A growing number of defined benefit plans, predominately large ones, are investing through hedge funds and in private equity funds, but the total investment constitutes less than 15% of total plan assets, the Government Accountability Office says in a new study.
The GAO report also cautions that investment in these entities constitutes substantially more ‘challenges” than do investment in more prosaic instruments, like stocks and bonds.
The GAO report criticizes the Department of Labor (which regulates defined benefit plans as part of its duties for oversight of ERISA), saying the agency has not followed through on a 2008 recommendation that it provide guidance to defined benefit plans on investing in hedge funds and private equity partnerships.
The GAO cites a concern about having smaller funds invest in these instruments.
“According to plan officials, state and federal regulators, and others, some pension plans, such as smaller plans, may have particular difficulties in addressing the various demands of hedge fund and private equity investing,” the GAO says. “The Department of Labor generally agreed with our recommendation, but has yet to take action.”
The GAO report notes that “the lack of uniformity among these investments could complicate the development of comprehensive guidance for plan fiduciaries.” The report adds that, according to a survey of large plans, the share of plans with investments in hedge funds grew to 60% in 2010 from 11% in 2001.
Over the same period, investments in private equity were more prevalent but grew more slowly, an increase of large plans to 92% in 2010 from 71% in 2001.
But GAO says the average allocation of plan assets to hedge funds was a little over 5%. And the average allocation to private equity was just over 9%.
“Available data also show that investments in hedge funds and private equity are more common among large pension plans, measured by assets under management, compared with midsize plan,” the GAO says.
The GAO says that survey information on smaller plans was unavailable, so the extent to which these plans invest in hedge funds or private equity is unknown. The GAO report adds the challenges posed by investment in hedge funds and private equity partnerships include uncertainty about the precise valuation of their investment.
The report says that, hedge funds may, for example, own thinly traded assets whose valuation can be complex and subjective, making valuation difficult.
Furthermore, hedge funds and private equity funds may use considerable leverage (borrowed money or other techniques), can magnify profits, but can also magnify losses if the market goes against the fund’s expectations.
“Also, both are illiquid investments–that is they cannot generally be redeemed on demand, the GAO says. “Finally, investing in hedge funds can pose operational risks–that is, the risk of investment loss from inadequate or failed internal processes, people, and systems, or problems with external service providers rather than an unsuccessful investment strategy.”
The GAO report observes that investors in both hedge funds and private equity funds may be able to negotiate fee structure and valuation procedures, and the degree of leverage employed.
“Also, plans address various concerns through due diligence and monitoring, such as careful review of investment, valuation, and risk management processes,” the GAO says.