Pension Officers Putting Billions Into Hedge Funds
By Riva D. Atlas and Mary Williams Walsh
New York Times
Sunday, November 27, 2005
Faced with growing numbers of retirees, pension plans are
pouring billions into hedge funds, the secretive and lightly
regulated investment partnerships that once managed money
only for wealthy investors.
The plans and other large institutions are expected to
invest as much as $300 billion in hedge funds by 2008, up
from just $5 billion a decade ago, according to a study by
Bank of New York and Casey, Quirk & Associates, a
consulting firm. Pension funds account for roughly 40
percent of all institutional money.
This month, the investment council that oversees the New
Jersey state employees pension fund said it would put some
of its money into hedge funds for the first time, investing
$600 million over the next several months.
While most pension plans have modest stakes in hedge funds,
others have invested more than 20 percent of their assets.
Weyerhaeuser, the paper company, has 39 percent of its
pension fund's assets in hedge funds. In Congress, there has
been a push for amendments that would make it easier for
hedge funds to manage even more pension money, without
having to comply with the federal law that governs company
Pension officials who have been shaken by market downturns
and persistent deficits are attracted by hedge funds'
promise of richer, or more consistent, returns. But the
trend has caused some consultants and academics to voice
cautions. They question whether hedge funds, with risks that
are hard to measure, are appropriate for pension funds,
whose sole purpose, by law, is to pay out predetermined
benefits to retired workers.
Those benefits are considered so crucial that they are
guaranteed: corporate pension failures are covered by the
Pension Benefit Guaranty Corporation, a federal agency,
while pension failures by state and local governments are
covered by taxpayers. Given that the benefits are paid out
on a set schedule, critics wonder whether it makes sense to
rely on investments whose returns are hard to predict,
managed by private partnerships that disclose little about
their operations and charge some of the highest fees on Wall
"It's very inappropriate when the company is offering a
pension plan that is guaranteed by the federal government,"
said Zvi Bodie, a professor of finance and economics at
Boston University who is enthusiastic about hedge funds in
Hedge funds make large, sophisticated investments based on
the premise that by swimming outside the currents of the
markets, often betting against conventional wisdom, they can
outperform other investments. Hedge funds became famous in
the 1990's, when managers like Michael Steinhardt and
George Soros made huge swashbuckling bets that sometimes
produced returns of 30 percent or more.
More recently, hedge funds have made headlines when they ran
into trouble: Long-Term Capital Management, a hedge fund
whose principals included two Nobel Prize-winning
economists, nearly collapsed in 1998; and this summer, Bayou
Group, a $450 million hedge fund based in Connecticut, shut
down after most of its money disappeared. Its two officers
have pleaded guilty to fraud charges. Hedge funds have
traditionally been only for wealthy, sophisticated investors
so regulators have not monitored them as they have stocks or
mutual funds, although they are starting to do so.
The news of splashy gains and scandals may not paint an
accurate picture of a business that in many ways has become
more conservative as a result of the flood of pension fund
money. To attract that money, many hedge fund managers
Among pension fund managers, however, "the whole mentality
has changed," said Jane Buchan, chief executive of Pacific
Alternative Asset Management, which manages $7.5 billion in
funds that invest in hedge funds, primarily for large
pension funds. "They are saying, we need returns and we will
be aggressive about getting them. They just don't want any
One of the first pensions to start working with hedge funds
is also the nation's biggest corporate pension fund, the $90
General Motors fund. It started with a small test
investment in 1999 and increased it to about $2 billion in
2003, said Jerry Dubrowski, a G.M. spokesman.
The company is using hedge funds, along with other
unconventional investments, in hopes of getting something
close to stock market returns without the market's
volatility, Mr. Dubrowski said. To pay out the $6.5 billion
G.M. owes to its retirees each year, the pension fund must
produce annual returns of a little more than 7 percent.
Otherwise, G.M. will have to dip into the fund's principal.
At current interest rates, G.M. cannot get those returns
with bond investments, and if it tries to juice returns by
betting on the stock market, it will have to cope with
"It's really not helpful to have that up-10, down-10"
performance, Mr. Dubrowski said. "You want a return that
allows you to cover the benefits payments without attacking
the capital." It is that kind of consistency some pension
mangers are seeking.
"We are looking for consistently positive returns rather
than the absolute highest returns," said Robert Hunkeler,
International Paper's $6.8 billion pension plan, which
has been invested in hedge funds for around five years.
Most pension funds have modest stakes of less than 5
percent, according to a recent J. P. Morgan survey.
Verizon has 3 to 4 percent of its portfolio invested
with hedge funds, and is considering adding to its
investment, said William F. Heitmann, senior vice president
Some pension fund managers say that diversifying away from
stocks through a modest stake in hedge funds is reasonable,
especially as hedge funds offer the promise of returns not
linked to stock market performance. In 2000, for example,
when the Standard & Poor's 500-stock index fell 9 percent,
hedge funds rose 5 percent, according to Hedge Fund
The New Jersey state pension fund's investment of $600
million represents less than 1 percent of its assets, but it
hopes eventually to raise the figure to $3 billion as part
of a plan to diversify its portfolio, said Orin Kramer, the
chairman of the oversight board.
The New Jersey fund has been wrestling with a $30 billion
shortfall, after the stock market bubble burst five years
ago. "In recent years, conventional stock investments
haven't worked," said Mr. Kramer, who is also a hedge fund
manager. He said that in general it is good to diversify no
matter what the market does.
Other pension plan managers are far more aggressive. Eli
Lilly has about 20 percent in hedge funds and the
Pennsylvania state employees' pension fund has 22 percent.
Weyerhaeuser's big position has significant benefits for the
company. Accounting rules let companies factor expected
pension returns into their operating income; Weyerhaeuser's
hedge-fund-laden portfolio allows it to claim expected
annual returns of 9.5 percent. By comparison, the 100
largest companies that sponsor pension funds predicted last
year that their average long-term returns would be 8.5
percent, according to Milliman Inc., an actuarial firm.
For Weyerhaeuser, each 0.5 percent increase in the expected
rate of return is worth an additional $21 million to the
company's pretax income this year, according to S.E.C.
filings. Weyerhaeuser did not respond to phone inquiries
about its hedge fund investments, but said in S.E.C. filings
that its actual pension investment returns more than justify
its assumption of 9.5 percent.
Hedge fund investors place a lot of trust in the funds'
managers, giving them great flexibility in how they produce
returns. The managers do not need to give investors
specifics about trading activities, and there are no daily
updates on the value of investors' holdings as there are
with mutual funds.
Employees of G.M., Verizon or International Paper, who are
involuntary hedge-fund investors through their participation
in pension plans, will not find any reference to the funds
in those companies' annual reports. In their footnotes,
these and other companies drop hints that a sophisticated
investor might recognize as a reference to hedge funds, but
they do not give the particulars. International Paper's
description of its pension asset allocation, for example,
breaks it down into "equity securities," "debt securities,"
"real estate" and "other."
Some companies and governments, like Pennsylvania, make the
argument that hedge funds are not really an asset class at
all, but an "asset management tool" that does not have to be
disclosed as part of the fund's allocation to stocks or
That lack of disclosure has some regulators and pension
specialists worried. Labor Department officials, who
regulate pension funds, declined to discuss the hedge fund
phenomenon, but referred to a 1996 letter the department
wrote to the United States comptroller of the currency.
The letter said that the Labor Department still expected
pension officials to exercise prudence when investing in
derivatives, a form of trading in which hedge funds often
engage. The letter also said pension officials were
responsible for understanding and fully vetting their hedge
fund investments, and measuring how they might perform - and
how they might affect the pension fund - under a variety of
Susan M. Mangiero, author of "Risk Management," a textbook
for pension officials, said she had come across pension
executives who had not done that level of analysis. Some did
not even know they had derivatives in their portfolios, she
"A lot of well-intentioned people don't know they don't
know," she said.
In Washington, despite concerns over the health of the
nation's pension system, there has been little discussion of
pension plans' growing use of nontraditional investments.
Even as Congress has been working to shore up the pension
system and strengthen the Pension Benefit Guaranty
Corporation, a provision to relax the pension law for hedge
funds has been proposed.
The provision would raise the limit on how much pension
money a hedge fund can handle before it is deemed a
fiduciary under the pension law, which would require it to
be more prudent and careful than is required under
securities law and would bar some trades entirely. The
provision was added to a broad pension bill in the House
shortly before the Committee on Education and the Workforce
approved the legislation.
Currently a financial institution becomes a pension
fiduciary when more than 25 percent of its assets consist of
pension money; the bill would raise that to 50 percent. The
House bill would also change the definition of "plan
assets," so that only corporate pension money would be
counted, not pension money from government plans or foreign
These two changes are not in the counterpart Senate pension
bill that was recently approved, but they could be added
soon during efforts to reconcile the House and Senate bills.
Wall Street's interest in overcoming these legal barriers
shows the allure of pension money, which tends to stick with
an investment strategy and is far less likely to fly out the
door when the markets turn bad.
"Pension money is the stickiest form of capital," Mr. Kramer
of the New Jersey pension fund noted.
But the surge of pension money is coming at a time when the
returns of many hedge funds have not been as strong as in
past years, raising questions about whether pensions are
arriving at the party late. Hedge funds actually lost money
in four of the first ten months of this year, although they
still had an overall average return of 5.7 percent.
Those returns easily beat the stock market: the S.& P. 500
index was up 1 percent in the same period. But as they
continue to attract money, hedge funds may start to more
closely mimic the performance of plain old stocks and bonds.
"There is no such thing as a free lunch," said Frank Partnoy,
a professor at the University of San Diego law school and a
former trader at
Morgan Stanley whose clients once included large pension
funds. "And even if there were, nobody is offering it to