Alternative investing plans to boost underfunded pensions

Detroit's bankruptcy has shined a harsh light on public pension plans that don't have enough money to pay what they owe retirees. According to the Public Fund Survey 2013, the nation's hundred biggest funds had an aggregate actuarial funding level of 73 cents for every dollar in obligations.

To help bridge the gap, Detroit and many other pension plans have tried to boost returns by turning away from stocks and bonds and toward alternative investments like real estate, venture capital and hedge funds. Critics like David Kotok of Cumberland Advisors, say these options are too risky. “In this era of very low interest rates, they are chasing a better yield,” says Kotok. “They are adding to the imbalance to try to get returns. That’s dangerous.”

Kotok, who advises pension funds, says the sole goal of a pension portfolio is to earn just enough to cover pension checks, with as little risk as possible. “We don’t know what an appropriate level of alternative investment is for a long-lived pension plan,” he says.

Records from June 2012 show that before Detroit declared bankruptcy, alternative investments comprised 12 percent of the city’s pension fund. That’s low, compared with the 96 pension plans surveyed by the National Association of State Retirement Administrators. The average portion of pension dollars devoted to real estate and alternative investments has more than tripled over the last 12 years, growing from 7 percent to around 22 percent today.  

The association says its members are not taking unnecessary risks and says alternative investments add diversification to a fund's asset allocation. Keith Brainard, research director at the National Association of State Retirement Administrators, adds, “The introduction of other asset classes such as real estate and hedge funds can reduce the overall level of risk of the portfolio.”

This trend toward alternative investments picked up steam in the early 2000s, when the tech bubble popped and pensions lost money. It gained even more momentum in 2008 when the market dropped again and pension funds rushed to decrease their reliance on publically traded stocks and bonds.

It's a trend that has alarmed former social security official Andrew Biggs, now at the American Enterprise Institute, a conservative think tank. “Plans that invested in alternatives have received slightly higher returns in the last few years,” he says. “But they have also had more risk to their investments.” 

The returns have helped the Pennsylvania employees' retirement system, which has just 58 cents for every dollar it owes retirees. It holds more than $6 billion in alternative investments -- roughly a quarter of the fund. For the year ending September 2013, Pennsylvania made a 10.5 percent return on those investments, compared with the 7.5 percent it needs to meet its obligations.

In response to questions from Al Jazeera about risk, a Pennsylvania fund spokeswoman wrote, "What is considered 'appropriate' or 'risky' for one fund might not be for another." And in its latest investment report, administrators write that the plan's " investment policy is based on a comprehensive asset allocation study ... evaluated to identify the most efficient portfolios at different levels of risk, return and liquidity."

But Biggs is not convinced. "Putting a few percentage points into alternatives is not a big deal, but when you are shifting heavily into it, that tells me that they are not simply about risk/return trade-offs, they are trying to get more returns in order to avoid some of these other tough choices," he says. 

With more than 20 million Americans banking on getting monthly pension checks—not to mention the politically tough and painful options of cutting benefits or raising taxes—some experts expect pensions to keep chasing fatter returns and taking on greater risk.