable losses. 

For example, according to documentation provided by one private sector 

plan, the plan had earned a net return of slightly more than 16 percent on

its private equity investments over the 10-year period ending September 

30, 2007, which was their highest return for any asset class over that time

period.42

To a lesser degree, pension plans also invest in private equity to further 

diversify their portfolios. To the extent that private equity is not closely 

correlated with the stock market, these investments can reduce the 

volatility of the overall portfolio. However, some plan representatives 

cautioned that the diversification benefits are limited because the 

performance of private equity funds is still strongly, although not perfectly, 

linked to the stock market.43

 41We conducted our interviews on plans’ private equity investments from October 2007 to 

January 2008; therefore, their comments may not reflect more recent changes to market 

conditions. 

42Some public plans also invest in private equity, in part, to promote local economic 

development in accordance with state policy. According to plan representatives and an

industry organization, venture capital investments have, in some cases, been viewed as a 

way to promote local economic growth, while at the same time, providing returns that 

bolster retirement income for plan beneficiaries. Most public plan officials we interviewed, 

however, did not cite promoting local economic development as an explicit goal for their 

private equity investments. 

43Several studies show a range of correlation between private equity and the stock market. 

Correlations cited range from the low, 30 percent, to the very high, 95 percent. 

Page 32 GAO-08-692 Defined Benefit Pension Plans
Pension plans investing in private equity face several challenges and risks, 

which include the concentration of underlying holdings, use of leverage, 

and wide variation in performance among funds. In addition, the value of 

the underlying holdings is difficult to estimate prior to their sale and

private equity investments entail long-term commitments, often of 10 years

or more. 

Pension plans that invest in private equity funds face a number of 

investment risks, beyond the risks of traditional investments. Unlike a 

traditional fund manager who diversifies by investing in many stocks or 

bonds, a private equity fund manager’s strategy typically involves holding a 

limited number of underlying companies in their portfolio. A single private 

equity fund generally invests in only about 10 to 15 companies, often in the 

same sector.44 The risks associated with such concentrated, undiversified 

funds may be compounded by particular aspects of the buyout and venture 

capital sectors. Fund managers in the buyout sector generally invest using 

leverage to seek greater returns but such investments also increase 

investment risks. In the venture capital sector, fund managers typically 

make smaller investments in companies that may have a limited track 

record and rely on technological development and growing the company’s

commercial capacity for success. In light of this, some plan officials noted 

that some of these companies will fail, but the success of one or more of 

the portfolio firms is often large enough to more than compensate for the 

losses of other investments. 

Pension Plans Face 

Several Challenges and 

Risks When Investing in 

Private Equity 

Investment Risk 

Like other investments, the returns to private equity funds are susceptible 

to market conditions when investments are bought or sold. When 

competition among private equity fund managers is intense, research has 

shown that a fund manager may pay more for an investment opportunity 

that leads to lower net returns.45 In addition, the returns of a private equity 

fund are also affected by the condition of the market when the underlying

 44One study shows that, on average, funds in the study invested close to 40 percent of 

capital in a single industry. Alexander Ljungquist and Matthew Richardson, “The Cash 

Flow, Return and Risk Characteristics of Private Equity,” National Bureau Economic

Research, Working Paper, No. 9454 (January 2003). 

45See, for example: Paul Gompers and Josh Lerner, “Money chasing deals? The impact of

fund inflows on private equity valuations,” Journal of Financial Economics, vol 55. (2000); 

and Alexander Ljungquist and Matthew Richardson, “The Cash Flow, Return and Risk 

Characteristics of Private Equity.” National Bureau Economic Research, Working Paper, 

#9454, Jan. 2003; and David Swensen, Pioneering Portfolio Management: An 

Unconventional Approach to Institutional Investment, The Free Press: New York (2000).

Page 33 GAO-08-692 Defined Benefit Pension Plans
investments are sold. For example, a private equity fund may have lower 

returns if its underlying holdings are sold through an initial public offering 

made during a period of low stock values. An official from one plan told us 

that private equity funds that sold investments around 2000 had lower 

returns because of the overall decline in the stock market. However, a 

representative of another plan noted that, while market conditions have 

some effect on the performance of a private equity fund, the effect may be 

mitigated by the ability of the fund managers to enact sound business 

plans and thereby add value to the underlying companies. 

Further, the challenge of meeting the high performance goals for private 

equity investments is compounded by the relatively high fees that private 

equity funds charge. Similar to hedge funds, private equity funds typically 

charge an annual fee of 2 percent of invested capital and 20 percent of 

returns, whereas mutual fund managers typically charge a fee of about 1 

percent or less of assets under management. If the gross returns from a 

private equity fund are not sufficiently high, net returns to investors will 

not meet the commonly cited goal of exceeding the return of the stock 

market. 

Another risk from investing in private equity is the variation of 

performance among private equity funds. Officials of an investment 

consulting firm, a state regulatory agency, and several pension plans noted

that, compared to other asset classes, private equity has greater variation 

in performance among funds and cited research to support this view. For 

example, one study found that the difference in returns between the 

median and top quartile funds is much greater for private equity, 

particularly among venture capital investments, than it is for domestic 

stocks.46 Another study found that returns of private equity funds at the 

75th percentile were more than seven times greater than the returns of 

funds at the 25th percentile.47

Variation of Performance 

among Private Equity Funds 

A further challenge of investing with private equity funds—regardless of 

how they perform—is that they often require commitments of 10 years or 

more during which a plan may not be able to redeem its investment. The 

longer-term commitment of private equity funds contrasts with stock and

Long-Term Commitment of 

Private Equity Funds 

 46David Swensen, Pioneering Portfolio Management: An Unconventional Approach to 

Institutional Investment, The Free Press: New York (2000).

47Steven Kaplan and Antoinette Schoar, “Private Equity Performance: Returns, Persistence, 

and Capital Flows.” Journal of Finance, vol. LX, No. 4 (August 2005). 

Page 34 GAO-08-692 Defined Benefit Pension Plans
bond investments, which can be bought and sold daily, and hedge fund

investments, which can be redeemed episodically. Plans must provide 

committed capital when called upon by the fund manager, and may not 

redeem invested capital or typically see any return on the investment, for 

at least several years.48 However, several plan representatives and other 

experts we interviewed stated that the nature of private equity funds 

necessitates long commitments as returns are generated through longerterm growth strategies, rather than short-term gains. A private equity fund

cycle typically follows a pattern known as the “J-curve,” which reflects an

initial period of negative returns during which investors provide the fund

with capital and then obtain returns over time as investments mature (see 

fig. 6). Representatives of several plans noted that they expect higher 

returns from private equity in exchange for the long-term commitment. 

 48Officials with some plans explained that an investor might sell its stake in a private equity 

fund on a secondary market; however, interests in a private equity fund are typically sold at 

a discount. One plan also noted that selling a stake on the secondary market would also 

jeopardize their reputation as an investor with private equity funds since the fund managers 

look unfavorably on such transactions. 

Page 35 GAO-08-692 Defined Benefit Pension Plans
Figure 6: Returns from a Private Equity Fund Generally Follow a J-Curve Trend over the 10-Year Fund Cycle Inve

stment return

s

1 2 3 4 5 7 8 9 10 6

Years invested

Source: CalPERS.

0

An additional challenge of private equity investments is the uncertain 

valuation during the fund cycle. Unlike stocks and bonds, which are traded 

and priced in public markets, plans have limited information on the value

of private equity investments until the underlying holdings are sold. Some 

plan representatives we interviewed explained that fund managers often 

value underlying holdings at their initial cost until they are sold through an

initial public offering or other type of sale.49 In some cases private equity 

funds estimate the value of the fund by comparing companies in their 

Valuation of Private Equity 

Fund Investments 

 49Plan officials we interviewed also noted that they expect private equity valuation to 

become more frequent and market-based following recent changes to accounting 

standards. In September 2006, the Financial Accounting Standards Board issued Statement 

of Financial Accounting Standards (SFAS) No.157, “Fair Value Measurements.” This

standard defines fair value as the price that would be received to sell an asset or paid to

transfer a liability in an orderly transaction between market participants at the 

measurement date. As discussed in SFAS No. 157, the changes to current practice resulting 

from the application of this standard relate to the definition of fair value, the methods used 

to measure fair value, and the expanded disclosures about fair value measurements. The 

new definition of fair value may change the manner in which some entities, such as private 

equity funds, determine fair value. 

Page 36 GAO-08-692 Defined Benefit Pension Plans
portfolio to the value of comparable publicly-traded assets. However, an 

investment consultant explained that such periodic valuations have 

limited utility. Prior to the sale of underlying investments, it is difficult to 

assess the value a private equity fund manager has generated. While plan

officials we interviewed acknowledged the difficulty of valuing private 

equity investments, they generally accepted it as a trade-off for the 

potential benefits of the investment. 

Taking Steps to Address 

the Challenges and Risks 

of Investing in Private 

Equity May Be Too Costly 

and Complex for Some 

Plans 

Plan representatives said that they take several key steps to address the 

challenges of investing in private equity funds. Plan representatives and 

industry experts emphasized the importance of investing with topperforming funds to mitigate the wide variation in fund performance; 

however, they noted that access to these top-performing funds is very 

limited, particularly for new investors.50 Furthermore, due diligence and 

ongoing monitoring of private equity investments requires substantial 

effort and expertise, which may be too complex or costly for plans with 

more limited resources. 

The majority of plan representatives we interviewed told us that, because 

of the wide variation in performance among private equity funds, they 

must invest with top-performing funds in order to achieve long-term 

returns in excess of the stock market. In addition to identifying the topperforming fund managers, plan officials explained that the selection 

process involves a thorough assessment of the fund manager’s investment 

strategy. For example, an official from one state plan told us that their 

assessment includes a review of a fund manager’s strategy for improving 

the operations and efficiency of its proposed investments and they invest 

with managers that have a persuasive business model. Plan officials 

stressed the importance of these steps, and some noted that investing in 

private equity is only worthwhile if they can invest with funds in the top 

quartile of performance. For example, one plan official said that if a plan 

does not invest with a top quartile fund, it may not obtain returns in excess 

of stock market returns and, thus, will not have earned a premium for 

assuming the risks and fees inherent in private equity fund investments. 

Selection of Private Equity 

Fund Investments 

 50Plan officials noted that top-performing private equity fund managers tend to consistently 

perform well over time and some plans cited research in support of this view. See, for 

example, Steven Kaplan and Antoinette Schoar, “Private Equity Performance: Returns, 

Persistence, and Capital Flows.” Journal of Finance, vol. LX, No. 4 (August 2005). 

Page 37 GAO-08-692 Defined Benefit Pension Plans
While many plans we interviewed noted the importance of investing with 

top-performing funds, the competition to gain access to these funds may 

make it difficult or impossible for some plans, especially smaller plans, to

do so. Several of the plan representatives we interviewed noted that 

investment opportunities with top-performing funds are limited, and the 

demand for such opportunities is high. According to representatives of a 

venture capital trade association, there is greater demand to invest in 

venture capital funds than can be absorbed, because the venture capital

sector is relatively small in size.51 Plan officials also noted that access to 

private equity funds can be limited, because fund managers prefer to deal

with larger, more sophisticated investors or investors who have invested 

in the fund manager’s previous private equity funds. For example, one 

state official told us that the largest public plan in the state has the clout to

gain access to top-performing funds, but smaller public funds in the state 

do not. He added that top-performing funds are very selective, and 

generally will not respond to solicitation by smaller public funds. 

Plan representatives told us they further mitigate the challenges of 

investing in private equity funds by diversifying their investments. Plan 

representatives we interviewed said they invest with multiple fund 

managers to mitigate the risk that some managers may have mediocre or 

poor performance. For example, a representative of one plan said they 

would be comfortable investing about 5 percent of their private equity 

allocation with one carefully vetted fund manager, but investing 20 percent 

with one manager would be overly risky. The director of another plan told

us the plan aims to ensure diversification by investing with over 130 

different private equity funds, encompassing more than 80 fund managers. 

Plans also stagger investments over several years to ensure their private 

equity fund investments are ready to sell their underlying investments at 

different times. Staggering investments over time helps mitigate the risk of

fund managers selling funds’ underlying holdings during a time of poor 

market conditions, which may reduce the funds’ returns to investors. For 

example, one plan official noted they have investments in funds that were 

established in many different years, dating back to 1994. In addition, some 

plan officials told us they further diversify their private equity investments 

among funds concentrated in different industries and regions. 

Diversification 

 51According to the National Venture Capital Association, more than half of venture capital 

funds manage $100 million or less in capital. 

Page 38 GAO-08-692 Defined Benefit Pension Plans
Plan representatives said that they mitigate the long-term commitments of 

private equity investments by limiting the size their allocation. Officials we 

interviewed at several plans noted that their allocation to private equity is 

only about 5 percent of the portfolio and benefit obligations can be paid 

from more liquid assets. They said it is important to estimate a plan’s 

benefit obligations and determine the need for liquid investments to 

ensure the plan can pay benefits when they are due. They also noted that

once liquidity needs are determined, a plan can more safely invest in an 

illiquid asset that cannot be used to pay benefits in the near term. 

Planning for Liquidity Needs 

Plans attempt to negotiate key terms of the investment contract to further 

manage the risks of investing in private equity, but, as one large public 

plan noted, their ability to negotiate favorable contract provisions is 

limited when investing with top-performing funds because investing in 

these funds is highly competitive. Like hedge fund investments, these 

contract terms may include the fee structure and valuation procedures of 

the fund. In addition, many plan representatives we interviewed said they 

can redeem their investments before the end of the originally agreed 

investment period if staff that are considered key to the success of the 

fund leave prematurely. 

Negotiation of Key Terms of 

the Investment Contract 

Similar to hedge fund investments, plans take additional steps to mitigate 

challenges of investing in private equity through extensive and ongoing 

management, beyond those required for traditional investments. Plan 

representatives we interviewed said these steps include regularly 

reviewing reports on the performance of the underlying investments of the 

private equity fund and having periodic meetings with fund managers. In 

some cases, plans participate on the advisory board of a private equity 

fund, which provides a greater opportunity for oversight of the fund’s 

operations and new investments; however this involves a significant time

commitment and may not be feasible for every private equity fund 

investment.52 Plan representatives and investment consultants noted that, 

as with hedge funds, private equity investments entail considerably greater 

due diligence and ongoing monitoring than traditional investments and 

some plan representatives said they needed to hire an external investment 

consultant because the plan lacked sufficient internal resources. 

Due Diligence and Ongoing 

Monitoring 

 52While the advisory board of a private equity fund may allow investors some degree of

oversight, it does not provide investors with an active role in the management of the fund. 

Page 39 GAO-08-692 Defined Benefit Pension Plans
Funds of private equity funds, like funds of hedge funds, enable plans to 

address several challenges of investing in private equity, for an additional 

cost. Benefits of investing in funds of funds can include diversification 

across fund managers, industry, geographic region, and year of initial 

investment. Through funds of funds, plans can also gain access to topperforming fund managers that may otherwise be unavailable to them. One 

plan representative stated that, due to the competition among investors, 

funds of funds are their best option for accessing top-performing funds. In

addition, several plan representatives said that they invest in funds of 

funds to benefit from the expertise of the fund manager. For example, 

officials of two large plans said they generally limit their use of funds of 

funds to private equity investments in emerging markets and small funds 

because the plan prefers not to devote resources to maintaining expertise

in these areas. Nonetheless, fund of funds’ managers charge their own fees 

in addition to the fees the fund of funds pays the underlying private equity

fund managers. According to a plan official and an investment consulting 

firm, a fund of funds manager typically charges a fee of 1 percent of 

invested capital over the fees it pays to the underlying funds. 

Funds of Private Equity Funds 

The federal government does not specifically limit or monitor private 

sector pension investments in hedge funds or private equity, and state 

approaches for public plans vary. ERISA requires that plan fiduciaries 

meet general standards of prudent investing but does not impose specific 

limits on investments in hedge funds or private equity. Further, while 

Labor has conducted enforcement actions that have involved hedge fund 

or private equity funds, it does not specifically monitor these investments. 

While states generally impose a prudent man standard, similar to ERISA’s, 

on plan fiduciaries, some states still have policies that restrict or prohibit 

pension plan investment in hedge funds or private equity. 

The Federal 

Government Does Not 

Specifically Limit or 

Monitor Private 

Sector Plans’ 

Investments in Hedge 

Funds and Private 

Equity, but Some 

States Do So for 

Public Sector Plans 

through Various

Approaches 

Page 40 GAO-08-692 Defined Benefit Pension Plans
Although ERISA governs the investment practices of private sector 

pension plans, neither federal law nor regulation specifically limit pension 

investment in hedge funds or private equity. Instead, ERISA requires that 

plan fiduciaries apply a prudent man standard, including diversifying 

assets and minimizing the risk of large losses. The prudent man standard 

does not explicitly prohibit investment in any specific category of 

investment.53 Further, an unsuccessful individual investment is not 

considered a per se violation of the prudent man standard, as it is the plan 

fiduciary’s overall management of the plan’s portfolio that is evaluated 

under the standard.54 In addition, the standard focuses on the process for 

making investment decisions, requiring documentation of the investment 

decisions, due diligence, and ongoing monitoring of any managers hired to 

invest plan assets. 

The Federal Government 

Does Not Specifically Limit 

or Monitor Pension Plans’ 

Investments in Hedge 

Funds or Private Equity 

nor Has It Provided 

Recommended Guidance 

Although there are no specific federal limitations on pension plan 

investments in hedge funds, two federal advisory committees have, in

recent years, highlighted the importance of developing best practices in 

hedge fund investing. In November 2006, the ERISA Advisory Council 

 53However, ERISA may indirectly limit a pension plan’s ability to invest in specific hedge 

funds or private equity funds. Under Labor’s plan asset regulation, if the aggregate 

investment by benefit plan investors in the equity interest of a particular entity is 

“significant,” and that equity interest is not (i) a publicly-offered security, (ii) issued by a

registered investment company, such as a mutual fund, nor (iii) issued by an operating

company, then the assets of that entity are deemed assets of each benefit plan investor (i.e., 

plan assets). See 29 C.F.R. § 2510.3-101 (2007). As a result, any person who exercises 

management authority over the entity now deemed to hold plan assets will become subject 

to ERISA’s fiduciary standards. The equity investments by benefit plan investors are

considered “significant” if at any time the aggregate investment of the benefit plan 

investors represents 25 percent or more of the value of any class of equity in the entity. 

According to one industry expert, in order to avoid being deemed a plan fiduciary (and

assuming all of the liabilities that accompany that status), many managers of hedge funds, 

which generally are not publicly-traded, not registered investment companies, nor 

operating companies, carefully monitor the level of investments in the hedge fund by 

benefit plan investors to ensure that their aggregate investment remains below the 25

percent threshold. Prior to the Pension Protection Act of 2006 (PPA), the calculation of the 

25 percent threshold pertained to investments by ERISA plans and certain non-ERISA 

covered plans, such as public sector and foreign retirement plans. However, in accordance

with section 611(f) of the PPA, investments by certain plans, including public sector and 

foreign retirement plans, are now excluded from the calculation. Pub. L. No.109-280, § 

611(f), 120 Stat. 780, 972 (codified at 29 U.S.C. § 1002(42)). This modification may facilitate 

an increase in the level of investments by pension plans in hedge funds and private equity 

funds. 

54With some exceptions, ERISA does prohibit plans from investing more than 10 percent of

plan assets in the sponsoring company’s stock. See 29 U.S.C. § 1107. In addition to 

requiring plan fiduciaries to adhere to certain standards of conduct, ERISA also prohibits

plan fiduciaries from engaging in specified transactions. See 29 U.S.C. § 1106.

Page 41 GAO-08-692 Defined Benefit Pension Plans
recommended that Labor publish guidance describing the unique features 

of hedge funds, and matters for consideration in their adoption for use by 

qualified pension plans.55 To date, Labor has not acted on this 

recommendation. According to Labor officials, an effort to address these 

recommendations was postponed while Labor focused on implementing 

various aspects of the Pension Protection Act of 2006.56 However, in April 

2008, the Investors’ Committee established by the President’s Working 

Group on Financial Markets, composed of representatives of public and

private pension plans, endowments and foundations, organized labor, nonU.S. institutions, funds of hedge funds, and the consulting community, 

released draft best practices for investors in hedge funds.57 These best 

practices discuss the major challenges of hedge fund investing, and 

provide an in-depth discussion of specific considerations and practices 

that investors in hedge funds should take. While this guidance should 

serve as an additional tool for pension plan fiduciaries and investors to use 

when assessing whether and to what degree hedge funds would be a wise 

investment, it may not fully address the investing challenges unique to 

pension plans leaving some vulnerable to inappropriate investments in 

hedge funds. Although many private sector plans are insured by the PBGC, 

which guarantees most benefits when an underfunded plan terminates, 

public sector plans are not insured and may call upon state or local 

taxpayers to overcome funding shortfalls.58

Labor does not specifically monitor pension investment in hedge funds or

private equity. Labor annually collects information on private sector 

pension plan investments via the Form 5500, on which plan sponsors 

report information such as the plan’s operation, funding, assets, and 

investments. However, the Form 5500 includes no category for hedge 

 55The ERISA Advisory Council was created by ERISA to provide advice to the Secretary of

Labor. 29 U.S.C. § 1142. 

56The PPA is the most recent comprehensive reform of federal pension laws since the

enactment of ERISA. It establishes new funding requirements for DB pensions and includes

reforms that will affect cash balance pension plans, defined contribution plans, and 

deferred compensation plans for executives and highly compensated employees. 

57Principles and Best Practices for Hedge Fund Investors: Report of the Investors’

Committee to the President’s Working Group on Financial Markets, April 15, 2008. The

President’s Working Group on Financial Markets includes the heads of the U.S. Treasury 

Department, the Federal Reserve, the SEC, and the Commodity Futures Trading 

Commission. 

58Plan underfunding can occur for several reasons, including poor investment performance

and insufficient contributions. 

Page 42 GAO-08-692 Defined Benefit Pension Plans
funds or private equity funds, and plan sponsors may record these 

investments in various categories on the form’s Schedule H. In addition, 

because there is no universal definition of hedge funds or private equity 

and their strategies vary, their holdings can fall within many asset classes. 

While EBSA officials analyze Form 5500 data for reporting compliance 

issues—including looking for assets that are “hard to value”—they have 

not focused on hedge fund or private equity investments specifically.59

According to EBSA officials, there have been several investigations and 

enforcement actions in recent years that involved investments in hedge 

funds and private equity, but these investments have not raised significant

concerns. 

Some Selected States 

Regulate and Monitor 

Investments of Public 

Sector Plans Using Varying 

Approaches 

Our state pension plan contacts indicated that, in recent years, state 

regulation of public pension plan investments has become generally more 

flexible. According to a NASRA official, state regulation of public pension 

plan investments has gradually become less restrictive and more reliant on

fiduciary prudence standards.60 This official noted that, for example, 

blanket prohibitions on investments such as international stocks or real 

estate have given way to permission for a wider range of investments. 

Some of our state contacts described this shift over time from a 

prescriptive list of authorized investments (“legal lists”) and asset 

allocation limits to a more flexible approach, such as adoption of the 

prudent man standard. 

Of the state pension plan officials we contacted in 11 states, officials in 7

states indicated that applicable state law imposes restrictions on the 

ability of public pension plans to invest in hedge funds and/or private 

equity, as seen in table 2.61 Among these seven states, the restriction may 

be in the form of (i) a provision applicable to investments in hedge funds 

 59“Hard to value” assets are those that are not traded on an exchange. “Hard to value”

assets may include hedge funds, private equity funds, and real estate. It is difficult to 

distinguish the type of investment with the information provided. Federal agency officials 

use the Form 5500 report data to enforce ERISA pension requirements, monitor plan 

compliance, develop aggregate pension statistics, and conduct policy and economic 

research. 

60NASRA is a non-profit association whose members are the directors of the nation’s state 

and territorial public retirement systems.

61We contacted the 10 states with the largest amount of public pension assets under 

management, as well as Massachusetts, because that state provided valuable information 

during our initial work. Our methodology is discussed in greater detail in appendix I. 

Page 43 GAO-08-692 Defined Benefit Pension Plans
or private equity funds specifically, (ii) an exclusive list of permissible of 

investments that is not likely to capture hedge funds or private equity 

investments, or (iii) a provision that restricts investments in certain 

categories of assets that, because of the typical structure or investment 

strategy of hedge funds or private equity funds, are likely to apply to 

investments in such funds.62

Table 2: Restrictions on Pension Investments in Hedge Funds and Private Equity 

Identified by Plan Officials in 11 Selected States 

State Hedge funds Private equity 

California

Florida X X

Illinois X X

MassachusettsaX X

New Jersey X X 

New York X X 

North Carolina X X 

Ohio

Pennsylvania

Texas X

Wisconsin

Source: GAO analysis based on information provided by state officials. 

a

Restrictions identified in Massachusetts are based on administrative policy adopted by its Public 

Employees Retirement Administration Commission, which is generally responsible for oversight of 

public pension systems in the state, rather than on statute or regulation. 

Some of the selected states have, through statute or regulation, established 

explicit limitations on the amount that pension plans can invest in hedge 

funds or private equity. For example, under Texas law, the Teacher 

Retirement System of Texas (TRS)—the largest public pension plan in 

Texas—is statutorily limited to investing no more than 5 percent of the 

 62Restrictions applicable across various plans were identified through conversations with 

relevant officials in each state, except North Carolina. In addition, individual plans may 

have their own restrictions adopted by plan boards or staff. In some states, state 

restrictions apply quite broadly, and in others, the restrictions apply to a more narrow

range of plans or public plan assets, therefore the existence of a restriction in a state does 

not necessarily indicate that the restriction exists for every public plan in the state. 

Page 44 GAO-08-692 Defined Benefit Pension Plans
plan’s total assets in hedge funds.63 According to a Texas Pension Review 

Board official, the statute codified TRS’s ability to invest in hedge funds 

while at the same time limiting the amount TRS can invest in hedge funds. 

According to a TRS official, this law was a compromise between TRS’s 

desire to invest more broadly in hedge funds and some state legislators 

who were concerned about the possible risks of hedge funds.64 Other 

states we reviewed have comparable limitations for public plans. 

The Commonwealth of Massachusetts’ Public Employee Retirement 

Administration Commission (PERAC) has established a detailed set of 

limitations and guidance, with particular limitations on smaller public 

plans. In Massachusetts, public plans with less than $250 million in assets 

may not invest in hedge funds directly, but they may invest through a statemanaged hedge fund investment pool (see table 3). According to a PERAC 

official, this limitation exists because hedge funds are relatively new 

investments for pension plans and because they require high levels of due

diligence and expertise that may be excessive for smaller plans. PERAC 

also limits and offers guidance to larger public plans, emphasizing 

diversification, to help limit a plan’s exposure to potential losses from 

hedge fund failures. According to a PERAC official, the group is less strict 

about private equity investments because private equity is a more familiar 

asset class among the state’s public plans. Public plans with less than $25 

million in assets may invest up to three percent of assets in private equity 

and plans with more than $25 million may invest up to 5 percent of assets 

in private equity. PERAC requires plans of either size to obtain PERAC 

permission before investing in private equity above those levels. 

 63See Tex. Gov. Code Ann. § 825.3012. For purposes of this Texas state law restriction, 

“hedge fund” is defined as a private investment vehicle that (i) is not registered under an

investment company act, (ii) issues securities only to accredited investors or qualified 

purchasers under an exemption from registration, and (iii) engages primarily in the

strategic trading of securities and other financial instruments. 

64According to TRS officials, no other public funds in Texas are, by state law, under explicit 

restrictions regarding hedge fund or private equity investments. 

Page 45 GAO-08-692 Defined Benefit Pension Plans
Table 3: Massachusetts Policies on Public Plan Investments in Hedge Funds

Plans with less than $250 million Plans with greater than $250 million 

• May invest in hedge funds only

through the state’s common 

hedge fund vehicle 

• May not invest more than 10

percent of assets in hedge funds 

• May not invest more than 10 percent of assets

in hedge funds

• May only invest in hedge funds through funds

of funds 

• May only invest in hedge fund products whose 

performance is not influenced by market 

movements 

• No single fund of funds may account for more

than 2 percent of assets 

• Hedge fund investments should be invested 

through a minimum of 75 separate underlying 

hedge funds 

• The market value of any single underlying 

hedge fund investment should not exceed 2.5 

percent of the total hedge fund investment 

• A fund of hedge funds’ volatility should not be

greater than 7.5 percent 

• Funds of hedge funds must provide reasonable 

transparency and disclosure 

• Funds registered with SEC are to be preferred 

Source: Commonwealth of Massachusetts Public Employee Retirement Administration Commission Guidelines for Hedge Fund 

Investment. 

Some of the selected states have instituted “legal lists” of authorized 

investments for pension plans that do not specifically include investments 

in hedge funds or private equity funds as authorized assets. According to a 

NASRA official, this was the dominant regulatory approach of state 

pension investment 40 years ago, and while some states have moved away

from this approach, others have continued to maintain legal lists. Illinois 

has established a legal list of assets that does not include interests in 

hedge funds or private equity funds, in which certain smaller plans that 

cover police officers and fire fighters are authorized to invest.65 Large 

statewide plans, such those managed by the Illinois State Board of 

Investment, are governed by a prudent man standard, which does not 

explicitly restrict investment of pension assets in any particular 

investment. In some instances, states allow a certain percentage of plan

assets to be invested in assets that do not qualify under one of the 

authorized categories on the legal list. For example, the New York State 

Common Retirement Fund is governed by a legal list, but the state allows 

 65See Ill. Comp. Stat. Ann. 5/1-113.1. 

Page 46 GAO-08-692 Defined Benefit Pension Plans
the plan to invest up to 25 percent of its assets in investments not 

otherwise permitted by the legal list.66

Finally, public pension plan investments in hedge funds are prohibited or 

limited in some states by laws restricting pension plan investment in 

certain investment vehicles or trading strategies. For example, the North 

Carolina Retirement system can not invest more than 10 percent of plan 

assets in limited partnerships or limited liability corporations. Similarly, 

before new legislation broadening investment authority went into effect in

April 2008, the Wisconsin Retirement System could not invest assets in 

vehicles that trade options or engage in short selling, two techniques 

commonly used by hedge funds.67 However, with the new statutory 

authority, the Wisconsin Retirement System may use any investment 

strategy that meets its prudent investor standard.68

States we contacted take a variety of approaches to overseeing and 

monitoring public pension plan investment. In Massachusetts, before 

conducting a hedge fund manager search, public plans must first obtain 

PERAC approval and provide the agency with a summary of the plan’s 

objectives, strategies, and goals in hedge fund investing. PERAC requires 

pension plans to document the major due diligence steps taken in the 

hedge fund manager selection process. In addition, prospective hedge fund 

managers must submit detailed information to PERAC regarding their key 

personnel, assets under management, investment strategy and process, 

risk controls, past performance, and organizational structure. Finally, 

hedge fund managers must also submit quarterly performance and strategy 

review reports directly to PERAC. Officials in other states we contacted 

may review hedge fund and private equity investments as part of a broader 

oversight approach. For example, the Ohio Retirement Study Council 

reviews the five large statewide public retirement funds semiannually to 

evaluate a plan’s investment policies and objectives, asset allocations 

 66Assets invested under the basket provision are still subject to the prudent investor 

standard. 

67The Wisconsin Retirement System is a consolidated system that covers all state, local, and 

school district employees, with the exception of the city and county of Milwaukee. Short

selling is the selling of a security that the seller does not own, or any sale that is completed 

by the delivery of a security borrowed by the seller. Short sellers assume that they will be 

able to buy the stock at a lower amount than the price at which they sold short. Selling 

short is the opposite of going long. That is, short sellers make money if the stock goes

down in price.

682008 Wis. Sess. Laws. 212. 

Page 47 GAO-08-692 Defined Benefit Pension Plans
decisions, and risk and return assumptions. In California, individual 

pension boards have sole and exclusive authority over investment 

decisions; however, they ensure public information on investment 

decisions and fund performance, including detailed reports of alternative 

investments, are publicly available. 

Available data indicate that pension plans have increasingly invested in 

hedge funds and have continued to invest in private equity to complement 

their traditional investments in stocks and bonds. Further, these data 

indicate that individual plans’ hedge fund or private equity investments 

typically comprise a small share of total plan assets. However, data are 

generally not available on the extent to which smaller pension plans have

made such investments. Because such investments require a degree of 

fiduciary effort well beyond that required by more traditional investments, 

this can be a difficult challenge for plans, especially smaller plans. Smaller 

plans may not have the expertise or financial resources to be fully aware 

of these challenges, or have the ability to address them through 

negotiations, due diligence, and monitoring. In light of this, such 

investments may not be appropriate for some pension plans. 

Conclusions 

Although plans are responsible for making prudent choices when investing 

in any asset, EBSA also has a role in helping to ensure that pension plan 

sponsors fulfill their fiduciary duties in managing pension plans that are 

subject to ERISA. This can include educating employers and service 

providers about their fiduciary responsibilities under ERISA. Many private 

sector plans are insured by the PBGC, which guarantees most benefits 

when an underfunded plan terminates; however, public sector plans are 

not insured and may call upon state or local taxpayers to overcome 

funding shortfalls. 

The importance of educating investors about the special challenges 

presented by hedge funds has been recognized by a number of 

organizations. For example, in 2006, the ERISA Advisory Council 

recommended that Labor publish guidance about the unique features of 

hedge funds and matters for consideration in their use by qualified plans. 

To date, EBSA has not acted on this recommendation. More recently, in

April 2008, the Investors’ Committee formed by the President’s Working 

Group on Financial Markets published draft best practices for investors in 

hedge funds. This guidance will be applicable to a broad range of 

investors, such as public and private pension plans, endowments, 

foundations, and wealthy individuals. EBSA can further enhance the 

usefulness of this document by ensuring that the guidance is interpreted in

Page 48 GAO-08-692 Defined Benefit Pension Plans
light of the fiduciary responsibilities that ERISA places on private sector 

plans. For example, EBSA could outline the implications of a hedge fund’s 

or fund of funds’ limited transparency on the fiduciary duty of prudent 

oversight. EBSA can also reflect on the implications of these best practices 

for some plans—especially smaller plans—that might not have the 

resources to take actions consistent with the best practices, and thus 

would be at risk of making imprudent investments in hedge funds. While 

EBSA is not tasked with offering guidance to public sector plans, such 

plans may nonetheless benefit from such guidance. 

To ensure that all plan fiduciaries can better assess their ability to invest in

hedge funds and private equity, and to ensure that those that choose to 

make such investments are better prepared to meet these challenges, we

recommend that the Secretary of Labor provide guidance specifically

designed for qualified plans under ERISA. This guidance should include 

such things as (1) an outline of the unique challenges of investing in hedge 

funds and private equity; (2) a description of steps that plans should take 

to address these challenges and help meet ERISA requirements; and (3) an

explanation of the implications of these challenges and steps for smaller 

plans. In doing so, the Secretary may be able to draw extensively from 

existing sources, such as the finalized best practices document that will be 

published in 2008 by the Investors’ Committee formed by the President’s 

Working Group on Financial Markets.69 

We provided a draft copy of this report to the Department of Labor, PBGC, 

the Department of the Treasury, the SEC, and the Federal Reserve Bank 

for their review and comment. Labor generally agreed with our findings 

and recommendation. With regard to our recommendation, Labor stated 

that providing more specific guidance on investments in hedge funds and 

private equity may present challenges. Specifically, Labor noted that given 

the lack of uniformity among hedge funds, private equity funds, and their

underlying investments, it may prove difficult to develop comprehensive 

and useful guidance for plan fiduciaries. Nonetheless, Labor agreed to 

consider the feasibility of developing such guidance. Labor’s formal 

comments are reproduced in appendix III. 

Recommendation for 

Executive Action 

Agency Comments 

and Our Evaluation 

 69A draft version of this report, Principles and Best Practices for Hedge Fund Investors: 

Report of the Investors’ Committee to the President’s Working Group on Financial

Markets, was published on April 15, 2008.

Page 49 GAO-08-692 Defined Benefit Pension Plans
We agree that the lack of uniformity among hedge funds or private equity 

funds may pose challenges to Labor. However, we do not believe it will be 

an insurmountable obstacle to developing guidance for plan sponsors. 

Indeed, the lack of uniformity among hedge funds and private equity funds

is itself an important issue to convey to fiduciaries, and highlights the need

for an extensive due diligence process preceding any investment. 

Additionally, as we state in the recommendation, Labor’s efforts can be 

facilitated through use of existing best practices documents, such as the 

best practices for investors in hedge funds document that will be 

published in the summer of 2008 by the Investors’ Committee formed by 

the President’s Working Group on Financial Markets. 

The PBGC also provided formal comments, which are reproduced in 

appendix IV. PBGC generally concurred with our findings. Labor, PBGC, 

the Department of the Treasury, and the Federal Reserve Bank also 

provided technical comments and corrections, which we have 

incorporated where appropriate. 

As arranged with your offices, unless you publicly announce its contents 

earlier, we plan no further distribution of this report until 30 days from the 

date of this letter. At that time, we will send copies of this report to 

interested congressional committees and members, federal agencies, and

other interested parties. We will also make copies available to others upon 

request. 

Page 50 GAO-08-692 Defined Benefit Pension Plans
If you or your staff has any questions concerning this report, please 

contact Barbara Bovbjerg on (202) 512-7215 or Orice Williams on (202) 

512-8678. Contact points for our Office of Congressional Relations and 

Office of Public Affairs can be found on the last page of this report. Key 

contributors are listed in appendix V.

Barbara D. Bovbjerg 

Director, Education, Workforce and

 Income Security 

Orice M. Williams 

Director, Financial Markets and 

 Community Investment 

Page 51 GAO-08-692 Defined Benefit Pension Plans
List of Congressional Requesters 

The Honorable Max Baucus 

Chairman 

The Honorable Charles E. Grassley 

Ranking Member 

Committee on Finance 

United States Senate 

The Honorable Charles B. Rangel 

Chairman 

The Honorable Jim McCrery 

Ranking Member 

Committee on Ways and Means 

House of Representatives 

The Honorable Barney Frank 

Chairman 

Committee on Financial Services 

House of Representatives 

The Honorable Michael E. Capuano

House of Representatives 

The Honorable Paul E. Kanjorski 

House of Representatives 

Page 52 GAO-08-692 Defined Benefit Pension Plans
Appendix I: Objectives, Scope, and Appendix I: Objectives, Scope, and Methodology 

Methodology 

Our objectives were to address the following questions: 

1. To what extent do public and private sector pension plans invest in 

hedge funds and private equity funds? 

2. What are the potential benefits, risks, and challenges pension plans 

face in making hedge fund investments, and how do plans address the 

risks and challenges? 

3. What are the potential benefits, risks, and challenges pension plans 

face in making private equity fund investments, and how do plans 

address the risks and challenges? 

4. What mechanisms regulate and monitor pension plan investments in 

hedge funds and private equity funds? 

To answer the first question, we obtained and analyzed survey data of

private and public sector defined benefit (DB) plans on the extent of plan

investments in hedge funds and private equity from three private 

organizations: Greenwich Associates, Pensions & Investments, and 

Pyramis Global Advisors.1

 We identified the three surveys through our 

literature review and interviews with plan representatives and industry 

experts. As seen in table 4, the surveys varied in the number and size of 

plans surveyed. Using the available survey data, we determined the 

percentage of plans surveyed that reported investments in hedge funds or

private equity. Using data from Greenwich Associates, we also determined 

the percentage of plans surveyed that invested in hedge funds or private 

equity by category of plan size, measured by total plan assets. We further 

examined data from each survey on the size of allocations to hedge funds 

or private equity as a share of total plan assets. Using the Pensions & 

Investments data, we analyzed allocations to these investments for 

individual plans and calculated the average allocation for hedge funds and 

private equity, separately, among all plans surveyed that reported these 

investments. The Greenwich Associates and Pyramis data reported the 

size of allocations to hedge funds or private equity as an average for all

plans surveyed. Through our research and interviews, we were not able to

 1

Greenwich Associates is an institutional financial services consulting and research firm;

Pyramis Global Advisors, a division of Fidelity Investments, is an institutional asset 

management firm; and Pensions & Investments is a money management industry 

publication. 

Page 53 GAO-08-692 Defined Benefit Pension Plans
Appendix I: Objectives, Scope, and 

Methodology 

identify any relevant surveys that included plans with less than $200 

million in total assets. 

While the information collected by each of the surveys is limited in some 

ways, we conducted a data reliability assessment of each survey and 

determined that the data were sufficiently reliable for purposes of this 

study. These surveys did not specifically define the terms hedge fund and 

private equity; rather, respondents reported allocations based on their own 

classifications. Pensions & Investments reported private equity in three 

mutually-exclusive categories—buyout, venture capital, and an “other” 

private equity category, which includes investments such as mezzanine 

financing and private equity investments traded on the secondary market. 

Data from all three surveys are reflective only of the plans surveyed and 

cannot be generalized to all plans. 

Table 4: Number and Size of DB Plans Observed in Recent Surveys 

Greenwich

Associates (2006) 

Pensions & 

Investments (2007) 

Pyramis Global 

Advisors (2006) 

Sample size 584 DB plans 133 DB plans 214 DB plans 

Total assets of plans 

in survey 

$3.649 trillion $4.4 trillion n/a 

Range of total plan 

assets 

$250 million or more >$1 billion or more >$200 million 

Source: GAO analysis.

Note: Pensions & Investments surveyed the largest 200 plans, ranked by combined DB and defined 

contribution (DC) plan assets. With one exception, all DB plans ranked in the top 200 plans had more 

than $1 billion in total assets. Of the top 200 plans, 133 were DB plans that completed the survey and 

provided asset allocation information. 

To answer the second and third questions, we conducted in-depth 

interviews with representatives of 26 private and public sector DB plans, 

listed in table 5, from June 2007 to January 2008 and, where possible, 

obtained and reviewed supporting documentation. Interviews related to 

hedge fund investments were conducted from June 2007 to December 

2007. Interviews related to private equity investments were conducted 

from October 2007 to January 2008. The interviews with plan 

representatives were conducted using a semi-structured interview format, 

which included open-ended questions on the following topics, asked 

separately about hedge funds or private equity: the plan’s history of 

investment in hedge funds or private equity; the plan’s experiences with 

these investments to date; the plan’s expected benefits from these 

investments; challenges the plan has faced with these investments; and 

Page 54 GAO-08-692 Defined Benefit Pension Plans
Appendix I: Objectives, Scope, and 

Methodology 

steps the plan has taken to mitigate these challenges, including due 

diligence and ongoing monitoring. We interviewed five plans that did not 

invest in hedge funds to discuss the reasons the plan decided not have 

such investments. We also interviewed officials of government agencies, 

relevant industry organizations, investment consulting firms, and other 

national experts listed in appendix II. In addition, we interviewed officials 

from the Arizona State Retirement System and Missouri Local Government 

Employees’ Retirement System to discuss the recent decision of these 

plans to invest in private equity. 

Table 5: List of DB Plans for In-Depth Interviews 

Hedge fund 

interview

Private equity

interview

Private sector plans: 

American Airlines √

Boeing √

Exxon Mobil √

GE Asset Management √

International Association of Machinists 

National Pension Fund 

√

John Deere √

Macy’s √

Northrop Grumman √

Prudential √

Target √

United Mine Workers of America 

Health and Retirement Funds

√ √

United Technologies √

Walt Disney √ √

Public sector plans: 

California Public Employees’ 

Retirement System 

√ √

California State Teachers’ Retirement 

System 

√ √

Illinois State Board of Investments √

Los Angeles County Employee

Retirement Administration 

√

Massachusetts Pension Reserves 

Investment Management Board 

√

Missouri State Employees’ Retirement 

System 

√

Page 55 GAO-08-692 Defined Benefit Pension Plans
Appendix I: Objectives, Scope, and 

Methodology 

Hedge fund 

interview

Private equity

interview

National Railroad Retirement Trust 

Fund 

√

New York State Common Retirement 

Fund 

√ √

Pennsylvania Public School 

Employees’ Retirement System 

√ √

Pennsylvania State Employees’ 

Retirement System 

√ √

San Diego County Employees’

Retirement System 

√

South Dakota Retirement System √

Washington State Investment Board √

Source: GAO.

Note: Five of the plans interviewed about hedge funds did not invest in hedge funds.

The plans we interviewed were selected based on several criteria. We 

attempted to select plans that varied in the size of allocations to hedge

funds and private equity as a share of total plan assets. We also attempted 

to select plans with a range of total plan assets, as outlined in table 6. We

identified these plans using data from the Pensions & Investments 2006 

survey and through our interviews with industry experts. 

Table 6: Criteria Used in Selection of Plans for In-Depth Interviews 

Number of plans 

interviewed – hedge funds 

Number of plans 

interviewed – private 

equity

Size of allocation to hedge 

funds or private equity: 

 None 5 

 5% or less 10 5

 >5 to 10% 3 6

 >10% 2 2

Total plan assets: 

 $10 billion or less 8 5

 >$10 to $100 billion 9 5

 >$100 billion 3 3

Source: GAO analysis of Pension & Investments 2006 survey. 

To identify and analyze the regulation of public DB pension investments 

by states we consulted officials at the Department of Labor and 

Page 56 GAO-08-692 Defined Benefit Pension Plans
Appendix I: Objectives, Scope, and 

Methodology 

representatives of relevant agencies in selected states, and reviewed 

relevant policy documents. The states we selected included the 10 states 

with the largest public pension assets according to our review of the 

National Association of State Retirement Administrators (NASRA) Public 

Funds Survey data listed in table 7. We also included Massachusetts 

because our previous contact with that state produced valuable

information for this objective.2

 Those states chosen based on the size of 

plan assets were: California, New York, Texas, Ohio, Florida, Illinois, 

Pennsylvania, New Jersey, Wisconsin, and North Carolina. In 9 of 10 states

we spoke with the offices of the State Auditor, the State Treasurer, and the 

State Comptroller or equivalent offices. North Carolina’s Chief Investment 

Officer of the State Treasurer’s Office affirmed our analysis through email. Finally we informed each of these states of our analysis and gave 

them the opportunity to comment on our description of regulations in 

their state. 

Table 7: Ten States with the Largest Total Public DB Pension Plan Assets 

(Dollars in billions) 

Rank State

Sum of market value for state’s public 

plan assets

1 California $417.4

2 New York 301.9

3 Texas 156.3

4 Ohio 147.3

5 Florida 116.3

6 Illinois 96.0

7 Pennsylvania 90.1

8 New Jersey 79.3

9 Wisconsin 67.9

10 North Carolina 66.7

Source: GAO analysis of NASRA Public Funds Survey 2007 data. 

We conducted this performance audit from June 2007 to July 2008, in 

accordance with generally accepted government auditing standards. Those 

standards require that we plan and perform the audit to obtain sufficient, 

appropriate evidence to provide a reasonable basis for our findings and 

conclusions based on our audit objectives. We believe that the evidence 

 2

Massachusetts ranks 20th with $32.4 billion in public pension plan assets, according to the 

2007 Public Funds Survey. 

Page 57 GAO-08-692 Defined Benefit Pension Plans
Appendix I: Objectives, Scope, and 

Methodology 

obtained provides a reasonable basis for our findings and conclusions 

based on our audit objectives. 

Page 58 GAO-08-692 Defined Benefit Pension Plans
Appendix II: Government Agencies, Industry

Organizations, Investment Consulting Firms, Appendix II: Government Agencies, Industry and Other Organizations Interviewed 

Organizations, Investment Consulting Firms, 

and Other Organizations Interviewed 

Government agencies 

Department of Treasury 

Department of Labor, Employee Benefit Security Administration 

Board of Governors of the Federal Reserve System 

Pension Benefit Guaranty Corporation 

Securities and Exchange Commission 

Hedge fund and private equity industry organizations 

Managed Funds Association 

National Venture Capital Association (NVCA) 

Private Equity Council (PEC) 

Investment consulting firms 

Cambridge Associates 

Cliffwater, LLC 

Fiduciary Counselors 

McCarter & English, LLP 

Mercer Associates 

Offices of Wilkie, Farr, and Gallagher, LLP 

Pension Governance, LLC 

Other industry organizations 

American Benefits Council (ABC) 

American Federation of Labor and Congress of Industrial Organizations 

(AFL-CIO) 

American Federation of State, County, and Municipal Employees 

(AFSCME)

Committee on the Investment of Employee Benefit Assets (CIEBA) 

Financial Policy Forum 

National Association of State Retirement Administrators (NASRA) 

North American Securities Administrators Association (NASAA) 

National Conference of State Legislatures (NCSL) roundtable: 

National Association of Police Organizations (NAPO) 

National Conference on Public Employee Retirement Systems 

 (NCPERS) 

National Association of State Treasurers 

National Association of Counties (NACo) 

Grand Lodge Fraternal Order of Police 

Page 59 GAO-08-692 Defined Benefit Pension Plans
Appendix II: Government Agencies, Industry

Organizations, Investment Consulting Firms, 

and Other Organizations Interviewed 

National Association of State Auditors, Comptrollers, and Treasurers 

(NASACT) 

National Education Association (NEA) 

National Council on Teacher Retirement (NCTR) and California Public 

 Employees’ Retirement System 

National Conference of State Legislatures (NCSL) 

National Association of State Retirement Administrators (NASRA) 

Page 60 GAO-08-692 Defined Benefit Pension Plans
Appendix III: Comments from the Department Appendix III: Comments from the of Labor 

Department of Labor 

Page 61 GAO-08-692 Defined Benefit Pension Plans
Appendix III: Comments from the Department 

of Labor 

Page 62 GAO-08-692 Defined Benefit Pension Plans
Appendix IV: Comments from the Pension Appendix IV Benefit Guaranty Corporation : Comments from the Pension 

Benefit Guaranty Corporation 

Page 63 GAO-08-692 Defined Benefit Pension Plans
Appendix IV: Comments from the Pension

Benefit Guaranty Corporation 

Page 64 GAO-08-692 Defined Benefit Pension Plans
A

A

ppendix V: GAO Contacts and Staff 

cknowledgments 

Page 65 GAO-08-692

Appendix V: GAO Contacts and Staff 

Acknowledgments 

Barbara D. Bovbjerg (202) 512-7215 or bovbjergb@gao.gov

Orice M. Williams (202) 512-8678 or williamso@gao.gov

David Lehrer, Assistant Director, and Michael Hartnett managed this 

report. Sharon Hermes, Angela Jacobs, and Ryan Siegel made important 

contributions throughout this assignment. 

Joseph A. Applebaum, Joe Hunter, Ashley McCall, Jay Smale Jr., Jena 

Sinkfield, Frank S. Synowiec, Karen Tremba, Rich Tsuhara, Charlie 

Willson, and Craig Winslow also provided key support. 

Defined Benefit Pension Plans

GAO Contacts 

Staff 

Acknowledgments 

(130664) 
GAO’s Mission The Government Accountability Office, the audit, evaluation, and 

investigative arm of Congress, exists to support Congress in meeting its 

constitutional responsibilities and to help improve the performance and 

accountability of the federal government for the American people. GAO 

examines the use of public funds; evaluates federal programs and policies; 

and provides analyses, recommendations, and other assistance to help

Congress make informed oversight, policy, and funding decisions. GAO’s 

commitment to good government is reflected in its core values of 

accountability, integrity, and reliability. 

The fastest and easiest way to obtain copies of GAO documents at no cost

is through GAO’s Web site (www.gao.gov). Each weekday, GAO posts 

newly released reports, testimony, and correspondence on its Web site. To

have GAO e-mail you a list of newly posted products every afternoon, go 

to www.gao.gov and select “E-mail Updates.” 

The first copy of each printed report is free. Additional copies are $2 each. 

A check or money order should be made out to the Superintendent of 

Documents. GAO also accepts VISA and Mastercard. Orders for 100 or 

more copies mailed to a single address are discounted 25 percent. Orders 

should be sent to: 

U.S. Government Accountability Office 

441 G Street NW, Room LM 

Washington, DC 20548 

To order by Phone: Voice: (202) 512-6000 

TDD: (202) 512-2537 

Fax: (202) 512-6061 

Contact: 

Web site: www.gao.gov/fraudnet/fraudnet.htm

E-mail: fraudnet@gao.gov

Automated answering system: (800) 424-5454 or (202) 512-7470 

Ralph Dawn, Managing Director, dawnr@gao.gov, (202) 512-4400 

U.S. Government Accountability Office, 441 G Street NW, Room 7125 

Washington, DC 20548 

Chuck Young, Managing Director, youngc1@gao.gov, (202) 512-4800 

U.S. Government Accountability Office, 441 G Street NW, Room 7149 

Washington, DC 20548 

Obtaining Copies of 

GAO Reports and 

Testimony

Order by Mail or Phone 

To Report Fraud,

Waste, and Abuse in 

Federal Programs 

Congressional 

Relations 

Public Affairs 

PRINTED ON RECYCLED PAPER