In today’s New York Times there is a story about South Carolina’s retirement system investing half of its money in alternative investments on the recommendation of their former investment chief, a civil servant who made half-a-million dollars a year, drove a Lamborghini, and didn’t put a lot in his calendar. I looked at the latest valuation report for the South Carolina plan and…….
it’s a disaster. Look at these three pages of excerpts and you will see that the plan is spiraling to bankruptcy as $1.6 billion in contributions is coming in and $2.5 billion (and rising) is going out in benefits. The fund has $26 billion as of 6/30/11 with half of that in ‘alternative investments’
….For public pension plans the main factor looks like it’s the client’s need to inflate asset values so as not to raise taxes or cut benefits.South Carolina’s fund made over $4 billion in earnings for the year ended 6/30/11 with the value of their alternative investments increasing by$3 billion. Last year in New Jersey the State Investment Council, which sets pension policy, raised the cap to 38 percent from 28 percent on how much pension money can be invested in hedge funds, private equity and other so-called alternative investments and the value of assets in the plan have only kept steady because of the ever-increasing valuations of that portion of the portfolio.
One of the things I do in my day job is look at financials of insurance companies, especially the balance sheets. Now, insurance companies are allowed to hold "alternative investments", but the amount they hold is highly curtailed. Heck, the amount of public equity they hold outside Separate Accounts (I'm not explaining that right now) is constrained. For all the alternative investments they hold, they have to hold risk-based capital against the possibility of the loss of value of those assets… and the capital charges can be quite high.
So that keeps the insurance company shenanigans somewhat limited in their investments (don't throw AIG at me — that was outside its subsidiary insurance companies, and I don't want to get into it right now). But public pensions… sky's the theoretical limit. There's no such concept as risk-based capital for public pensions, which would be especially laughable given it's considered "good" to have your liabilities only 80% covered by assets. No insurance company could get away with that.
But this is the obvious end to allowing discount rates of 8.5%. If you can't make that sort of return on bonds, or even public equity, you lard on the risk with these alternative investments… which increases the likelihood of the fund cratering. Risk is both downside and upside, doncha know.
Otherwise it wouldn't be risky, now would it?
MORE: Leo Kolivakis on possible kickbacks in this arrangement. He also has some recommendations, such as the involvement of forensic accounting firms as well as more stringent restrictions on plan fund managers from jumping ship to work in the funds chosen for the plan funds.