August 31, 2011 / 7:36 PM / in 6 years

Pensions using hedge funds don't always know risks: GAO

WASHINGTON (Reuters) - More and more U.S. pension plans are investing in hedge funds, even though the plans’ administrators struggle to understand what is in the funds or their true exposure to risk, a federal auditor said on Wednesday.

As companies move to defined contribution plans, such as 401-ks, states and local governments have come to dominate the pension world. They rely heavily on returns for their investments to pay benefits to retirees.

Recent volatility in the values of those investments, along with cuts in amounts states and local governments put into the funds during the recession, have raised alarm about shortfalls in pension funding. One answer has been to invest the funds’ dollars into riskier hedge funds and private equity that can pay higher returns.

“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,” said the Government Accountability Office’s managing director, Barbara Bovbjerg, who focuses on workforce issues.

“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,” she added in testimony for the Labor Department’s pension council.

The share of large plans with investments in hedge funds grew to 60 percent in 2010 from 11 percent in 2001, according to the GAO. Investments in private equity also grew, to 92 percent in 2010 from 71 percent.

“But such investments are generally a small portion of plan assets,” Bovbjerg said, with the average allocation to hedge funds a little more than 5 percent in 2010.

Plans made slightly more than 9 percent of their investments in private equity.

“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,” she said.

“Valuations of private equity investments are uncertain during the investment’s long duration, which often lasts 10 years or more,” she added.

Plan sponsors are careful about selecting hedge funds and many make sure they invest in top-performing private equity funds that achieve returns in excess of those in the stock market, Bovbjerg said.

They also perform more due diligence and monitoring on these risky investments than on those in the traditional asset classes in order to mitigate risk.

Still, “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,” she said.

Reporting by Lisa Lambert; Editing by Andrew Hay

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