(Bloomberg) -- Public pension funds have been moving huge amounts of money into alternative investments managed by Wall Street.
According to a recent report by Cliffwater LLC, an adviser to institutional investors, from 2006 to 2012 state pension funds more than doubled their allocations to alternative investments, which include private equity, real estate, hedge funds and commodities. Totaling almost $600 billion, these nontraditional investments now constitute 24 percent of public pension fund assets. In contrast, the funds dropped their investments in stocks to 49 percent from 61 percent over the six-year period.
Theres a reason for that big move, as explained in a recent International Monetary Fund report. Over the last 10 years, the average U.S. public pension fund earned a return of 6.4 percent a year, very healthy but not enough to meet the 8 percent return guaranteed to government employees. In an effort to take pressure off the state budgets that must cover those deficiencies, the IMF reports that state pension funds have been shifting billions to alternative investments promising higher yields.
To the casual observer, public pensions and hedge funds might seem like strange bedfellows. Public pension funds like to portray themselves as battlers for the little guy; hedge funds levy sizable fees that often go into the pockets of rich people.
Some commentators even depict pension fund participation in alternative funds as a cynical ploy by pension reformers to transfer wealth from retirees to billionaire fund managers. That was the myth promoted in an Oct. 12 op-ed article in the San Francisco Chronicle by self-proclaimed progressive writers Matt Taibbi of Rolling Stone and David Sirota. But pension funds started shoveling money into alternative investment programs well before pension reform was even in the news. As one example, the California Public Employees Retirement System, the largest U.S. public pension fund and a vigorous opponent of pension reform, has more than doubled its targeted investment in private equity over the past 10 years. Its 2012 report lists almost $20 billion of investments in funds managed by Blackstone Group LP, Apollo Global Management LLC, the Carlyle Group LP, KKR & Co. and other well-known private equity companies. Calpers and other public-pension funds moved into alternatives for one reason: They are desperate to achieve higher yields to help close pension deficiencies. If they are successful, there will be greater security for retirees and less pressure to cut public services or to raise taxes.
Of course, the foray by Calpers into alternatives isnt a panacea. Pension costs continue to rise in California. Calpers has announced an additional 50 percent increase in costs commencing in 2015, and the most recent performance of its alternatives has lagged that of its conventional assets. But the trajectory of Californias rising pension costs would have been even steeper had Calpers not increased its allocation to alternatives.
Sirota and Taibbi are right that the fees paid for alternative investment management are higher than those charged for managing conventional assets. But state pension funds are still welcoming alternative-fund managers with open arms because ultimately what counts most to them and their members are higher net yields after -- and regardless of -- fees. Would you prefer to earn (say) 10 percent after a 2 percent fee or (say) 7 percent after a 1 percent fee? In and of itself, fee size shouldnt drive investment selection.
Fortunately for those funds, the higher fees have paid off. According to Cliffwater, alternative investments played a role in the above-average performance of 19 of the 20 top-performing state pension funds over the last 10 years. Pension funds that allocated less to alternatives did worse.
Absurdly, Sirota and Taibbi also accuse alternative investment managers of favoring an end to defined-benefit pensions. The reality is exactly the opposite. Defined-benefit plans are a gravy train for private equity and hedge fund managers; 401(k) plans deploy much less capital into such nonconventional investments. Alternative investment managers would lose a fortune if pension money were shifted to 401(k) plans.
Theres no guarantee unconventional assets will outperform conventional assets, but for now state pension funds and defined-benefit pension defenders have good reason for their aggressive support of alternative investments. So-called progressives who prefer to portray Wall Street as sucking blood from working people and conspiring to end their pensions should acknowledge that truth.
(David Crane, a former financial-services executive, is a lecturer at Stanford University and president of Govern for California, a nonpartisan government-reform group. He was an economic adviser to California Governor Arnold Schwarzenegger from 2004 to 2011.)