Public pension funds across the country were hit hard over the last few years in the wake of the financial crisis, as investment yields dropped while payment obligations to public employees remained. In an effort to make up for those lean years, many public pension funds have invested heavily in so-called "alternative investments," which include vehicles like hedge funds and private equity funds. While these investments can yield higher returns, they are also riskier and require more active oversight from brokers on Wall Street, which means higher costs in the form of management fees.
These can be great investments -- if the returns are consistent over the long term. The problem for those relying on public pension fund payments (and the taxpayers who help finance them) is that recently they haven't been, even as States are relying on them more to keep their pension funds solvent.
New research from the Maryland Public Policy Institute (MPPI) shows just how much of a difference even a slightly subpar investment can make. The MPPI compared Maryland's pension fund performance to an index of other states' returns, and found that it lagged 0.92 percent below the nation-wide median over the past ten years. That less-than-one-percent difference means that Maryland lost out on $3.22 billion in potential returns, an amount that would have more than paid for the $2.9 billion "gas tax" the state enacted in 2013. In that same time, Maryland's pension fund paid nearly $300 million in management fees to hedge fund and private equity fund managers.
The high cost of alternative investments has some public pension funds rethinking their commitments to actively-managed funds. The California Public Employees' Retirement System (CalPERS), the largest in the U.S., recently announced that it was pulling all $4 billion it had invested in such funds. CalPERS spent an estimated $135 million in hedge fund management fees in fiscal year 2014 alone.
The stakes are high for public pension fund managers, who must maintain consistent investment results or cut pension benefits and force taxpayers to make up the difference. The high cost of hedge fund management, combined with their lackluster returns in recent years, should prompt more states to reconsider how they allocate their pension investments.