“Alternative” investing threatens public retirement funds with high risks and low returns.
Public pension systems are collapsing across the country. In Chicago, Mayor Rahm Emanuel is under growing pressure to find a way to mitigate the city’s nearly $20 billion shortfall to its municipal retirement plan. The mayor’s plan to reduce workers’ benefits and raise property taxes — which would only resolve half of the deficit — has met with open opposition from the unions and taxpayer advocate groups. In San Bernardino, Calif., bankruptcy hearings for the city are stalled due to failing negotiations with its biggest creditor, the California Public Employees’ Retirement System. Difficulties in meeting payments to the system were a major factor forcing San Bernardino into bankruptcy.
The primary culprit behind this decline is the country’s shifting demographics. In 1960, there were five workers to every one retiree, providing a funding base that was able to maintain adequate monetization levels with the pensions. Seeing the pensions as a nearly uncollapsible financial structure, many politicians “borrowed” from the pensions to support underfunded government issues, such as infrastructure repairs and capital investment. As the “baby boomers” started to retire and as the ratio of workers to retirees dropped due to declining birth rates to 3 to 1 in 2009 — with the ratio expected to reach 2 to 1 by 2030 — the portion of unfunded obligations with the pensions has reached a point that many governments cannot effectively manage. In 2011, according to some estimates, state debt — including pensions — had reached $4.2 trillion.
It is estimated that the current average of 20 percent of municipal budgets allocated for pension management could hit 75 percent if current trends continue. To help reduce their unfunded obligations and to help inject more money into retirement funds, the managers of many municipal and state pensions have opted to do something that would have been entirely unthinkable 20 years ago — invest public pension funds into Wall Street’s “alternative” investment vehicles.
Based on data cited from the National Association of State Retirement Administrators by Al Jazeera America, 22 percent of the nation’s public pensions’ $3 trillion in total assets — $660 billion in public money — is being tied into high-fee, high-risk investments such as real estate and hedge funds. It has been alleged that these pension managers may have entered into “alternative” investment deals in which the fee structures, nature of the confidentiality agreements and structure of the investments themselves gave the “alternative” investment vehicle owners a significant advantage at the cost of the public.
Blackstone and Kentucky
In documents obtained by Pandodaily by Securities and Exchange Commission whistleblower Chris Tobe, the public was given its first chance to look at the language of these agreements. The documents reflect an SEC inquiry into the Kentucky Retirement Systems regarding “placement agent fees” — fees paid to investment “headhunters” to secure an investment by these governmental pensions with various brokers and hedge fund managers. In this particular case, KRS failed to disclose additional placement agent fees that existed on top of the already discovered $14 million in fees. This discovery suggests that inadequate and inappropriate safeguards for protecting the state pension exist, prompting questions over whether more undisclosed payments may have been delivered.
Tobe’s documents detail KRS’s dealings with Blackstone — a significant Wall Street investment firm and a major financial backer of Senate Minority Leader Mitch McConnell. According to The Wall Street Journal, “About $37 of every $100 of Blackstone’s $111 billion investment pool comes from state and local pension plans.”
According to the documents, Blackstone is guaranteed its annual management fee, regardless of the performance of the investment. In addition, the pension money is exempt from some of the protections guaranteed to other investment capital under federal law, including bans against Blackstone engaging in conflicts of interests — such as investing in companies Blackstone already has a relationship with — and assurances that damages sought against the fund managers will be paid from the fund’s assets themselves.
Additionally, even though these documents involve government agencies and public funding, they were marked confidential and hidden from public view.
“These agreements aren’t unique to Kentucky – they are everywhere,” Tobe told Pando. “They include exactly the kind of risk and boilerplate heads-I-win-tales-you-lose (sic) language that is almost certainly standard in the contracts that so many other pension funds have been signing… This is a national problem.”
High risks, low returns
There is a certain level of recklessness in this kind of investment. One of Tobe’s documents contains a 2011 memo showing that KRS wanted to invest approximately $400 million in Blackstone’s Alternative Asset Management Fund. Blackstone was guaranteed 50 basis points — half of 1 percent of all investments — in fees, plus 10 percent of the overall profits, 1.62 percent in management fees and 19.78 percent in incentive fees on top of underlying and undisclosed individual hedge fund manager fees. The decision to invest in this fund was made at a time when Blackstone was facing repeated SEC investigations.
In 2013, Blackstone’s Alternative Asset Management Fund earned a 11.54 percent return. The S&P 500 earned a 32.39 percent return, meaning that if Kentucky would have invested in a low-fee basic S&P index fund, the state would have seen almost three times the profit, or approximately $78 million.
“There is simply no correlation between high money management fees and high investment returns,” said John J. Walters, co-author and visiting fellow at the Maryland Public Policy Institute. In a 2013 press release, the Maryland Public Policy Institute pointed out that the 10 states paying the most in Wall Street fees saw an annualized five-year return of 1.34 percent, while the 10 states paying the lowest fees saw a return of 2.38 percent.
“Retired state employees and taxpayers across the country are not getting their money’s worth,” it said. “They deserve a simpler, more effective investment strategy for their retirement savings.”
A broken system
This situation represents a confluence of heavy lobbying, campaign finance and failures in public disclosure. While some reports — such as Oregon’s pension fund reporting an average annual return of 15.8 percent over the last three decades on the back of private equity — have helped to sell the notion of alternative investment to states and municipalities, the lack of disclosure makes informed decision-making difficult.
In the case of Oregon, for example, much of the positive gain in the three-decade average happened during the tech boom of the 1990s. The drop in return after the tech bubble burst convinced Oregon to make up the difference through “alternative” investment.
With much of this “alternative” investment being based on high-risk instruments — corporate buyouts, distressed and unsecured debt, venture capital and mortgage derivative swaps — a lack of a clear understanding of what exactly is going on with the investment seems foolhardy. This is even more so when taking into account that the firms offering these investments also directly lobby the administrators and finance the campaigns of politicians charged with the oversight of these public funds.
Traditionally, public pensions work under the “prudent person rule,” which states that public pensions are to avoid “shady, risky or otherwise poor investments” in order to avoid unwarranted risks. But, with Blackstone admitting that investing in its alternative asset fund “involves a high degree of risk,” “the possibility of partial or total loss of capital will exist,” “there can be no assurance that any (investor) will receive any distribution,” and an investment “should only be considered by persons who can afford a loss of their entire investment,” one must question whether such investments protect the pensioners’ or the public’s best interests.