Despite costs, pension investments get exotic

(MoneyWatch) Pension funds across the country face massive deficits, estimated to be as much as $3 trillion. In an attempt to cover these deficits and keep their promises to retirees, many pension plans have dramatically increased their allocations to alternative investments. According to Wilshire Trust Universe Comparison Service, retirement systems with at least $1 billion in assets had raised their stake in real estate, private equity, and hedge funds from 10.7 percent in 2007 to 18.3 percent by the end of 2011.

The big question is whether such aiming at higher returns is worth the fees. The New York Times reported that the $24.5 billion South Carolina Retirement Systems paid $344 million in fees in 2011 alone, up from just $22 million in 2005. For those staggering fees, the system earned an annualized (and before-fees) return of 3.1 percent for the three years ending June 2011, though the system's performance over the next six months made its three-year average rise above the national average.

Private equity and venture capital funds are supposed to generate higher returns than public equities. Of course, they generally come with significantly more risk. Whether pension plans, with their known obligations, should take on these incremental risks (with taxpayer dollars) is a separate issue. The issue we'll address is whether there is any reason to believe that the pension plans will actually earn higher returns.

Unfortunately, as the evidence presented in my book, "The Only Guide to Alternative Investments You'll Ever Need," demonstrates, there's no evidence to support that belief.

Hedge funds

The list of issues with investing in hedge funds is quite long: no persistent outperformance, highly illiquid, and tax inefficient, among other reasons. And for all those risks, investors haven't been well rewarded, with returns lagging not only stock indexes, but even bond indexes.

Private equity

When we turn to private equity, we find that the evidence is better, but still not good. For example, a study covering the period July 1986-June 2005 found that while private equity outperformed the S&P 500 Index (13.8 percent versus 11.2 percent), it underperformed similarly risky public small value stocks, which returned 16 percent.

Similar to hedge funds, investors in private equity forgo the benefits of liquidity, transparency, broad diversification, and daily pricing. In addition, the distributions of private equity returns look like a lottery ticket -- there's a small likelihood of extreme outperformance and a large likelihood of underperformance. For risk-averse investors like pension plans, these investments don't seem appropriate.

Unfortunately, most alternative investments are vehicles that are designed to separate assets from their owners (in the case of pension plans its taxpayers like you), transferring them to the wallets of the purveyors. While these vehicles haven't delivered on their promise of superior returns, they certainly have been successful at enriching their owners.

What's also disconcerting is that we have an uneven match. In the contest between the sophisticated marketing machines of Wall Street (with large marketing budgets) and local public servants, who do you think is likely to win? In case you need a hint, you might try recalling the 1994 bankruptcy of California's Orange County, which at the time was the largest U.S. county to have gone bankrupt. The county's longtime treasurer was Robert Citron, whose "sophisticated" investment strategies bankrupted the county.

Image courtesy of taxbrackets.org

[twisi]

Hi Larry,another great article. Does the same go for endowed assets of charitable foundations?

Thanks

[LarryswedroeCBS]

Pretty much the same is true. Big trend toward alternatives despite the fact that they have delivered poor results, persistently.

Investors are much better off simply building globally diversified portfolios using passively managed low cost funds, taking no more risk than they have the ability, willingness or need to take, and then staying the course. Simply rebalancing and tax managing as needed. Those who have done so have outperformed the vast majority of investors, both individual and institutional. and it's a virtual guarantee that they will continue to do so, assuming they have the ability to stay the course, ignoring the noise of the markets.

The winning strategy is very simple as I have laid out in my books such as Wise Investing Made Simple, The Quest for Alpha and The Only Guide You'll Ever Need for the Right Financial Plan, among others. Simple but not easy because emotions get in the way.

Best wishes
Larry

[LarryswedroeCBS]

Yes, sorry to say, despite all the evidence as I present in The Only Guide to Alternative Investments You'll Ever Need and The Quest for Alpha. They should know better.

Best wishes
Larry

[matt6052]

I don't know where I'm a gonna go when the volcano blows

[hypnotoad72]

Oh, does "investing" still get applied to swindlers like Enron, whose CEOs urged and compelled their employees to buy stock... with the CEOs then cashing in by selling their stock and leaving the employees with nothing in return?

[hypnotoad72]

Sorry, but from workers' standpoints, they put in their money fair and square.

As was said, neither private nor public industry has been very conscious in keeping said promises and said balance sheets on the level.

And you wonder why people have cultivated an anti-business sentiment. Business has become anti-worker, over a period of time.

[bckrd1]

The only ones who benefit from these plans are the ones who sell them. Period. Our city is thinking of borrowing 300M in bonds to do this. Bad idea.

[hypnotoad72]

Agreed.

It's another supply-side bailout/swindle.

For once it's as simple as that.

[hypnotoad72]

The city should be bringing back middle class wage-paying jobs; reverse the horrors that started this mess in the first place (offshoring, cutting quality controls, and other means to quietly profiteer while the whole system started to decay as a result...)

All the details have been pointed out in various articles I've posted over time... which includes these and others:




http://www.epi.org/publication/ib330-productivity-vs-compensation/
http://www.realitybase.org/journal/2009/3/10/the-american-dream-died-in-february-1973.html
http://www.csmonitor.com/Business/2012/0612/How-skewed-is-America-s-income-inequality-Take-our-quiz/Median-income/
http://www.nytimes.com/2012/05/13/opinion/sunday/fables-of-wealth.html
http://krugman.blogs.nytimes.com/2012/04/28/where-the-productivity-went/
http://motherjones.com/kevin-drum/2010/01/vicious-cycle-stagnant-wages
http://www.nytimes.com/2009/05/04/opinion/04krugman.html?_r=4
http://www.ctj.org/html/layoffs.htm
http://www.nytimes.com/2011/05/01/opinion/01eggers.html
http://greatdivide.typepad.com/across_the_great_divide/2009/06/walmart-workers-on-welfare-lets-look-for-the-spin.html
http://www.usatoday.com/news/nation/story/2011-09-13/census-household-income/50383882/1
http://www.thefiscaltimes.com/Media/Slideshow/2012/04/04/Minimum-Wage-and-What-It-Buys-You-1950s-to-Now.aspx?index=1
http://www.hollandsentinel.com/opinions/x13292164/COLUMN-American-workers-got-what-they-deserved
http://underthemountainbunker.com/2011/03/31/senator-bernie-sanders-guide-to-corporate-freeloaders/
http://www.truth-out.org/top-us-corporations-outsourced-more-24-million-american-jobs-over-last-decade/1303196400
http://www.ctj.org/html/corp0402.htm
http://money.cnn.com/2008/12/19/news/companies/auto_crisis/index.htm
http://www.sociology.vt.edu/course/socprobs/corporatewelfare.html
http://popwatch.ew.com/2011/05/02/undercover-boss-season-finale/
http://www.techrepublic.com/blog/career/supervisor-wants-employee-to-quit-part-time-job/2902
http://www.lawyersandsettlements.com/case/hiring-illegal-immigrants.html
http://www.cato.org/pub_display.php?pub_id=6283
http://ecosalon.com/squawk-our-tax-dollars-help-mcdonalds-hawk-chicken-in-europe/
http://drich13.newsvine.com/_news/2011/03/20/6307764-study-governor-walkers-budget-will-cut-21843-jobs-could-actually-hurt-state-economy
http://www.progress.org/cwfedex.htm
?http://www.infoworld.com/d/adventures-in-it/why-us-it-jobs-arent-coming-back-465?source=fssr
http://www.infoworld.com/d/the-industry-standard/beware-the-plot-increase-the-h-1b-visa-program-269
http://hubpages.com/hub/HowH1BVisaFRAUDiskillingAmerica?
http://www.computerworld.com/s/article/9133529/U.S._H_1B_workers_outnumber_unemployed_techies
http://www.ourfuture.org/corporate-welfare
http://mydd.com/story/2007/2/7/184312/5388
http://acsa.net/press/savearticlegates.htm
http://www.ritholtz.com/blog/2011/03/ronald-reagan-where-free-unions-and-collective-bargaining-are-forbidden-freedom-is-lost/
http://money.cnn.com/2009/08/28/news/economy/paycuts/index.htm
http://greatdivide.typepad.com/across_the_great_divide/2009/06/walmart-workers-on-welfare-lets-look-for-the-spin.html
http://www.larouchepub.com/other/2003/3045walmart_iowa.html
http://www.businessinsider.com/microsoft-to-grassley-were-still-using-h-1bs-no-moral-imperative-to-hire-americans-2009-3
http://www.google.com/search?q=americans+train+replacements+H1B
http://www.youtube.com/watch?v=uJDhS4oUm0M
http://anti-union.blogspot.com/2008/11/greedy-american-union-auto-workers-and.html
http://management.fortune.cnn.com/2011/03/25/unpaid-jobs-the-new-normal/

And others...