Defined Benefit Pension Plans: Guidance Needed to Better Inform Plans of the Challenges and Risks of Investing in Hedge Funds and Private Equity
Published: 2008-08-14T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: 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.
section_title: What GAO Found
paragraphs: 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 resourcesbeyond 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.

section_title: Letter
paragraphs: Millions of Americans rely on defined benefit pension plans for their  financial well-being after their working years. 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. 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  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  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.
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.
subsections: section_title: Background
paragraphs: 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 long- term returns at the risk of considerable volatility, that is, the likelihood of  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. 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. 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.
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.
subsections: section_title: Hedge Funds Use Broad Range of Investment Strategies to Achieve Desired Return
paragraphs: 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.
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  market. 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, Securities  Exchange Act of 1934, Investment Company Act of 1940, and Investment  Advisers Act of 1940 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.
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.
section_title: Private Equity Funds Obtain Returns from Manager Skill and Investing Capital in a Limited Number of Private Firms
paragraphs: 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.
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  specializing further in terms of industry or geographical area. 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.
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.
section_title: 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
paragraphs: 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.
subsections: section_title: Investments in Hedge Funds and Private Equity Typically Comprise a Small Share of Total Plan Assets
paragraphs: 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. 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.
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). 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  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.
section_title: While More Pension Plans Invest in Private Equity, the Number of Plans with Investments in Hedge Funds Has Experienced Greater Growth in Recent Years
paragraphs: 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 large- size plans, held investments in hedge funds as of 2006, according to data  from Greenwich Associates and Pyramis. 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. Nearly half—8 out of  17—of collectively bargained plans surveyed invested in hedge funds.
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  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.
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. 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  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. 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.
section_title: Investments in Hedge Funds and Private Equity Are More Commonplace among Larger Pension Plans
paragraphs: 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. 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).
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. 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.
section_title: Pension Plans Seek Various Investment Objectives through Hedge Funds, and Such Investments Pose Challenges That Require Considerable Effort and Expertise to Address
paragraphs: 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.
subsections: section_title: Broad Market Events and a Desire for Specific Benefits Have Driven Pension Plans’ Allocations to Hedge Funds
paragraphs: 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,  and questioned whether such managers delivered returns that justified the  fees the managers’ charge.
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.  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 long- term 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  results. 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.
section_title: Hedge Funds Pose Significant Challenges and Risks, Beyond Those Posed by Traditional Investments
paragraphs: 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.
subsections: section_title: Investment Risks
paragraphs: 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.
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. For example, hedge fund managers may seek to  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 long- term. 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.
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. 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. 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. Concerns about leverage were cited by several pension  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.
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.
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. 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  invest in hedge funds. 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.
section_title: Liquidity Limitations
paragraphs: 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.
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. 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. Further, the study noted that contracts can delegate immense  discretionary authority to the hedge fund manager to change conditions  and rules.
section_title: Operational Risk
paragraphs: 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.  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.
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,  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.
section_title: Addressing the Challenges and Risks of Hedge Fund Investing Requires Considerable Effort and Expertise
paragraphs: 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.
subsections: section_title: Clear Investment Purpose and Strategy
paragraphs: 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.
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.
section_title: Identification and Negotiation of Important Investment Terms
paragraphs: 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.
section_title: Due Diligence and Monitoring
paragraphs: 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.
section_title: Investing Via Funds of Hedge Funds
paragraphs: 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  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. 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.
section_title: Some Pension Plans May Not Be Able to Meet the Demands of Hedge Fund Investing
paragraphs: 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.
section_title: Private Equity Investments May Provide Important Benefits, but Pension Plans Face Limited Access to Top- Performing Funds and Other Challenges
paragraphs: 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.
subsections: section_title: Plans Have Long Investment History in Private Equity and Primarily Seek Returns Superior to Those Attained in the Stock Market
paragraphs: 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. 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 well- established and proven asset class compared to other alternative  investments, such as hedge funds.
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.
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. 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.
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.
section_title: Pension Plans Face Several Challenges and Risks When Investing in Private Equity
paragraphs: 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.
subsections: section_title: Investment Risk
paragraphs: 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. 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.
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. In addition, the returns of a private equity  fund are also affected by the condition of the market when the underlying  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.
section_title: Variation of Performance among Private Equity Funds
paragraphs: 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. 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.
section_title: Long-Term Commitment of Private Equity Funds
paragraphs: 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  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. 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 longer- term 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.
section_title: Valuation of Private Equity Fund Investments
paragraphs: 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. In some cases private equity  funds estimate the value of the fund by comparing companies in their  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.
section_title: Taking Steps to Address the Challenges and Risks of Investing in Private Equity May Be Too Costly and Complex for Some Plans
paragraphs: 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 top- performing 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. 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.
subsections: section_title: Selection of Private Equity Fund Investments
paragraphs: 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 top- performing 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.
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. 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.
section_title: Diversification
paragraphs: 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.
section_title: Planning for Liquidity Needs
paragraphs: 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.
section_title: Negotiation of Key Terms of the Investment Contract
paragraphs: 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.
section_title: Due Diligence and Ongoing Monitoring
paragraphs: 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. 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.
section_title: Funds of Private Equity Funds
paragraphs: 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 top- performing 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.
section_title: 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
paragraphs: 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.
subsections: section_title: The Federal Government Does Not Specifically Limit or Monitor Pension Plans’ Investments in Hedge Funds or Private Equity nor Has It Provided Recommended Guidance
paragraphs: 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. 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. 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.
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  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. 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. 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, non- U.S. institutions, funds of hedge funds, and the consulting community,  released draft best practices for investors in hedge funds. 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.
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  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.  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.
section_title: Some Selected States Regulate and Monitor Investments of Public Sector Plans Using Varying Approaches
paragraphs: 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. 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. Among these seven states, the restriction may  be in the form of (i) a provision applicable to investments in hedge funds  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.
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  plan’s total assets in hedge funds. 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. 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 state- managed 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.
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. 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  the plan to invest up to 25 percent of its assets in investments not  otherwise permitted by the legal list.
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. However, with the new statutory  authority, the Wisconsin Retirement System may use any investment  strategy that meets its prudent investor standard.
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  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.
section_title: Conclusions
paragraphs: 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.
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  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.
section_title: Recommendation for Executive Action
paragraphs: 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.
section_title: Agency Comments and Our Evaluation
paragraphs: 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.
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.
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.
section_title: Appendix I: Objectives, Scope, and Methodology
paragraphs: 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. 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  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.
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  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.
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.
To identify and analyze the regulation of public DB pension investments  by states we consulted officials at the Department of Labor and  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. 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 e- mail. 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.
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.
section_title: Appendix II: Government Agencies, Industry Organizations, Investment Consulting Firms, and Other Organizations Interviewed
paragraphs: 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)
Cambridge Associates  Cliffwater, LLC  Fiduciary Counselors  McCarter & English, LLP  Mercer Associates  Offices of Wilkie, Farr, and Gallagher, LLP  Pension Governance, LLC  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  National Association of State Auditors, Comptrollers, and Treasurers  (NASACT)  National Education Association (NEA)  National Council on Teacher Retirement (NCTR) and California Public  National Conference of State Legislatures (NCSL)  National Association of State Retirement Administrators (NASRA)
section_title: Appendix III: Comments from the Department of Labor
section_title: Appendix IV: Comments from the Pension Benefit Guaranty Corporation
section_title: Appendix V: GAO Contacts and Staff Acknowledgments
subsections: section_title: GAO Contacts
section_title: Staff Acknowledgments
paragraphs: 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.