Defined Benefit Pension Plans: Plans Face Challenges When Investing in Hedge Funds and Private Equity
Published: 2011-08-31T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Millions of Americans rely on retirement savings plans for their financial well-being in retirement. Plan sponsors are increasingly investing in assets such as hedge funds (privately administered pooled investment vehicles that typically engage in active trading strategies) and private equity funds (privately managed investment pools that typically make long-term investments in private companies). Given ongoing market challenges, it is important that plan fiduciaries apply best practices, and choose wisely when investing plans assets to ensure that plans are adequately funded to meet future promised benefits. This statement addresses (1) what is known about the extent to which defined benefit plans have invested in hedge funds and private equity, (2) challenges that such plans face in investing in hedge funds and private equity, (3) steps that plan sponsors can take to address these challenges, and (4) the implications of these challenges for plan sponsors and the federal government.
section_title: What GAO Found
paragraphs: A growing number of private and public sector pension plans have invested in hedge funds and private equity, but such investments generally constitute a small share of total plan assets. According to a survey of large plans, the share of plans with investments in hedge funds grew from 11 percent in 2001 to 60 percent in 2010. Over the same time period, investments in private equity were more prevalent but grew more slowly--an increase from 71 percent of large plans in 2001 to 92 percent in 2010. Still, the average allocation of plan assets to hedge funds was a little over 5 percent, and the average allocation to private equity was a little over 9 percent. Available data also show that investments in hedge funds and private equity are more common among large pension plans, measured by assets under management, compared with midsize plans. Survey information on smaller plans is unavailable, so the extent to which these plans invest in hedge funds or private equity is unknown. Hedge funds and private equity investments pose a number of risks and challenges beyond those posed by traditional investments. For example, investors in hedge funds and private equity face uncertainty about the precise valuation of their investment. Hedge funds may, for example, own thinly traded assets whose valuation can be complex and subjective, making valuation difficult. Further, hedge funds and private equity funds may use considerable leverage--the use of borrowed money or other techniques--which can magnify profits, but can also magnify losses if the market goes against the fund's expectations. Also, both are illiquid investments--that is they cannot generally be redeemed on demand. Finally, investing in hedge funds can pose operational risks--that is, the risk of investment loss from inadequate or failed internal processes, people, and systems, or problems with external service providers rather than an unsuccessful investment strategy. Plan sponsors GAO spoke with address these challenges in a number of ways, such as through careful and deliberate fund selection, and negotiating key contract terms. For example, investors in both hedge funds and private equity funds may be able to negotiate fee structure and valuation procedures, and the degree of leverage employed. Also, plans address various concerns through due diligence and monitoring, such as careful review of investment, valuation, and risk management processes. The Department of Labor (Labor) has a role in helping to ensure that private plans fulfill their fiduciary duties, which includes educating employers and service providers about their fiduciary responsibilities under Employee Retirement Income Security Act of 1974 (ERISA). According to plan officials, state and federal regulators, and others, some pension plans, such as smaller plans, may have particular difficulties in addressing the various demands of hedge fund and private equity investing. In light of this, in 2008, GAO recommended that Labor provide guidance on the challenges of investing in hedge funds and private equity and the steps plans should take to address these challenges. Labor generally agreed with our recommendation, but has yet to take action. The agency explained that the lack of uniformity among these investments could complicate the development of comprehensive guidance for plan fiduciaries.

section_title: Letter
paragraphs: I am pleased to be here today to discuss plan fiduciaries’ investments in  hedge funds and private equity. As you know, millions of Americans rely  on retirement savings plans for their financial well-being in retirement.  Much has happened in the financial markets since we issued three  reports in 2008—one that addressed defined benefit (DB) pension plan  investments in hedge funds and private equity, another that addressed  federal oversight and other issues regarding hedge funds exclusively, and  a third that addressed private equity funds. Hedge funds were deeply  affected by the financial market events of 2008. 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.
My statement today is based primarily on findings from our 2008 report on  private and public sector DB pension plan investments in hedge funds  and private equity, and a subsequent 2010 testimony that we have  updated to reflect more recent data. Specifically, my comments will focus  on (1) the extent to which DB plans have invested in hedge funds and  private equity, (2) challenges that such plans face in investing in hedge  funds and private equity, (3) steps that plan sponsors can take to address  these challenges, and (4) the implications of these challenges for plan  sponsors and the federal government. In addition, we currently have work  under way examining DB plans’ recent experiences investing in these  vehicles. Specifically, this project—being conducted for the ranking  member of the Subcommittee on Health, Employment, Labor and  Pensions of the House Committee on Education and the Workforce— seeks to assess the extent to which DB plans have realized desired  benefits from investing in hedge funds and private equity, and what  actions they may have taken in response to lessons learned over the last  5 years. We expect to issue a report on this work early next year.
In conducting our prior work, 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 and Pensions &  Investments. We updated these data for purposes of my statement today.  We also conducted in-depth interviews with representatives of 26 public  and private sector DB pension plans and obtained and reviewed available  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. We conducted our work in  accordance with generally accepted government auditing standards.  Additional information on our scope and methodology is available in the  published reports.
subsections: 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: We reported in 2008 that DB plan investments in hedge funds and private  equity have grown, but such investments are generally a small portion of  plan assets. This remains the case today. According to a Pensions &  Investments survey, the percentage of large plans (as measured by total  plan assets) investing in hedge funds grew from 11 percent in 2001 to 60  percent in 2010 (see fig. 1). Over the same time period, the percentage of  large plans that invest in private equity grew at a much slower rate—71  percent to 92 percent—likely because of the fact that a much larger  percentage of plans were already invested in private equity in 2001.
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 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 was a little over 9  percent. 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. Of the 78 large plans that reported hedge fund investments in  2010, 20 had allocations of 10 percent or more (see fig. 2). The highest  reported hedge fund allocation was 33 percent of total assets. Similarly,  of the 121 plans that reported private equity investments in 2010, 34 had  allocations of 10 percent or more, and the highest reported private equity  allocation was 30 percent.
Available survey data show that larger plans, measured by total plan  assets, are more likely to invest in hedge funds and private equity  compared with midsize plans. As shown below, a 2010 survey by  Greenwich Associates 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 and, in the absence of this information,  the extent to which these smaller plans invest in hedge funds and private  equity is unclear.
section_title: Hedge Fund and Private Equity Investments Pose Various Risks and Challenges for Plan Sponsors
subsections: section_title: Valuation Risk
paragraphs: One of the major challenges that both hedge fund and private equity  investments pose to plan sponsors is uncertainty over the current value of  the sponsors’ investment. With regard to hedge funds, we noted that plan  officials may lack information on both the nature of the specific underlying  holdings of the hedge fund, as well as the aggregate value on a day-to- day basis. Because many hedge funds may own thinly traded securities  and derivatives whose valuation can be complex and subjective, a plan  official 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 the release of such information could compromise  their trading strategy. In addition, even if hedge fund managers were to  provide detailed positions, these managers may seek to profit through  complex and simultaneous positions and can abruptly change their  positions and trading tactics in order to achieve a desired return as  changing market conditions warrant, making it difficult for plans to  independently ascertain the value or fully assess the degree of  investment risk. Although we noted in January 2008 that some hedge  funds have improved disclosure and transparency about their operations  because of the demands of institutional investors, several pension plans  cited limited transparency as a prime reason they had chosen not to  invest in hedge funds.
As with hedge funds, valuations of private equity investments are  uncertain during the investment’s long duration, which often lasts 10  years or more. Unlike investments that are traded and priced in public  markets, plan officials have limited information on the value of private  equity investments until the underlying holdings are sold. In some  cases, private equity funds estimate the value of the fund by comparing  the value of companies in their portfolio with the value of comparable  publicly traded assets. However, prior to the sale of underlying  investments, assessing the value of a private equity fund is difficult.
section_title: Investment Risk
paragraphs: While any plan investment may fail to deliver expected returns over time,  hedge fund and private equity investments pose investment challenges  beyond those posed by traditional investments. For example, both hedge  fund and private equity managers may use leverage—that is, borrowed  money or other techniques—to potentially increase an investment’s return  without increasing the amount of capital invested. Although registered  investment companies are subject to strict leverage limits, a hedge fund  or private equity fund can make relatively unrestricted use of leverage.  Leverage can magnify profits, but can also magnify losses to the fund if  the market goes against the fund’s expectations. In addition, a private  equity fund manager’s strategy typically involves concentrating its  holdings in a limited number of underlying companies—generally about  10 to 15 companies, often in the same sector. The returns for such  concentrated, undiversified funds are highly susceptible to the success or  failure of each underlying company and related market sector conditions.  Further, hedge funds and private equity funds can also feature relatively  costly fee structures compared with those of mutual funds. These fee  structures can have a significant impact on net investment returns.  Despite these fee structures, pension plan officials we contacted cited  attaining returns superior to those attained in the stock market as a  reason for investing in hedge funds and private equity. One plan official  noted that as long as hedge funds add value net of fees, they found the  higher fees acceptable.
section_title: Lack of Liquidity
paragraphs: Hedge funds and private equity are also relatively illiquid investments— that is, investors generally cannot easily redeem their investments on  demand. Hedge funds often require an initial lockup of a plan’s  investment for a year or more, during which an investor cannot cash out  of the hedge fund. After the initial lockup period, hedge funds offer only  periodic liquidity, such as quarterly. Hedge funds impose such liquidity  limits because sudden liquidations could disrupt a carefully calibrated  investment strategy. Nonetheless, these constraints also pose certain  disadvantages to plan sponsors, such as inhibiting a plan’s ability to limit  a hedge fund’s investment loss. Private equity funds require an even  longer-term commitment than hedge fund investments, and during that  period, a plan may have no ability to redeem its investments—and can  often require additional capital over the life of the investment. 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 to invest in underlying companies and then obtain  returns over time as investments mature.
section_title: Operational Risk
paragraphs: We reported that pension plans investing in hedge funds are also  exposed to operational risk—that is, the risk of investment loss because  of 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. While most investments can pose some type of operational  risk, according to a report by an investment consulting firm, many hedge  funds engage in active, complex, and sometimes heavily leveraged  trading, and a failure of operational functions, such as processing or  clearing one or more trades, and may have particularly grave  consequences for the overall position of the hedge fund.
section_title: Plan Sponsors Take a Number of Steps to Address the Risks of Hedge Fund and Private Equity Investing
paragraphs: Pension plan officials we spoke with take a number of steps in an attempt  to mitigate the risks and challenges of investing in hedge funds and  private equity.
First, plan sponsors noted the importance of making careful and  deliberate fund selection when investing in hedge funds and private  equity. In the case of hedge funds, plan sponsors emphasized defining a  clear purpose and strategy for their hedge fund investments. Most of the  plans we contacted described one or more specific strategies for their  hedge fund investments. Several sources stated that private equity  investments have greater variation in performance among funds,  particularly among venture capital investments compared with other asset  classes such as domestic stocks, and therefore they must invest with top- performing funds in order to achieve long-term returns in excess of those  of the stock market.
Plan sponsors and others also cited the importance of negotiating key  terms of investments in hedge funds and private equity. They said in the  case of hedge funds, such terms 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  hedge fund investment passes a previous peak value of the fund  shares—known as a high-water mark. Key contract terms for private  equity may also include fee structure and valuation procedures, though  one plan sponsor noted the ability to negotiate favorable contract terms is  limited when investing in top-performing funds, because investing in such  funds is highly competitive.
Due diligence and ongoing monitoring, beyond those required for  traditional investments, are also important. For hedge funds, due  diligence can be a wide-ranging process including study of a hedge fund’s  investment, valuation, risk management processes, and compliance  procedures, as well as a review of back office operations. As with hedge  fund investments, plans take additional steps to mitigate the challenges of  investing in private equity through extensive and ongoing monitoring,  beyond that 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 investment.
Also, several plan sponsors address some of the risks and challenges of  investing in hedge funds and private equity by investing via a fund of  funds. Investing in a fund of funds provides investors with diversification  across multiple funds, which can mitigate the effect of one manager’s  poor performance. In particular, a fund of private equity funds can allow  plans to invest in a variety of managers, industries, geographies, and year  of initial capital investment. In addition, a plan sponsor may be able to rely  on a fund of funds manager to conduct negotiations, due diligence, and  monitoring of the underlying hedge funds. As we reported, funds of funds  can be appropriate if plan sponsors do not have the skills necessary to  manage a portfolio of hedge funds. In addition, investing through a fund of  funds may provide a plan better access to hedge funds or private equity  funds than a plan would be able to obtain through direct investment.  Nonetheless, investing in a fund of funds has some drawbacks and  limitations, including an additional layer of fees—such as a 1 percent flat  fee and a performance fee of 5 to 10 percent of returns—on top of the  substantial fees that a fund of funds manager pays to the underlying  hedge funds. Furthermore, funds of funds also pose the same challenges  as hedge funds, such as limited transparency and liquidity, and the need  for the plan to conduct a due diligence review of the fund of funds firm.  However, investing through a fund of funds does not relieve plan  sponsors of their fiduciary duties; accordingly, the plan sponsors must act  prudently in selecting and monitoring funds of funds.
section_title: The Federal Government Can Help Educate Plans on the Challenges of Investing in Hedge Funds
paragraphs: According to plan officials, regulators, and others, some pension plans— especially smaller plans—may find it particularly difficult to address the  various demands of hedge fund investing. For example, medium-size and  small plans may not have the expertise to oversee the trading and  investment practices of hedge funds. Some plans may also lack the ability  to conduct the necessary due diligence and monitoring of hedge fund  investments. Smaller plans may have only one-or two-person staffs, or  may lack the resources to hire outside consulting expertise and may be  locked out of top-performing funds. To a lesser extent, some 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 due diligence necessary during the fund selection process.
In light of these challenges, and as predecessors to this 2011 ERISA  Advisory Council have concluded, the Department of Labor (Labor) can  play a role in helping to ensure that plans fulfill their Employee Retirement  Income Security Act of 1974 (ERISA) fiduciary duties when investing in  hedge funds and private equity. 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. In 2008, the ERISA Advisory Council recommended  that Labor publish guidance to clarify the role of ERISA fiduciaries in  selecting, valuing, and accounting for hard-to-value assets, of which  many hedge funds and private equity funds are composed. In addition,  the Investor’s Committee formed by the President’s Working Group on  Financial Markets published a report in January 2009 on the best  practices for hedge fund investors. The report acknowledged that hedge  fund investments are not necessarily suitable for some investors and  provided many recommendations for investors selecting and monitoring  their hedge fund investments—including best practices for valuation— such as obtaining a written statement of the fund’s valuation policies and  procedures and ensuring the fund’s portfolio is being valued in  accordance with Generally Accepted Accounting Principles (GAAP).
In 2008, we recommended that Labor provide guidance for qualified plans  under ERISA on the unique challenges of investing in hedge funds and  private equity and the steps plans should take to address these  challenges. For example, we stated that Labor’s Employee Benefits  Security Administration (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. Finally,  we noted that while EBSA is not tasked with offering guidance to public  sector plans, such plans may nonetheless benefit from such guidance.  Although Labor generally agreed with our recommendation, the agency  explained that the lack of uniformity among these investments could  complicate the development of comprehensive guidance for plan  fiduciaries. To date, Labor has not acted on this recommendation.
section_title: Concluding Observations
paragraphs: As plan sponsors seek to better ensure adequate return on assets under  management, recent trends suggest that investments in alternative assets  such as hedge funds and private equity are becoming more  commonplace. In light of these trends and ongoing public equity market  volatility, it is reasonable to expect that the number of plan sponsors  making such investments will increase in the future. Our past work  indicates that such assets may serve useful purposes in a well-thought- out investment program, offering plan sponsors advantages that may not  be as readily available from more traditional investment options.  Nonetheless, it is equally clear that investments in such assets place  demands on plan sponsors that are significantly beyond the demands of  more traditional asset classes.
These challenges can be daunting even for large plan sponsors.  Accordingly, we believe that, as we recommended in 2008, the Secretary  of Labor should provide guidance regarding investing in hedge funds and  private equity specifically designed for qualified plans under ERISA. In  particular, we believe that a discussion of the challenges that such  investments pose to small plan sponsors would be beneficial.
This concludes my prepared statement. I would be happy to answer any  questions that the council may have.
section_title: GAO Contacts and Staff Acknowledgments
paragraphs: For further questions on this statement, please contact me at (202) 512- 7215. Individuals making key contributions to this statement include  Michael Hartnett, Sharon Hermes, David Lehrer, and Amber Yancey  Carroll.
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