Defined Benefit Pension Plans: Recent Developments Highlight Challenges of Hedge Fund and Private Equity Investing
Published: 2012-02-16T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Millions of Americans rely on defined benefit pension plans for their financial well-being in retirement. Plan representatives are increasingly investing in a wide range of assets, including hedge funds and private equity funds. In recent years, GAO has noted that plans may face significant challenges and risks when investing in these alternative assets. These challenges and ongoing market volatility have raised concerns about how these investments have performed since 2008.
As requested, to better understand plan sponsors experiences with these investments, GAO examined (1) the recent experiences of pension plans with investments in hedge funds and private equity, including lessons learned; (2) how plans have responded to these lessons; and (3) steps federal agencies and other entities have taken to help plan sponsors make and manage these alternative investments.
To answer these questions, GAO analyzed available data; interviewed relevant federal agencies and industry experts; conducted follow-up interviews with 22 public and private pension plan sponsors selected among the top 200 plans and contacted in the course of GAOs prior related work; and surveyed 20 plan consultants, academic experts and other industry experts.
This report reemphasizes a 2008 recommendation that the Secretary of Labor provide guidance to help plans investing in hedge funds and private equity.
section_title: What GAO Found
paragraphs: While plan representatives GAO contacted generally stated that their hedge fund and private equity investments met expectations in recent years, a number of plans experienced losses and other challenges, such as limited liquidity and transparency. National data indicated that hedge fund and private equity investments were significantly affected by the 2008-2009 financial crisis, and plans and experts GAO contacted indicated that pension plan investments were not insulated from losses. Most of the 22 plan representatives GAO interviewed said that their hedge fund investments met expectations overall, despite, in some cases, significant losses during the financial crisis. A few plan representatives, however, expected hedge fund investments to be much more resilient in turbulent markets, and found the losses disappointing. Given the long-term nature of private equity investments, almost all of the representatives were generally satisfied with these investments over the last 5 years. Some plan representatives described significant difficulties in hedge fund and private equity investing related to limited liquidity and transparency, and the negative impact of the actions of other investors in the fundsometimes referred to as co-investors. For example, representatives from one plan reported they were unable to cash out of their hedge fund investments due to discretionary withdrawal restrictions imposed by the fund manager, requiring them to sell some of their stock holdings at a severe loss in order to pay plan benefits.
Most plans included in our review have taken actions to address challenges related to their hedge fund and private equity investments, including allocation reductions, modifications of investment terms, and improvements to the fund selection and monitoring process. National data reveal that plans have continued to invest in hedge funds and private equityfor example, one survey revealed that the percentage of large plans investing in hedge funds grew from 47 percent in 2007 to 60 percent in 2010and most plans GAO contacted have also maintained or increased their allocations to these investments. However, most plans have adjusted investment strategies as a result of recent years experiences. For example, three plans have reduced their allocations to hedge funds or private equity. Other plan representatives also took steps to improve investment terms, including more favorable fee structures and enhanced liquidity. However, some plan representatives and experts indicated that smaller plans would likely not be able to take some of these steps.
The Department of Labor has provided some guidance to plans regarding investing in derivatives, but has not taken any steps specifically related to hedge fund and private equity investments. In recent years, however, other entities have addressed this issue. For example, in 2009, the Presidents Working Group on Financial Markets issued best practices for hedge fund investors. Further, both GAO and a Department of Labor advisory body have recommended that the department publish guidance for plans that invest in such alternative assets. To date, it has not done so, in part because of a concern that the lack of uniformity among such investments could make development of useful guidance difficult. In 2011, the Department of Labor advisory body specifically revisited the issue of pension plans investments in hedge funds and private equity, and a report is expected in early 2012.

section_title: Letter
paragraphs: Millions of Americans rely on defined benefit pension plans for their  financial well-being in retirement. In order to pay promised retirement  benefits when due and 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.  Public and private sector pension plans have primarily invested in  traditional investments such as stocks and bonds, but plans are  increasingly investing in “alternative” investments such as hedge funds  and private equity funds.
Generally, hedge funds and private equity funds are privately organized  and managed funds that are available only to institutional investors or  wealthy individuals. Historically, both have been managed in ways that  exempt them from certain aspects of federal securities law and regulation  that apply to other investment pools such as mutual funds. However, as a  result of the Dodd-Frank Wall Street Reform and Consumer Protection  Act (Dodd-Frank Act), most hedge fund and private equity managers will  be required to register with the Securities and Exchange Commission  (SEC) and comply with new aspects of federal securities law.
Much has happened in the financial markets since GAO issued a report in  2008 examining the extent to which pension plans invest in hedge funds  and private equity. The financial market events of the second half of  2008 significantly affected hedge funds. According to a 2009 industry  survey, most hedge fund strategies produced double-digit losses in 2008,  and hedge funds saw approximately $70 billion in redemptions between  June and November 2008. Nevertheless, many of these investments  have rebounded, and a 2010 industry survey of institutional investors  suggests that these investors continue to be committed to investing in  hedge funds but with a shifting set of objectives and criteria. Private  equity investment values were also substantially lowered during this  period and have similarly recovered along with values in the public  equities market. However, given ongoing market volatility, concerns  remain about how well such investments will meet the expectations of  plan sponsors that have invested in them.
In order to assess the extent to which pension plans have realized  desired benefits from investing in hedge funds and private equity, and  actions they may have taken in response to recent experiences,  particularly given ongoing market volatility, you asked us to examine the  following questions:
What is known about the experiences of defined benefit pension plans  with investments in hedge funds and private equity, including recent  lessons learned?
How have plan sponsors responded to lessons learned from recent  experiences with such alternative investments?
What steps have federal agencies and other entities taken to help  plan sponsors make and manage investments in such alternative  assets, and what additional steps might be warranted?
To answer these questions, we reviewed relevant literature; analyzed  data; interviewed relevant federal agencies and industry experts;  conducted in-depth, follow-up interviews with pension plan sponsors  contacted in the course of our prior related work; and surveyed a selected  group of 20 plan consultants, academic experts, and other industry  experts. Specifically, we conducted in-depth, follow-up interviews with  representatives of 22 public and private sector defined benefit pension  plans that were interviewed for our 2008 report examining the extent to  which pension plans invest in hedge funds and private equity.identified these plans in 2008 using data from the 2006 Pensions &  Investments survey of the largest 200 pension plans and through our  interviews with industry experts. Plan representatives’ responses from  these interviews do not represent a statistically generalizeable sample of  all pension plans. We interviewed officials of federal agencies, relevant  national organizations, pension plan consulting firms, and other national  experts. We conducted a survey of five open-ended questions with plan  consultants, academic and industry experts, representatives of plan  participants, and representatives of public and private plan sponsors. We  obtained data on the national performance of hedge fund and private  equity investments from private organizations, Cambridge Associates  LLC and Hedge Fund Research, Inc. We obtained and analyzed survey  data on the extent to which pension plan sponsors continue to invest in  hedge funds and private equity from two private organizations, Greenwich  Associates and Pensions & Investments. We conducted our work from  February 2011 to February 2012 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. For  more information on our objectives, scope, and methodology, see  appendix I.
subsections: section_title: Background
paragraphs: Defined benefit pension plans are intended to pay retirement benefits that  are generally based on an employee’s years of service and other factors.  The financial condition of these plans—and hence their ability to pay  retirement benefits when due—depends on adequate contributions from  employers and sometimes employees, and prudent investments that yield  an adequate rate of return over time. Poor investment choices can have  serious implications for both the plan sponsor and, potentially, plan  beneficiaries. Poor investment results may necessitate greater  contributions by the plan sponsor, which could result in lower profits in the  case of a private plan sponsor, or higher taxes in the case of a public  plan. In some cases, the plan sponsor could opt to require greater  participant contributions or reduce future retiree benefits. Plan sponsors  generally try to maximize returns for an acceptable level of risk and, in  doing so, may invest in various categories of asset classes, which for  many years have consisted mainly of stocks and bonds. Plan sponsors  may also invest in other asset classes or trading strategies, sometimes  referred to as alternative investments—which can include a wide range of  assets such as hedge funds, private equity, real estate, and commodities.  Plans may make such investments in an effort to diversify their portfolios,  achieve higher returns or for other reasons. In recent years, hedge funds  and private equity have been two of the most common alternative assets  held by institutional investors such as public and private pension plans.
Although there is no 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 who often  engage in active trading of various types of securities, commodity futures,  options contracts, and other investment vehicles. Hedge funds can also  hold relatively illiquid and hard-to-value investments such as real estate  or shares in private equity funds. Although hedge funds have a reputation  of being risky investments that seek exceptional returns, this was not their  original purpose, and is not true of all hedge funds today. Established 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 the stock market.investment portfolios and engaged in a wider variety of investments  strategies. As GAO reported in 2008, defined benefit pension plans have  invested in hedge funds for a number of reasons, including the desire for  investment returns that exceed the returns available in the stock market  or obtaining steadier, less volatile returns.
Over time, hedge funds diversified their  Likewise, there is no commonly accepted definition of private equity  funds, but such funds are generally privately managed pools of capital  that invest in companies, many of which are not listed on a stock  exchange. Unlike many hedge funds, private equity funds typically make  longer-term investments in private companies. Private equity funds also  seek to obtain financial returns through long-term appreciation based on  active management. Strategies of private equity funds vary, but most  funds target either venture capital or buy-out opportunities. Venture  capital funds invest in young companies that often are developing a new  product or technology. Private equity fund managers may provide  expertise to a fledgling company to help it become suitable for an initial  public offering. Buy-out 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. 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.
Traditionally, hedge funds and private equity funds and their managers  have been exempt from certain registration, disclosure and other  requirements under various federal securities laws. The presumption is  that investors in such vehicles have the sophistication to understand the  risks involved in investing in them and the resources to absorb any losses  they may suffer. However, as a result of the Dodd-Frank Act, the  managers of such investment vehicles will be regulated in ways that they  have not been previously. For example, hedge fund and private equity  managers will generally now be required to register with the SEC,  establish a specific regulatory compliance program, and comply with  various record-keeping requirements.  While these fund managers must  now register with the SEC, the funds they manage will remain  unregistered.  Unlike other investment funds—such as mutual funds—that  register with the SEC, hedge funds and private equity funds are thus not  subject to certain requirements, such as limitations on leverage and  minimum requirements relating to corporate governance.
Private sector pension plan investment decisions must comply with  provisions of Employee Retirement Income Security Act (ERISA), which  set forth fiduciary standards based on the principle of a prudent standard  of care. 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 familiar with 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   Public sector plans, such as  total plan portfolio, rather than in isolation. those at the state, county, and municipal levels, are not subject to  funding, vesting, and most other requirements applicable to private sector  defined benefit pension plans under ERISA, but must follow requirements  established for them under applicable state law. Many states have  enacted standards comparable to those of ERISA.
ERISA’s “prudent man” standard with respect to investment duties is treated under 29  C.F.R. § 2550.404a-1(b).  In general, it provides that that the prudent man standard is  satisfied if the fiduciary has given appropriate consideration, among other facts and  circumstances, to the following factors (1) the composition of the plan portfolio with regard  to diversification of risk; (2) the volatility of the plan investment portfolio with regard to  general movements of investment prices; (3) the liquidity of the plan investment portfolio  relative to the funding objectives of the plan; (4) the projected return of the plan  investment portfolio relative to the funding objectives of the plan; and (5) the prevailing  and projected economic conditions of the entities in which the plan has invested and  proposes to invest.
In 2008, we reported on plan investments in hedge funds and private  equity, including a discussion of the benefits that plan fiduciaries seek  and challenges they face in doing so. We concluded that, because these  investments require a degree of fiduciary effort well beyond that required  by more traditional investments, doing so can be a difficult challenge,  especially for smaller plans. Such plans may not have the expertise or  financial resources to be fully aware of these challenges, or have the  ability to address them through negotiation, due diligence, and  monitoring. Further, we noted that, while plans are responsible for making  prudent choices when investing in any asset, the Department of Labor  (Labor) 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. In light of these duties,  and the risks and challenges of investing in hedge funds and private  equity, we recommended that the Secretary of Labor issue guidance  specifically designed for qualified plans under ERISA. We specifically  called for guidance that would (1) outline the unique challenges of  investing in hedge funds and private equity; (2) describe steps that plans  should take to address these challenges and help meet ERISA  requirements; and (3) explain the implications of these challenges and  steps for smaller plans. To date, Labor has not implemented this  recommendation. In responding to GAO’s 2008 recommendation, Labor  noted that while it would consider the recommendation, the lack of  uniformity among hedge funds and private equity funds could make  development of comprehensive and useful guidance difficult.
section_title: Selected Pension Plans Reported Mixed Experiences with Hedge Funds and Private Equity Investments, and Some Faced Significant Losses and Other Challenges
subsections: section_title: Hedge Fund and Private Equity Investments Were Affected by the Financial Crisis, but Most Selected Plans Indicated These Investments Met Expectations
paragraphs: Hedge fund and private equity indexes show that these investments were  significantly affected by the financial market turbulence of recent years,  and plans and experts we contacted indicated that pension plan  investments were not insulated from losses. According to a composite  hedge fund index, in the midst of the financial crisis, hedge funds  produced quarterly losses as great as 16 percent in the last quarter of  2008. Similarly, a private equity index measured losses throughout most  of 2008, with losses of a little more than 15 percent in the last quarter. In  comparison, the stock market, as measured by the Standard and Poor’s  500 index, declined in value by close to 40 percent in 2008 (see table 1  for a comparison of recent data from various indexes). Our in-depth  discussions with plan representatives were largely consistent with these  national trends. Although not all plan sponsor representatives we  interviewed reported specific performance data, a number of plan  representatives disclosed peak annual hedge fund losses in 2008 or 2009  ranging from about 12 percent to about 25 percent. Pension plan  representatives we interviewed generally reported more favorable  performance for private equity. Although a few plan representatives  reported private equity returns that were somewhat lower than in previous  years, one plan reported a close to 20 percent loss for their private equity  portfolio in 2009.
Despite experiencing some significant losses during the financial crisis,  representatives of selected plan sponsors we contacted generally told us  that both their hedge fund and private equity investments met their  expectations over the last 5 years given their reasons for investing.
Most of the 22 pension plan representatives we contacted indicated that  hedge fund investments met their expectations given their reasons for  investing. In 2008, we reported that many plans had invested in hedge  funds in response to prior significant stock market losses, and because  they were seeking specific benefits such as achieving (1) lower volatility;  (2) a more diversified portfolio by investing in a vehicle that would not be  correlated with other asset classes in the portfolio; and (3) returns greater  than those expected in the stock market. Given these reasons for  investing in hedge funds, most of the 22 plan representatives we  interviewed for this report said that these investments met plan  expectations (see table 2 for an overview of the responses).
Representatives of several plans stressed the moderating impact of  hedge fund investments by noting their ability to provide less price  volatility than other investments. One plan representative observed, that  even with hedge fund fees, their losses of 14 percent were still preferable  to stock market losses of 40 percent. Representatives from another plan  explained that, although hedge fund performance more closely paralleled  the stock market during the period than desired, there was generally no  safe haven and that hedge fund investments have generally performed  well. A few plan representatives noted that hedge funds delivered lower   Representatives from one plan were  volatility than other investments.particularly satisfied with how the plan’s hedge fund investments helped  limit overall portfolio risks, noting that although returns were below  benchmarks, the hedge funds provided much less volatility than the plan’s  publicly traded stock holdings. Similarly, representatives from another  plan noted that, since 2002, hedge funds have provided adequate  returns, but with much less volatility than publicly traded stocks.  Additionally, representatives from one plan, who had not invested in  hedge funds when we interviewed them for our 2008 report, have recently  begun implementing a relatively small hedge fund allocation that they  believe will complement the rest of their portfolio and provide greater  diversification benefits, including reducing overall portfolio volatility.
Some plan sponsor representatives stressed the positive long-term  performance of their hedge fund investments, despite intervals of poor  performance. While these plan representatives would have preferred  better hedge fund performance during the 2008-2009 financial crisis,  hedge funds have nonetheless filled an important long-term role in these  plans’ portfolios. Representatives from one plan noted hedge fund losses  of about 12 percent during 2009 but indicated that overall since 2004  these investments have performed well. Representatives from one plan  told us that while they were disappointed by the size of hedge fund losses  in 2008-2009, these investments have generally beaten long-term  benchmarks and have recovered since the crisis. Moreover, they noted  that compounded over the last 15 years, the plan’s hedge fund  investment returns are about twice those of the stock market. These plan  representatives also emphasized the importance of hedge funds, as well  as other alternative investments, to long-term investment returns by  noting that investing solely in fixed income investments would not have  sustained the plan’s funding needs, particularly given that the plan  sponsor had not made plan contributions in over 20 years.
In contrast, a number of plan sponsor representatives and experts noted  that hedge funds did not perform as expected. Representatives from one  plan explained that they expected these investments to provide an  absolute return—positive return regardless of the conditions in the stock  market—in exchange for muted returns in robust markets. Another plan  representative noted that while he understood these “absolute return”  funds may not always generate positive returns in all market  environments, he expected their hedge funds to deliver better than the  more than 20 percent losses they experienced from 2008-2009. Similarly,  a representative from one plan expected hedge fund investments to  perform more independently of stock market trends and was surprised  and disappointed by the magnitude of the negative returns. This  representative told us that for every dollar of loss in the 2008-2009 stock  market, their hedge fund investments lost two-thirds of a dollar. A few  experts noted that pension plan hedge fund investments were more  correlated than expected with the public markets during the financial  crisis, resulting in what one expert referred to as exacerbated losses. For  example, one expert noted that some plan representatives may have  overpaid for mediocre returns when they paid hedge fund performance  and management fees to obtain returns similar to the stock market.  Further, one specific hedge fund strategy performed poorly. Several plans  singled out the so-called “portable alpha” strategy, which typically  employs hedge funds in order to generate returns that exceed common  market benchmarks. A representative of one plan told us that the plan’s  portable alpha program was hugely disappointing and consequently being  dismantled. Specifically, in 2008-2009, a portion of the investment lost  considerable value when the stock market fell by more than 30 percent.
Some plan representatives and one surveyed expert singled out the  impact of fees on net performance. One expert cited the extra layer of  fees charged by funds of funds managers, asserting that these fees  substantially lowered plans’ net returns. Similarly, a plan representative  we spoke with found hedge fund fees at the individual fund level to be  eroding investment returns. This representative noted while the plan’s  hedge fund gross return has been outperforming the rest of the portfolio,  the investment has underperformed after fees have been deducted for the  last few years. For this reason, the plan is consciously lowering its  investment allocation in hedge funds. A representative from another plan  noted dissatisfaction with the plan’s hedge fund of funds investment as  one of the reasons that the plan had chosen not to reinvest and was  considering firing the fund manager.
The experience of plans with private equity investments should be  considered in the context of the long-term nature of these investments,  which require lengthy financial commitments and delayed financial returns  (see fig. 1). Given the long-term nature of private equity investments,  nearly all of the 22 pension plan representatives we interviewed were  generally satisfied with their private equity investments over the last 5  years. Based on findings from our 2008 report, plans we interviewed  generally invested in private equity to attain higher returns than the stock  market offered, in exchange for greater risk. Given these reasons for  investing in private equity, 20 of 22 plan representatives reported that the  plan’s private equity investments met plan expectations. Further, nearly  half of plan representatives indicated that their plans’ private equity  investments outperformed public equities over the last 5 years. For at  least one plan, private equity was the highest performing asset class. In  particular, several plan representatives and surveyed experts noted that  opportunistic investments, those investments that take advantage of  underperformance during market cycles, such as distressed debt,  performed relatively well during the last 5 years. Representatives from  at least one plan said they were disappointed to have had insufficient  capital available to invest more heavily in some of these opportunities.  Like many of the plan representatives we interviewed, experts we  surveyed largely found private equity investment performance for the  period to be positive.
Although plan representatives we interviewed almost unanimously  reported favorable results regarding private equity, this has not  necessarily been true of all plans over the last 5 years. As we reported in  2008, compared with other asset classes, performance varied widely  among private equity funds. For this reason, plan representatives  emphasized the importance of investing in the top funds, some noting that  they would not invest in private equity unless they could invest in funds  considered to be in the top quartile. Three of the experts we surveyed in  2011 also noted varying performance among private equity funds. One  expert noted a wide dispersion among the performance of private equity  funds, and that this dispersion likely is reflective of the broad experiences  of pension plans over time. Similarly, two other experts cited evidence  that, over the long-term, broad private equity fund returns did not  outperform the stock market, and one of these experts reported that lower  performance may be attributable to the typically riskier equities held in  these investments. A representative from one plan, for example,  remarked that the plan’s venture capital investments did not perform well.  In this particular case involving the biotech industry, the representative  noted that this was less a direct result of the financial crisis and more a  function of the decline in this industry as a whole. Representatives from  one large plan told us that venture capital investment performance had  been problematic for them in the last 10 years. Similarly, we found that a  number of plans we interviewed had lowered or eliminated their venture  capital investment in recent years.
section_title: Some Selected Plans Faced Specific Challenges with Hedge Fund and Private Equity Investments in Recent Years
paragraphs: Pension plan representatives we contacted experienced some challenges  in hedge fund and private equity investing beyond those of more  traditional investing, including limited liquidity and transparency, and the  negative impact of the actions of other investors in the fund—sometimes  referred to as co-investors.
A number of plan representatives we interviewed experienced challenges  with investment liquidity—a plan’s limited ability to redeem investment  shares on demand—in order to meet plan obligations. Although hedge  funds typically have limitations on the timing and magnitude of investor  redemptions, a few plan representatives we contacted were surprised and  financially harmed by “discretionary gates”—limitations on redemptions  imposed at a fund manager’s discretion. For example, a representative  from one large plan told us that some hedge fund managers imposed  discretionary gates based on what was best for the fund’s business model  and not what was in the best interests of the investors. This  representative was concerned that hedge fund managers lacked  incentives to seek returns and were focused on gathering assets, locking  them up, and collecting the fees. Public documents from this plan noted  the possibility that a hedge fund manager can earn tens of millions of  dollars in performance fees in 1 year and then experience sizable losses  in another, resulting in only a minimal capital gain or even net loss for the  investor, but sizable profits for the fund manager at the end of the  partnership.intended to use hedge fund redemptions to pay for plan obligations,  unexpected discretionary gates forced them to instead sell public equities  at a significant loss. Specifically, representatives from one plan told us  that when the market was down more than 30 percent, they were unable  to access their hedge fund investments due to gates imposed by the fund  manager after other co-investors began liquidating their holdings.  Representatives from this plan told us they were then compelled to sell  public equities at a price well below their assessment of the equities’  intrinsic value, in order to meet plan obligations, including benefit  payments to plan participants.
Also, because plan representatives from at least one plan  Some plans also faced challenges meeting requests for committed  capital—money they have committed to the fund manager for  investment—from private equity fund managers. A few plan  representatives relied on a “self funding” private equity program in which  private equity investment proceeds are sufficient to pay for a portion or all  of the program’s committed capital. However, in some cases, the severe  market decline during this period limited investment proceeds.  Consequently, a few plans had to look for liquidity in their portfolio in  order to fund capital commitments. While the plan representatives we  spoke with were able to meet these financial commitments, a number of  plans said they limited new private equity investment during this period.
A small number of plans we interviewed noted challenges with hedge  fund transparency during this period. One plan representative we  interviewed invested in a fund of hedge funds with very limited  transparency, but that promised access to certain high-quality hedge  funds. As transparency improved after the 2008-2009 financial crisis, the  plan sponsor learned that the various funds of funds had considerable  overlapping investments, which likely amplified the funds’ of funds  negative performance. A few plan representatives were unpleasantly  surprised by the extent to which their plans’ hedge funds were invested in  “side pockets”—separate side accounts holding illiquid investments, such  as private equity or real estate. For example, representatives from one  plan told us they were not fully aware of the way some of their funds were  invested in these side pockets and consequently were surprised by the  illiquidity of the investment. A representative from another plan was  similarly surprised by how embedded some of their hedge fund  investments were with side pockets, which proved problematic when the  plan looked to these hedge fund investments for liquidity during the  financial crisis and it was not available. Representatives of another plan  expressed an aversion to such side pocket investments and preferred to  invest in private equity directly rather than doing so unbeknownst to them  through a hedge fund manager.
A few of the plan representatives noted challenges related to co- investors’ actions. Under commingled investments arrangements, each  investor owns a certain number of shares in a fund. During the recent  financial crisis, the significance of these arrangements became  particularly challenging for a few plan representatives. For example,  representatives from one plan reported that while they were able to meet  all of their private equity capital calls—a request from the fund manager  for the investors to provide a portion of the money they have committed to  investing—they were concerned about the ability of other co-investors to  do so. In response to these concerns, the representatives felt compelled  to take the time to call each of their fund managers to confirm the ability  of all the investors to meet their financial commitments. Representatives  of another plan noted that the actions of co-investors can impact an  investment strategy, which may ultimately impact returns. For example,  representatives of this plan said they had invested with a private equity  fund manager who was implementing a strategy involving an investment  in 10, $1 billion companies. However, because not all investors could  meet their financial commitments, the fund manager had to restructure  the investment strategy. The plan representatives were troubled by the  strategy changes—involving investments in different companies—the  fund manager had to make as a result.
At least one plan representative also indicated that an onslaught of hedge  fund redemptions by other co-investors damaged their investments. For  example, representatives of one plan told us that many of their co- investors, alarmed by large losses during the financial crisis, moved  quickly to cash out investments. Because co-investor redemptions led to  further fund losses, plan representatives felt it was necessary to cash out  as well. However, they were unable to do so, because the fund manager  had imposed a discretionary gate to prevent further losses.
section_title: Plans Continue to Invest in Hedge Funds and Private Equity, but Some Plan Sponsors Have Taken Steps to Address Challenges
paragraphs: Available data reveal that plan investments in hedge funds and private  equity have continued to increase, and our contacts with 22 public and  private defined benefit (DB) plan sponsors also reveal a continued  commitment to these investment vehicles. Nonetheless, some plans have  reduced their allocations or made significant changes to their strategic  approach as a result of experiences in recent years. In addition, plan  representatives we contacted took significant steps to improve the terms  of their investments, including negotiating lower fees or more  advantageous fee terms, and obtaining greater liquidity or transparency.  Not all plans may be able to make such improvements, however.
subsections: section_title: Plans Have Continued to Invest in Hedge Funds and Private Equity
paragraphs: Available data and discussions with plan representatives indicate that DB  plans have continued to invest in hedge funds and private equity in recent  years. The percentage of large plans investing in both hedge fund and  private equity has increased since the onset of the 2008 financial crisis.  According to a Pensions & Investments survey, the percentage of large  plans (as measured by total plan assets) investing in hedge funds grew  from 47 percent in 2007 to 60 percent in 2010 (see fig. 2). Over the same  time period, the percentage of large plans that invested in private equity  also grew—from 80 percent to 92 percent. For both hedge funds and  private equity, as figure 2 shows, these trends are a continuation of a  decade-long upward trend. Data from the same survey reveal that  investments in hedge funds and private equity typically constitute a small  share of plan assets. The average allocation of portfolio assets to hedge  funds among plans with such investments was a little over 5 percent in  2010. Similarly, among plans with investments in private equity, the  average allocation of portfolio assets was a little over 9 percent.
We reported in 2008 that available survey data showed larger plans were  more likely to invest in hedge funds and private equity than midsize plans  and, according to a survey by Greenwich Associates, that seemed to be  the case in 2010 as well. The survey found that 22 percent of midsize  plans—those with $250 million to $500 million in total assets—were  invested in hedge funds compared with 40 percent of the largest plans— those with over $5 billion in total assets (see fig. 3). Survey data on plans  with less than $200 million in assets are unavailable, so the extent to  which these smaller plans invest in hedge funds and private equity is  unclear.
Comments made to us by representatives of selected plan sponsors  generally paralleled these national data. Of the 18 plans participating in  our review that had invested in hedge funds, 17 told us they had either  maintained or increased their allocations since our original contact in  2007 or 2008. For example, one public plan that already had invested a  substantial percentage of its assets in hedge funds increased its  investments by about another 10 percent of the total portfolio.  Representatives of this plan explained that hedge fund investments, while  not immune to stock market declines, had nonetheless performed much  better than stocks during the financial crisis. Similarly, of the 22 plans  participating in our review that had invested in private equity at the time of  our original contact in 2007-2008, 19 told us that they had either  maintained or increased their target allocation. Each of the 10 plans that  had increased their allocations also cited positive performance returns.  For example, one plan representative explained that the allocation to  private equity had increased even though the overall allocation to publicly  traded stocks has decreased. The representative explained that the plan  was lowering its allocation to stocks as part of a broad risk reduction  strategy, and that the additional return expected from private equity would  therefore be essential. As the representative explained, this change was  made with the belief that the increase in private equity will produce  relatively high risk-adjusted returns and will therefore compensate for the  lower expected yield resulting from the shift out of publicly traded stocks  to bonds.
section_title: Most Plans Have Modified Investment Strategies in Recent Years
paragraphs: Experiences of recent years have led most plans we contacted to make  significant changes to their hedge fund or private equity strategies, and in  three cases, reductions in the overall allocation to hedge funds or private  equity. For example, representatives of the one plan participating in our  review that had reduced its overall allocations to hedge funds said that  the plan’s poor experience with hedge funds was tied to illiquidity. These  representatives explained that they had expected that their hedge fund  investments would not be difficult to cash in when they needed to pay  obligations, but they were prevented from doing so by discretionary gates  imposed by the fund manager. As a result, the plan was forced to sell  stocks during the crisis when values were depressed, resulting in  significant losses.
Several plans also discontinued or reduced the use of certain hedge fund  strategies. For example, representatives of three plans told us that they  had discontinued so-called “portable alpha” strategies, which commonly  use hedge funds to help achieve returns that exceed those of the public  equities market. According to industry press, this technique largely fell out  of favor as a result of substantial investment losses during the 2008-2009  financial crisis. However, plan representatives indicated that  disenchantment with the portable alpha technique did not necessarily  mean abandonment of hedge funds generally. For example, after one of  these three plans discontinued the portable alpha strategy, it opted to  retain the hedge fund portion of the portable alpha investment. Several  other plans indicated that they invested in less aggressive hedge fund  strategies. For example, a representative of one plan explained that the  plan had shifted from hedge funds designed to deliver investment returns  that exceed the overall stock market to strategies that will deliver returns  comparable to the stock market but with less risk.
In contrast to the general trend toward greater investments in hedge  funds, some plans eliminated or substantially reduced their use of funds  of hedge funds. Representatives of one plan explained that this step was  part of a planned evolution—the plan had invested in funds of funds as a  first step, and planned on using its relationships with funds of funds  managers to develop the expertise to make direct hedge fund  investments. By 2011, this plan had accomplished that objective, and 80  percent of its hedge fund investments were direct hedge fund  investments. Another plan, however, discontinued funds of funds  investments, concluding that funds of funds added an unnecessary layer  of fees, offered the plan little opportunity to influence fees of underlying  hedge funds, limited the plan’s ability to conduct manager due diligence,  and led to some overlapping investments in underlying individual hedge  funds. A representative of this plan told us that one of the funds of funds  had emphasized its unique access to top tier hedge funds, and the plan  sponsor later learned that some of its other funds of funds were invested  in the same vehicle, diminishing the diversification benefits of the fund of  funds. However, funds of funds may be necessary for smaller pension  plans and plans that lack well-developed internal investment and risk  management that wish to invest in alternatives such as hedge funds and  private equity.
Several plans indicated that they have adjusted their private equity  strategies in recent years. For example, representatives of several plans  noted that as a result of the experiences during the financial crisis, they  preferred investing in private equity buyout funds that rely more on the  implementation of operational improvements in portfolio companies,  rather than funds that rely on so-called financial engineering—using  leveraging techniques to enhance the value of the stock. One plan  representative explained that many private equity firms using financial  engineering techniques had suffered severe losses during the financial  crisis. As a result, this representative said the plan now prefers private  equity funds that add value to portfolio companies through means such as  better control of costs, improved marketing, and a more efficient  distribution chain. Also, because of the diminished returns of venture  capital funds in recent years, representatives of several plans said they  have reduced investments in such funds. Finally, several of the plans we  contacted had made relatively short term, opportunistic investments in  distressed debt as a result of the financial crisis. One plan representative  explained that the financial crisis gave rise to this opportunity because  distressed debt oriented funds tend to perform well in bad economic times  as the universe of troubled companies grows and other investors become  more risk-averse.
section_title: Some Plans Have Improved Contractual Terms or Changed Investment Arrangements
paragraphs: Steps plan sponsors have taken to obtain more advantageous terms  when investing in hedge funds and private equity include lower fees,  greater control and transparency, and changed liquidity terms.
More advantageous fee terms. A little more than half of the plans included  in our review have taken steps to obtain more advantageous fee terms for  both hedge fund and private equity investments. For example, as part of a  broad policy change regarding its relationship with hedge fund managers,  one large public plan has determined that it will seek to avoid investing in  hedge funds that insist on the traditional “2 and 20” fee structure, under  which investors pay an annual management fee of 2 percent of assets  under management, and a performance fee of 20 percent of profits.  Instead, the plan will seek to limit both management and performance  fees and ensure that performance fees are paid not on an annual basis,  but for more sustained, long-term performance. Representatives of  another plan explained that they had obtained lower fees in exchange for  trade-offs related to other aspects of investment terms. Specifically, for  some hedge fund investments, this plan pays a flat fee of 1.5 percent of  assets under management, instead of the formerly standard 2 percent  fee. In exchange, the plan opted to sacrifice liquidity by agreeing to a 2- year lockup of its investment, thus providing the fund manager with  greater assurance that its capital and investment strategies would not be  disrupted. While illiquidity by itself may be perceived as a disadvantage to  an investor, this plan believed less liquidity was a worthwhile trade-off for  lower fees.
Principles developed by private equity investors. Large pension plans and  other institutional investors in private equity have, through the Institutional  Limited Partners Association (ILPA), taken significant steps to promote  more advantageous terms of investment, including lower fees and better  fee terms. The ILPA Private Equity Principles address in some detail how  fees should be aligned to the interests of investors. For example, ILPA  principles advocate a fee arrangement that would help ensure that  investors get back all invested capital, plus a specified return on  investment as soon as these returns are available. Sometimes referred to  as a “European waterfall”, this arrangement dictates that investors  recover their full initial investment plus a specified return on investment— such as an annualized 8 percent—before the fund manager obtains any  share of the profits.waterfall”, under which the fund manager may collect profits  corresponding to the sale of individual portfolio companies on a “deal by  deal” basis, regardless of whether investors have obtained any return on  their total investment in the fund. The overall advantage of the European  waterfall for investors is that they can recapture their initial invested  capital plus a specified return, as soon as that return exists, taking into  account any losses. Further, because the fund manager does not obtain a  share of the profits until after the investors have received the specified  return, the need for reclamations of disbursements that have been made  to the fund manager are minimized. Such reclamations—commonly  referred to as “clawbacks”—may be necessary if profits paid to the fund  manager based on the sale of portfolio companies early in the life of a  fund are negated by subsequent losses. The ILPA Principles also  address other issues, including notification of management changes and  the fund management’s financial stake in the fund.
This arrangement contrasts with an “American  Enhanced transparency, control, and liquidity through separate accounts.  Many of the plans we contacted told us that some of the challenges of  hedge fund investing could be addressed though the use of separate  accounts in place of commingled funds. Under a commingled hedge fund  arrangement, the investor owns a certain number of shares in the fund,  but the hedge fund manager determines what assets to invest in, and the  partnership collectively owns the underlying assets (see fig. 4). In  contrast, under a separate account, the hedge fund manager essentially  serves as a consultant who manages the assets in a way that generally  parallels the hedge fund itself, but the investor may specify investment  guidelines that result in differences between the commingled hedge fund  and separate account. Plan representatives and financial industry experts  cited multiple benefits of separate accounts, including (1) precise  knowledge of the nature of underlying assets, (2) ability to exclude certain  assets in the commingled hedge fund from its share of the rest of the  hedge funds assets, and (3) much greater liquidity because plan  sponsors own and can sell the underlying assets at will. Separate account arrangements are, however, more costly than commingled funds,  and hedge fund managers generally will not offer such arrangements  unless the size of an investment exceeds a certain threshold.
Other steps. Plan sponsor representatives also mentioned other steps  they took to address difficulties of the last several years. Some plans now  seek specific contractual terms that affect liquidity or other aspects of the  investment. For example, representatives of one plan explained that they  now seek investor level gates, under which cash-out limitations would be  triggered once an investor has liquidated more than a specified amount of  their investment. Other co-investors would not be affected and could still  cash out under the normal terms of the hedge fund. Other plans have  established certain criteria for selecting hedge fund or private equity  funds. A representative of one plan, for example, said that the plan avoids  hedge funds that have so-called side pockets—illiquid investments held  separate from the primary fund—such as a hedge fund that has an  investment in a private equity fund. A representative of one plan, which  had been surprised by the existence of such side-pocket illiquid  investments, noted that such investments can exacerbate illiquidity during  stressful times. A representative of another plan noted that the plan  prefers to select its own private equity investments and avoid locking in to  one of a hedge fund manager’s choosing. Finally, a few plans made  changes to overall portfolio management practices as a result of  experiences with hedge funds and private equity. For example, one plan  established a larger cash reserve and representatives of two plans  described steps to enhance or monitor liquidity.
section_title: Some Plans Described Investment Selection and Due Diligence Improvements, but Practices May be Uneven
paragraphs: A few plan representatives and experts described other improvements to  their selection or monitoring processes for hedge funds or private equity  investments. For example, two plan sponsors said they are much more  focused on how fund managers establish the value of invested shares.  One plan representative noted that, in the past, the plan took valuations  provided by the fund manager at face value, but they now examine  valuations much more closely. Representatives of other plans said that,  as a result of massive hedge fund cash-outs by other co-investors, they  consider the nature of other co-investors before investing. One plan  representative explained that he prefers investors who will ride out market  volatility and not flee the fund during episodes of volatility. Several  surveyed experts cited diligence improvements, including better  operational due diligence.
Some public plans have also taken significant steps to improve and  oversee the process of selecting hedge funds, private equity, and other  investments. For example, a special review undertaken by one large  public plan we contacted found significant problems involving the role of  placement agents and accompanying malfeasance by public officials,  which significantly compromised the plan’s selection of private equity  funds and other investment vehicles. Among other things, the report  raised the possibility that some private equity investments had been  based on a relationship with a placement agent, rather than on the quality  of the investment. Consequently, potentially superior investments may  have been bypassed in favor of those with better connections, and the  fund ultimately paid excessive fees that bore little or no relationship to the  services rendered by the placement agent. The report’s conclusions  emphasized that plan officials must increase vigilance on those portions  of the plan—such as hedge funds and private equity—that have not  traditionally been subject to as great a degree of public scrutiny as other  types of investments. The review also offered numerous  recommendations designed to prevent a recurrence of these events, and  the plan has taken some actions. For example, the plan has advocated,  and the California state legislature has enacted, a state law that imposes  on placement agents the same disclosure and registration requirements  that apply to lobbyists, and obtained over $200 million in fee reductions  and an agreement from elite money management firms to avoid using  placement agents for new plan investments. Further, partly as a result of  the review, the plan developed a comprehensive new policy designed to  ensure that it had more advantageous terms of investment with its hedge  fund managers. According to a representative of the National Association  of State Retirement Administrators, other public plans have experienced  similar problems and have made comparable reforms.
section_title: Plans May Have Limited Ability to Take Certain Steps
paragraphs: Although some plans have taken significant steps to improve the terms of  hedge fund and private equity investments in recent years, not all plans  may be able to take such steps, and it is not clear how extensive such  changes have been. For example, separate accounts may not be a  practicable option for all plan sponsors. Separate accounts impose  additional duties on hedge fund managers and, therefore, the fees  associated with them are often somewhat higher. In addition, they impose  additional burdens on the investor, such as ensuring that the  management of the separate account matches that of the commingled  fund. Further, according to plan sponsors and experts, hedge fund  managers will establish and operate separate accounts only for  investments of a certain magnitude; hedge fund managers may not  establish separate accounts for investments of less than approximately  $100 million. As a result, separate accounts would not be an option for  plans unable to make an investment of this magnitude.
Although our survey of experts identified some of the same actions that  plan representatives described, the narrative responses revealed no clear  pattern or consensus regarding these actions. Further, plan  representatives and some experts indicated that not all plans would be  able to take the steps described above. For example, plans’ ability to  obtain better fee terms is not universal. One plan representative noted  that his plan is not large enough to have much negotiation power with  fund managers, and the plan generally accepts the manager’s standard  fee structure. Another plan representative noted that the top fund  managers have not had to adjust fees. Also, with regard to due diligence  steps, some surveyed experts indicated that difficulties are likely to be  among smaller plans or plans with lesser resources. For example, one  respondent stated that while the use of best practices is becoming more  widespread, failure to observe them occurs among smaller funds that lack  resources or plans that are influenced by a salesperson.
Finally, it is not clear whether some of the changes in recent years will  permanently change the landscape. One of the leading plan consultants  noted that, since the financial crisis, plans have gained significant  bargaining power with hedge fund managers who desire plan  investments. However, representatives of two plans also indicated that  this development may be cyclical, and an outgrowth of the troubled  financial markets in recent years. These representatives also speculated  that, when financial markets heat up again, the environment may change  to a “seller’s” market, and fund managers may be able to reassert fee  structures and other investment terms that are less advantageous to  investors.
section_title: Federal Entities and Others Have Developed Guidance Addressing Hedge Funds and Private Equity
paragraphs: Various entities have developed guidance applicable to plan investments  in hedge fund and private equity, ranging from broadly applicable  guidance issued by Labor to detailed guidance issued by federal advisory  and industry bodies. While Labor has not developed guidance specifically  addressing hedge funds or private equity, departmental officials cited a  1996 information letter from Labor to the Comptroller of the Currency that  discusses the application of ERISA principles regarding the use of  alternative investments. The letter does not refer to hedge funds or  private equity, but departmental officials said that its basic principles  could be applied to these types of investments. The letter addresses  pension plans’ use of derivatives in their investment portfolios and states  that investments in derivatives are subject to ERISA fiduciary  responsibility rules, just as any other investment. In light of this, the  letter emphasizes several key considerations, including
Sophistication. Such investments may require more sophistication and  a deeper understanding on the part of fiduciaries than other  investments.
Adequate information. Fiduciaries are responsible for obtaining  sufficient information to understand such investments and, if the  investment is in a pooled fund managed by another entity, the  fiduciary should obtain sufficient information to determine the nature  of the pooled fund’s uses of derivatives.
Understanding of investment risk. The market risks of these  investments should be understood and evaluated in terms of, among  other considerations, the effect they have on the portfolio’s overall  risk.
Understanding operational and legal risk. The fiduciary must  determine whether it has adequate information and risk management  systems in place given the nature, size, and complexity of the  investment, and must ensure proper documentation of a derivative  transaction.
While Labor has issued this general guidance applying to investments in  derivatives, other organizations have published guidance specifically  encompassing or targeted at hedge fund and private equity. In December  2011, the Organisation for Economic Cooperation and Development  (OECD) and the International Organisation of Pension Supervisors  (IOPS) published a set of good practices for pension plans’ use of  alternative investments, including hedge funds and private equity.  Based on a survey of OECD and IOPS members, this document offers  recommended good practices on issues such as investment policy, risk  management, and contractual terms, as well as best practices for pension  fund regulators. In 2009, the President’s Working Group on Financial  Markets issued a report detailing important considerations and best  practices for hedge fund investors, including specific guidance for  fiduciaries. This document provides basic background information about  hedge funds, distinguishes them from more traditional investments, and  outlines some of the basic considerations a fiduciary should make in the  earliest stages of considering a hedge fund investment. The document  also provides extensive guidance and suggestions for best practices  related to due diligence steps, risk management, and various challenges  involved in hedge fund investing, including valuation, fees and expenses,  and legal and regulatory considerations, among other issues. Similarly,  the Greenwich Roundtable, a nonprofit research and educational  organization for investors in alternative assets, has issued a document  that outlines due diligence best practices for alternative investments,  including hedge fund and private equity investments. This document  describes basic considerations in the process of considering any  alternative investment, and it separately provides in-depth guidance on  specific steps that should be taken in making hedge fund, private equity,  and other illiquid investments.
In addition to these guidance documents, other organizations have  published briefer guidance documents. In 2008, the Government Finance  Officers Association published a brief advisory on the use of alternative  assets by public employee retirement systems. This three-page  document presents a condensed explanation of the risks inherent in  investing in hedge funds, private equity, and other alternative assets. It  also highlights key due diligence considerations and recommends that  state and local governments use extreme prudence in making such  investments. More recently, the ILPA published a set of principles aimed  at defined benefit pension plans and other institutional investors in private  equity. This document details important aspects of the terms of  investment between fund managers and investors, and best practices that  fund managers and investors should observe during the course of the  investment relationship.
The Advisory Council on Employee Welfare and Pension Benefit Plans, commonly  referred to as the ERISA Advisory Council, was created by ERISA to provide advice to the  Secretary of Labor.  29 U.S.C. § 1142. and matters for consideration in their adoption for use by qualified plans.  While the council concluded that hedge funds may be an acceptable form  of investment, its report noted that certain aspects of hedge fund  investments should be brought to the forefront in educating plan  fiduciaries and others. Among these are investment styles, liquidity  issues, and potential conflicts of interest. In 2008, the council reviewed  hard-to-value assets, which can include hedge funds, private equity, and  other alternative assets.  As a result of related hearings and  deliberations, the council recommended that Labor issue guidance  addressing the complex nature and distinct characteristics of such assets.  The council further specified that the guidance should define hard-to- value assets and describe ERISA obligations when selecting, valuing,  accounting for, monitoring, and reporting on these assets. To date, Labor  has implemented neither our recommendations nor the council’s  recommendations. In responding to our 2008 recommendation, Labor  noted that while it would consider the recommendation, the lack of  uniformity among hedge funds and private equity funds could make  development of comprehensive and useful guidance difficult.
In 2011, the ERISA Advisory Council specifically revisited the issue of  pension plans’ investments in hedge funds and private equity. The 2011  sessions of the council’s hearings prominently considered the potential  role of hedge fund and private equity investments in retirement plans. The  council’s report has not yet been published, but according to a Labor  official, publication is expected in early 2012.
section_title: Concluding Observations
paragraphs: Plans and their hedge fund and private equity investments have not been  immune to the effects of the financial market turbulence in recent years.  Despite significant losses, however, DB plan sponsors and experts we  contacted generally indicated that these alternative assets had met  expectations and still had a significant role to play in the plans’ investment  portfolios. Data from surveys of public and private plans clearly indicate  that the appetite for such investments is continuing to grow.
Nonetheless, the events of the last 4 years have reinforced our 2008  observation that hedge funds and private equity also pose risks and  challenges beyond those posed by more traditional investments.  Representatives of some of the plans that we contacted indicated that  hedge fund investments were less resilient than expected. As a result of  poor performance or other issues related to hedge funds and private  equity, some plans have taken significant steps to adjust the nature or  terms of such investments. These steps will likely benefit the plans and,  therefore, the plan participants and beneficiaries, in coming years.
Although some plans have taken significant actions, it is not clear how  extensive such changes have been and whether such changes would be  practical for those DB plans that lack both the resources and the  negotiating power available to other plans. Our selection of 22 DB plans  included some of the largest retirement plans in the nation, some of which  manage tens of billions of dollars. Yet despite their size and expertise,  some of these plans encountered significant difficulties with their  alternative investments in recent years, resulting in substantial  adjustments to plan investment practices. It is worth asking, if such large,  sophisticated institutions can have difficulties that result in significant  changes in the nature or terms of their investment in these alternative  asset classes, how much more difficult it might be for medium and smaller  plans.
In 2008, we recommended that the Secretary of Labor issue guidance  designed for qualified plans under ERISA concerning alternative  investment practices. We specifically called for guidance that would (1)  outline the unique challenges of investing in hedge funds and private  equity; (2) describe steps that plans should take to address these  challenges and help meet ERISA requirements; and (3) explain the  implications of these challenges and steps for smaller plans. We still  believe that providing such guidance would be beneficial. In fact, in light  of the guidance documents issued by other national and international  organizations in the intervening years, this task might now prove easier  for Labor than it would have been 4 years ago. Such guidance still has  the potential to help plan sponsors, and our work suggests a continued  need for such assistance.
section_title: Agency Comments
paragraphs: We provided a draft of this report to the Department of Labor, Department  of the Treasury, the Pension Benefit Guaranty Corporation, and the  Securities and Exchange Commission (SEC) for review and comment.  Labor, the Department of the Treasury, and SEC provided technical  comments which we incorporated as appropriate.
As agreed with your office, unless you publicly announce the contents of  this report earlier, we plan no further distribution until 30 days from the  report date. At that time, we will send copies of the report to the  appropriate congressional committees, the Secretary of Labor, Secretary  of the Treasury, the Director of the Pension Benefit Guaranty Corporation,  Director of the SEC, and other interested parties. This report will also  available at no charge on the GAO website at http://www.gao.gov.
If you or your staff have any questions regarding this report, please  contact Charles Jeszeck at (202) 512-7215 or jeszeckc@gao.gov .  Contact points for our Offices of Congressional Relations and Public  Affairs may be found on the last page of this report. Key contributors are  listed in appendix II.
section_title: Appendix I: Objectives, Scope, and Methodology
paragraphs: Our objectives were to answer the following research questions:
What is known about the experiences of defined benefit pension plans  with investments in hedge funds and private equity, including recent  lessons learned?
How have plan sponsors responded to lessons learned from recent  experiences with such alternative investments?
What steps have federal agencies and other entities taken to help  plan sponsors make and manage investments in such alternative  assets, and what additional steps might be warranted?
To answer all of the research questions, we conducted in-depth  interviews with plan representatives of the private and public sector  pension plans that were selected for our 2008 report examining the extent  to which pension plans invest in hedge funds and private equity. While  26 plans were interviewed for the 2008 report, 22 plans participated in  follow-up interviews for our report (see table 3 for a list of plan officials we  interviewed). We conducted interviews with representatives from June  2011 to September 2011 and, we obtained and reviewed available  supporting documentation. These interviews were conducted using a  semistructured interview format, which included open-ended questions on  the following topics, asked separately about each plan’s hedge funds or  private equity investments: history of investment in hedge funds or private  equity; experiences with these investments to date; lessons learned with  these investments; changes made to address these lessons, including  due diligence and ongoing monitoring; and actions federal agencies, such  as Labor, should take to ensure that pension plan fiduciaries better make  and manage their hedge fund and private equity investments. Four of the  plans, who did not invest in hedge funds when we interviewed them for  our 2008 report, were included in our in-depth interviews to determine  whether plan representatives subsequently invested in hedge funds and  to determine their experience given that decision. The results of the plan  sponsor interviews were limited by plan representatives’ willingness to  speak with us.
The plans we interviewed were selected based on several criteria  identified in our 2008 report. Specifically, when these plans were selected  for our prior report, 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 4. We identified these plans using data from  the 2006 Pensions & Investments survey of the largest 200 pension plans  and through our interviews with industry experts. While we selected plans  representing a range of total plan assets and varying size of allocations to  hedge funds and private equity as a share of total plan assets, these plan  representatives’ responses do not represent a statistically generalizeable  sample of all pension plans.
To further address the research questions, we surveyed a selected group  of 20 experts in the areas of pension plan hedge fund and private equity  investment. We asked these experts five questions related to  performance and management of these funds during the past 5 years and  also requested suggestions, if any, for regulatory improvements.  Specifically, we asked how pension plans’ hedge fund and private equity  investments have performed; lessons learned with respect to pension  plan hedge fund and private equity investments; changes to pension plan  hedge fund and private equity investment practices; the extent to which  pension plans observe best practices in hedge fund and private equity  due diligence; and actions federal agencies, such as Labor, should take  to ensure that pension plan fiduciaries better make and manage their  hedge fund and private equity investments. We used a Web-based form  to collect responses. This group of experts was selected from a number  of sources, including experts from our 2010 GAO Retirement Security  Advisory Panel, referrals from interviews and other experts, and  recommendations from GAO subject matter experts. To ensure we had a  range of views we invited participants from several different backgrounds  to participate in our survey including academics, representatives of public  and private plan sponsors, representatives of plan participants, pension  consultant groups, and other key national organizations and subject  matter experts. Of the 20 experts who agreed to participate in the survey,  19 completed the questionnaire within the requested time frame. The  survey was conducted in August 2011.
To quantitatively address national hedge fund and private equity  investment performance for the first question, we obtained and reviewed  broad industry performance data from two private organizations,  Cambridge Associates LLC and Hedge Fund Research, Inc. Data from  these organizations captured historical hedge fund and private equity  investment performance, including performance at the peak of the  financial crisis. We used these data to determine broad hedge fund and  private equity performance over the last 5 years.
While the data from each of these organizations are limited in some ways,  we conducted data reliability assessments for each data source and  determined that the data were sufficiently reliable for purposes of this  study. Data from these organizations are not specific to pension plan  hedge fund and private equity investments, which may have different  investment performance due to specific investment terms and industry  access. Moreover, because these data were from broad investment  indexes, they neither illustrated differences in performance for various  investment strategies within hedge fund and private equity investments,  nor did they distinguish performance of fund of funds investment. While  the most informative way to assess how well investments have performed  is to analyze actual portfolio investment data, we were unable to  quantitatively analyze specifically how pension plans’ investments in  hedge funds and private equity have performed over the past 5 years. We  attempted to obtain detailed investment performance data from selected  custodian banks and investment consulting firms. These two groups have  data on the largest pension plan investments in the country. However,  because of the proprietary nature and considerable cost, both in  resources and expense, we were not able to conduct this analysis.
To address the second question, we obtained and analyzed survey data  of private and public sector defined benefit plans on the extent of plan  investments in hedge funds and private equity from two private  organizations, Greenwich Associates and Pensions & Investments. We  identified these two surveys from prior work and obtained updated 2010  data. As seen in table 5, the surveys varied in the number and size of  plans surveyed. Using 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 surveyed plans 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  data reported the size of allocations to hedge funds or private equity as  an average for all plans surveyed.
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. Data from both surveys are reflective only of the  plans surveyed and cannot be generalized to all plans.
To address the third question, we first reviewed relevant literature and  spoke with federal officials from relevant agencies, including the Labor,  the SEC, and the Pension Benefit Guaranty Corporation to understand  federal agency action to date. In addition, we interviewed key national  organizations and pension industry experts to understand the perspective  of plan officials and their participants regarding federal actions to date, as  well as then need for additional federal action. Key national organizations  included representatives from organizations that represent plan  participants, such as AARP, and an organization that represents plan  officials, the American Benefits Council. In addition, we interviewed  academic and national experts in the pension and alternative investment  area and pension plan consultants. We also attended and participated in  Labor’s ERISA Advisory Council 2011 hearings on pension plan  investments in private equity and hedge funds, including the use of these  investments in defined contribution plans. We reviewed and analyzed the detailed information collected through the literature review, discussions,  and hearings to determine actions taken to date by federal agencies and  other entities to help plan sponsors make and manage hedge fund and  private equity investments.
We conducted this performance audit from February 2011 to February  2012 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: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Staff Acknowledgments
paragraphs: David Lehrer, Assistant Director, and Michael Hartnett, Analyst-in- Charge, managed this review.
Amber Yancey-Carroll also led portions of the research and made  significant contributions to all portions of this report.
Kathleen van Gelder helped develop the structure of the report, and  Luann Moy provided methodological assistance. Sheila McCoy and  Roger Thomas provided legal assistance. Ashley McCall assisted in  identifying relevant literature. James Bennett developed the report’s  graphics. Caitlin Croake and Lauren Gilbertson verified our findings.