Aiming High, Pension Funds Bet Wrong

Like retirees who make the mistake of reaching for yield, pension fund managers have been shifting into hedge funds and private equity — and losing.

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How many times must we learn that slow and steady wins the race? It was true 2,600 years ago, when Aesop told the story of the Tortoise and the Hare. It’s true today, when pension fund managers are piling into exotic investments in search of better returns—only to find that their performance winds up lagging peers content to plod along with plain old stocks and bonds.

That’s right. The professional money managers in charge of your guaranteed retirement income have been loading up on hedge funds, real estate and private equity investments—paying big fees in the process and earning scant returns, according to a report in The New York Times. Over the last five years, pension funds with the most alternative investments returned an average of 4.1% a year while those with the fewest alternative investments returned an average of 5.3% a year.

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It’s easy to see why pension fund managers have gone the alternatives route. In a tough economy where the stock market had been dead for a decade, fund managers came under pressure to find higher returns that would help keep their pension plans on solid footing. Pension systems have blown up in places like Rhode Island and Alabama. Private equity and hedge funds, in particular, held the promise of providing much needed gains in a directionless market.

So in the aftermath of the financial crisis, pension fund managers began shifting into alternatives. Two of the more aggressive were the $26 billion Pennsylvania State Employees and the $51 billion Pennsylvania Public School Employees funds. About 46% of their portfolios were in alternative investments. Together they paid almost $700 million in fees, roughly 10 times more than they might have paid with a traditional approach. Their returns the last five years were under 4% a year—at least a percentage point lower than the average pension fund return.

The move by pension funds into alternatives is a little like the mistake that retirees have been making in recent years—shifting into riskier investments in search of higher yields. Many retirees have gambled on junk bonds and dividend-paying stocks because with interest rates so low they’ve not been able to earn enough income on ultra-safe bank CDs and Treasury Securities. These strategies may work fine for a while, or longer. But the risk is real: When a company runs into trouble and must cut its dividend or default on its bonds the chickens come home to roost.

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Don’t reach for yield. It’s the first thing every retiree should be advised. Better to cut costs, sell something or just make do. Layering on risk too often backfires, especially on those who do not have enough time to wait out near-term troubles.

Pension fund managers have an advantage in this regard; they have a long investment horizon. Ultimately, their bet on alternative investments may work out just fine. Then again, in the long term a sensible mix of plain old stocks and bonds in a low-fee account is apt to work out just fine too, and with less risk—whether you’re investing $50 billion or $50,000. Just ask Aesop.