NEW YORK (Reuters) - Faced with growing obligations and shrinking returns, many of the largest U.S. public pensions have raised their exposure to alternative investments to record levels this year, despite ongoing criticism of the risks and costs.
Public pension fund managers have poured billions of dollars into alternative investments, ranging from Polish energy facilities to catastrophe bonds, as lackluster stock market returns and historically low interest rates have made it difficult for pensions to earn enough.
Public plans with more than $1 billion had a median of 15 percent in alternatives as of June 2012, the highest ever and up from 9.2 percent in June 2011, according to the Wilshire Trust Universe Comparison Service.
The increase carries risks of unstable performance and high fees amid a funding shortfall of $1.38 trillion as of 2010, according to Pew Center on the States data. Already, the vast majority of states have cut pension benefits or increased contributions from workers, or are trying to.
“There are several ways in which the economics can start to go against you,” Martin Fridson, global credit strategist at BNP Paribas Asset Management, said of pension funds investing in alternative assets. He noted that hedge fund performance varies, while private equity firms may take the reward while shifting more risk onto the pension fund.
The California Public Employees’ Retirement System - the largest U.S. public pension fund, with $237 billion - has a record 14 percent of its assets in alternatives, including venture capital, private equity, buyout funds and mezzanine debt. Calpers does not include hedge funds, real estate or commodities under alternative investments.
The South Carolina Retirement System still had a whopping 53 percent of its assets in alternatives as of May 30 despite a much-publicized debacle last year.
South Carolina’s former chief investment officer made alternative bets that resulted in manager fees of $344 million in 2011. At the same time, the fund had a deficit of about $14.4 billion, raising doubts that the returns were worth the risk and fees.
In recent years, market volatility and historically low interest rates have persuaded public pension funds to consider other options, especially because many are underfunded and unlikely to get large cash contributions in the current economy.
Barely more than half of public pensions were fully funded in fiscal 2010, according to the Pew Center.
Pension investment returns fell in 2011 to 4.4 percent, almost half of the historical target of 8 percent, according to data provided to Reuters by Callan Associates. Median returns were only 3.2 percent for the last five years.
In early August, New Jersey’s $69.9 billion public pension system announced that after a meager return of 2.26 percent in fiscal 2012, it plans to increase alternative investments in fiscal 2013 to 30 percent, up from nearly 23 percent in 2012. In the first five months of 2012, it had increased its investments in alternatives by nearly $4 billion.
“This is a continuing response to the problems raised in 2001, when the market collapsed and we lost more than $20 billion in value from our pension fund because we were so strongly invested in stocks and bonds,” said Andy Pratt, spokesman for the New Jersey Treasury Department’s Division of Investment.
The California Public Employees’ Retirement System has 14 percent of its assets in private equity, up from 12.5 percent at the end of fiscal 2010.
“There is a premium that goes with investing in alternative investments because they typically are a little bit riskier, but higher return,” said CalPERS spokesman Brad Pacheco. He added that the risk is “measured risk that we’re willing to accept within the portfolio.”
One reason alternatives are appealing is that they are not linked to the performance of the stock and bond markets. Public pension plans earned an average 12 percent return from private equity investments last year, compared with a 7.2 percent loss from stock investments, according to alternatives research and consultancy firm Preqin.
Pennsylvania Public School Employees’ Retirement System spokeswoman Evelyn Tatkovski said investments in catastrophe reinsurance- a type of alternative investment- through firms like Aeolus Capital Management Ltd. and Nephila Capital Ltd. are attractive because they are “uncorrelated” to traditional stock and bond markets.
The California State Teachers’ Retirement System, which has $155.5 billion in assets, invested $500 million in Industry Funds Management in February, which has a 40 percent stake in energy services provider Dalkia Polska - a Polish heating network.
“People need heat, so from a pension fund’s perspective, it’s highly valuable because there’s a continuous sort of cash-yield,” said Christian Seymour, head of European infrastructure for Industry Funds Management. “You’re certainly going to see an excess return, if you like, over government bonds” while avoiding the volatility associated with stocks, he said.
But not everyone is convinced that the added risk and costs of alternatives make them a good choice for pensions.
“Public pension plans are being forced into more alternatives, including the ‘exotics,’ in an effort to meet their assumed rate of return,” said Curtis Loftis, South Carolina’s state treasurer. That worries him because of their high and “opaque” fees.
Private equity firms typically charge a 2 percent management fee, and once they achieve returns of about 8 percent, collect 20 percent of the profits. Hedge funds charge an average management fee of 1.57 percent and a performance fee of 17.6 percent, according to Preqin. The average fee for mutual funds last year was 1.1 percent, according to Lipper.
The fees don’t guarantee performance, especially given lagging returns for hedge funds this year. The HFRI fund-weighted composite index, which tracks about 2000 hedge funds globally, was up 1.87 percent for the first six months of 2012.
In comparison, the S&P 500 has outperformed its exotic counterpart, with a return of 8.31 percent over that period.
Reporting by Sam Forgione; Editing by Jilian Mincer, Jennifer Ablan, Walden Siew and Dan Grebler