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. 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.