Despite costs, pension investments get exotic

Many pension plans are gambling that riskier investments will help them make up funding shortfalls.

(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.

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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.