oversight

Defined Benefit Pension Plans: Recent Developments Highlight Challenges of Hedge Fund and Private Equity Investing

Published by the Government Accountability Office on 2012-02-16.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

                United States Government Accountability Office

GAO             Report to the Ranking Member,
                Subcommittee on Health, Employment,
                Labor, and Pensions, Committee on
                Education and the Workforce, House of
                Representatives
February 2012
                DEFINED BENEFIT
                PENSION PLANS
                Recent Developments
                Highlight Challenges
                of Hedge Fund and
                Private Equity
                Investing




GAO-12-324
                                               February 2012

                                               DEFINED BENEFIT PENSION PLANS
                                               Recent Developments Highlight Challenges of Hedge
                                               Fund and Private Equity Investing
Highlights of GAO-12-324, a report to the
Ranking Member, Subcommittee on Health,
Employment, Labor, and Pensions, Committee
on Education and the Workforce, House of
Representatives


Why GAO Did This Study                         What GAO Found
                                               While plan representatives GAO contacted generally stated that their hedge fund
Millions of Americans rely on defined
                                               and private equity investments met expectations in recent years, a number of
benefit pension plans for their financial
well-being in retirement. Plan                 plans experienced losses and other challenges, such as limited liquidity and
representatives are increasingly               transparency. National data indicated that hedge fund and private equity
investing in a wide range of assets,           investments were significantly affected by the 2008-2009 financial crisis, and
including hedge funds and private              plans and experts GAO contacted indicated that pension plan investments were
equity funds. In recent years, GAO has         not insulated from losses. Most of the 22 plan representatives GAO interviewed
noted that plans may face significant          said that their hedge fund investments met expectations overall, despite, in some
challenges and risks when investing in         cases, significant losses during the financial crisis. A few plan representatives,
these alternative assets. These                however, expected hedge fund investments to be much more resilient in
challenges and ongoing market                  turbulent markets, and found the losses disappointing. Given the long-term
volatility have raised concerns about          nature of private equity investments, almost all of the representatives were
how these investments have                     generally satisfied with these investments over the last 5 years. Some plan
performed since 2008.                          representatives described significant difficulties in hedge fund and private equity
                                               investing related to limited liquidity and transparency, and the negative impact of
As requested, to better understand
                                               the actions of other investors in the fund—sometimes referred to as co-investors.
plan sponsors’ experiences with these
                                               For example, representatives from one plan reported they were unable to cash
investments, GAO examined (1) the
recent experiences of pension plans
                                               out of their hedge fund investments due to discretionary withdrawal restrictions
with investments in hedge funds and            imposed by the fund manager, requiring them to sell some of their stock holdings
private equity, including lessons              at a severe loss in order to pay plan benefits.
learned; (2) how plans have responded          Most plans included in our review have taken actions to address challenges
to these lessons; and (3) steps federal        related to their hedge fund and private equity investments, including allocation
agencies and other entities have taken         reductions, modifications of investment terms, and improvements to the fund
to help plan sponsors make and
                                               selection and monitoring process. National data reveal that plans have continued
manage these alternative investments.
                                               to invest in hedge funds and private equity—for example, one survey revealed
To answer these questions, GAO                 that the percentage of large plans investing in hedge funds grew from 47 percent
analyzed available data; interviewed           in 2007 to 60 percent in 2010—and most plans GAO contacted have also
relevant federal agencies and industry         maintained or increased their allocations to these investments. However, most
experts; conducted follow-up                   plans have adjusted investment strategies as a result of recent years’
interviews with 22 public and private          experiences. For example, three plans have reduced their allocations to hedge
pension plan sponsors selected among           funds or private equity. Other plan representatives also took steps to improve
the top 200 plans and contacted in the         investment terms, including more favorable fee structures and enhanced liquidity.
course of GAO’s prior related work;            However, some plan representatives and experts indicated that smaller plans
and surveyed 20 plan consultants,              would likely not be able to take some of these steps.
academic experts and other industry
experts.                                       The Department of Labor has provided some guidance to plans regarding
                                               investing in derivatives, but has not taken any steps specifically related to hedge
This report reemphasizes a 2008                fund and private equity investments. In recent years, however, other entities have
recommendation that the Secretary of           addressed this issue. For example, in 2009, the President’s Working Group on
Labor provide guidance to help plans           Financial Markets issued best practices for hedge fund investors. Further, both
investing in hedge funds and private           GAO and a Department of Labor advisory body have recommended that the
equity.                                        department publish guidance for plans that invest in such alternative assets. To
                                               date, it has not done so, in part because of a concern that the lack of uniformity
                                               among such investments could make development of useful guidance difficult. In
                                               2011, the Department of Labor advisory body specifically revisited the issue of
View GAO-12-324. For more information,         pension plans’ investments in hedge funds and private equity, and a report is
contact Charles Jeszeck at (202) 512-7215 or
jeszeckc@gao.gov.
                                               expected in early 2012.

                                                                                       United States Government Accountability Office
Contents


Letter                                                                                     1
              Background                                                                   4
              Selected Pension Plans Reported Mixed Experiences with Hedge
                Funds and Private Equity Investments, and Some Faced
                Significant Losses and Other Challenges                                    8
              Plans Continue to Invest in Hedge Funds and Private Equity, but
                Some Plan Sponsors Have Taken Steps to Address Challenges                18
              Federal Entities and Others Have Developed Guidance Addressing
                Hedge Funds and Private Equity                                           30
              Concluding Observations                                                    33
              Agency Comments                                                            35

Appendix I    Objectives, Scope, and Methodology                                         36



Appendix II   GAO Contact and Staff Acknowledgments                                      43



Tables
              Table 1: Recent Data from Hedge Fund, Private Equity, and S&P
                       500 Indexes                                                         9
              Table 2: Performance of Hedge Fund and Private Equity
                       Investments Compared to Selected Plans’ Expectations              10
              Table 3: List of Pension Plans Interviewed                                 37
              Table 4: Criteria Used in 2008 Selection of Plans for In-Depth
                       Interviews                                                        38
              Table 5: Number and Size of Pension Plans Observed in Recent
                       Surveys                                                           41


Figures
              Figure 1: Typical Private Equity Long-term Investment Profile              14
              Figure 2: Share of Large DB Plans Investing in Hedge Funds and
                       Private Equity from 2001 to 2010                                  19
              Figure 3: Pension Plans with Investments in Hedge Funds and
                       Private Equity by Size of Total Plan Assets in 2010               21
              Figure 4: Comparison of Commingled and Separate Accounts                   26




              Page i                                 GAO-12-324 Defined Benefit Pension Plans
Abbreviations

Dodd-Frank Act             Dodd-Frank Wall Street Reform and Consumer
                           Protection Act
ERISA                      Employee Retirement Income Security Act
ILPA                       Institutional Limited Partners Association
IOPS                       International Organisation of Pension Supervisors
Labor                      Department of Labor
OECD                       Organisation for Economic Cooperation and
                           Development
SEC                        Securities and Exchange Commission




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Page ii                                          GAO-12-324 Defined Benefit Pension Plans
United States Government Accountability Office
Washington, DC 20548




                                   February 16, 2012

                                   The Honorable Robert E. Andrews
                                   Ranking Member
                                   Subcommittee on Health, Employment, Labor,
                                     and Pensions
                                   Committee on Education and the Workforce
                                   House of Representatives

                                   Dear Mr. Andrews:

                                   Millions of Americans rely on defined benefit pension plans for their
                                   financial well-being in retirement. In order to pay promised retirement
                                   benefits when due and at an acceptable cost, employers must make
                                   adequate contributions to these funds, and plan fiduciaries must invest
                                   the fund balance in assets that yield an adequate rate of return over time.
                                   Public and private sector pension plans have primarily invested in
                                   traditional investments such as stocks and bonds, but plans are
                                   increasingly investing in “alternative” investments such as hedge funds
                                   and private equity funds.

                                   Generally, hedge funds and private equity funds are privately organized
                                   and managed funds that are available only to institutional investors or
                                   wealthy individuals. Historically, both have been managed in ways that
                                   exempt them from certain aspects of federal securities law and regulation
                                   that apply to other investment pools such as mutual funds. However, as a
                                   result of the Dodd-Frank Wall Street Reform and Consumer Protection
                                   Act (Dodd-Frank Act), 1 most hedge fund and private equity managers will
                                   be required to register with the Securities and Exchange Commission
                                   (SEC) and comply with new aspects of federal securities law.

                                   Much has happened in the financial markets since GAO issued a report in
                                   2008 examining the extent to which pension plans invest in hedge funds




                                   1
                                    Pub. L. No. 111-203, 124 Stat. 1376 (2010).




                                   Page 1                                         GAO-12-324 Defined Benefit Pension Plans
and private equity. 2 The financial market events of the second half of
2008 significantly affected hedge funds. According to a 2009 industry
survey, most hedge fund strategies produced double-digit losses in 2008,
and hedge funds saw approximately $70 billion in redemptions between
June and November 2008. 3 Nevertheless, many of these investments
have rebounded, and a 2010 industry survey of institutional investors
suggests that these investors continue to be committed to investing in
hedge funds but with a shifting set of objectives and criteria. 4 Private
equity investment values were also substantially lowered during this
period and have similarly recovered along with values in the public
equities market. However, given ongoing market volatility, concerns
remain about how well such investments will meet the expectations of
plan sponsors that have invested in them.

In order to assess the extent to which pension plans have realized
desired benefits from investing in hedge funds and private equity, and
actions they may have taken in response to recent experiences,
particularly given ongoing market volatility, you asked us to examine the
following questions:

•   What is known about the experiences of defined benefit pension plans
    with investments in hedge funds and private equity, including recent
    lessons learned?

•   How have plan sponsors responded to lessons learned from recent
    experiences with such alternative investments?




2
 This report, GAO, Defined Benefit Pension Plans: Guidance Needed to Better Inform
Plans of the Challenges and Risks of Investing in Hedge Funds and Private Equity,
GAO-08-692, (Washington, D.C.: Aug.14, 2008), was followed by other GAO documents
reflecting more recent data in 2010 and 2011. These documents were Defined Benefit
Pension Plans: Plans Face Valuation and Other Challenges When Investing in Hedge
Funds and Private Equity, GAO-10-915T (Washington, D.C.: July 20, 2010) and Defined
Benefit Pension Plans, Plans Face Challenges When Investing in Hedge Funds and
Private Equity, GAO-11-901SP (Washington, D.C.: Aug. 31, 2011).
3
 Greenwich Associates and SEI Knowledge Partnership, Hedge Funds under the
Microscope: Examining Institutional Commitment in Challenging Times (January 2009).
4
 Greenwich Associates and SEI Knowledge Partnership, Institutional Hedge Fund
Investing Comes of Age: A New Perspective on the Road Ahead (June 2011).




Page 2                                        GAO-12-324 Defined Benefit Pension Plans
•   What steps have federal agencies and other entities taken to help
    plan sponsors make and manage investments in such alternative
    assets, and what additional steps might be warranted?

To answer these questions, we reviewed relevant literature; analyzed
data; interviewed relevant federal agencies and industry experts;
conducted in-depth, follow-up interviews with pension plan sponsors
contacted in the course of our prior related work; and surveyed a selected
group of 20 plan consultants, academic experts, and other industry
experts. Specifically, we conducted in-depth, follow-up interviews with
representatives of 22 public and private sector defined benefit pension
plans that were interviewed for our 2008 report examining the extent to
which pension plans invest in hedge funds and private equity. 5 We
identified these plans in 2008 using data from the 2006 Pensions &
Investments survey of the largest 200 pension plans and through our
interviews with industry experts. Plan representatives’ responses from
these interviews do not represent a statistically generalizeable sample of
all pension plans. We interviewed officials of federal agencies, relevant
national organizations, pension plan consulting firms, and other national
experts. We conducted a survey of five open-ended questions with plan
consultants, academic and industry experts, representatives of plan
participants, and representatives of public and private plan sponsors. We
obtained data on the national performance of hedge fund and private
equity investments from private organizations, Cambridge Associates
LLC and Hedge Fund Research, Inc. We obtained and analyzed survey
data on the extent to which pension plan sponsors continue to invest in
hedge funds and private equity from two private organizations, Greenwich
Associates and Pensions & Investments. We conducted our work from
February 2011 to February 2012 in accordance with generally accepted
government auditing standards. Those standards require that we plan
and perform the audit to obtain sufficient, appropriate evidence to provide
a reasonable basis for our findings and conclusions based on our audit
objectives. We believe that the evidence obtained provides a reasonable
basis for our findings and conclusions based on our audit objectives. For
more information on our objectives, scope, and methodology, see
appendix I.




5
GAO-08-692.




Page 3                                  GAO-12-324 Defined Benefit Pension Plans
             Defined benefit pension plans are intended to pay retirement benefits that
Background   are generally based on an employee’s years of service and other factors.
             The financial condition of these plans—and hence their ability to pay
             retirement benefits when due—depends on adequate contributions from
             employers and sometimes employees, and prudent investments that yield
             an adequate rate of return over time. Poor investment choices can have
             serious implications for both the plan sponsor and, potentially, plan
             beneficiaries. Poor investment results may necessitate greater
             contributions by the plan sponsor, which could result in lower profits in the
             case of a private plan sponsor, or higher taxes in the case of a public
             plan. In some cases, the plan sponsor could opt to require greater
             participant contributions or reduce future retiree benefits. Plan sponsors
             generally try to maximize returns for an acceptable level of risk and, in
             doing so, may invest in various categories of asset classes, which for
             many years have consisted mainly of stocks and bonds. Plan sponsors
             may also invest in other asset classes or trading strategies, sometimes
             referred to as alternative investments—which can include a wide range of
             assets such as hedge funds, private equity, real estate, and commodities.
             Plans may make such investments in an effort to diversify their portfolios,
             achieve higher returns or for other reasons. In recent years, hedge funds
             and private equity have been two of the most common alternative assets
             held by institutional investors such as public and private pension plans.

             Although there is no universally accepted definition of hedge funds, the
             term is commonly used to describe pooled investment vehicles that are
             privately organized and administered by professional managers who often
             engage in active trading of various types of securities, commodity futures,
             options contracts, and other investment vehicles. 6 Hedge funds can also
             hold relatively illiquid and hard-to-value investments such as real estate
             or shares in private equity funds. Although hedge funds have a reputation
             of being risky investments that seek exceptional returns, this was not their
             original purpose, and is not true of all hedge funds today. Established in
             the 1940s, one of the first hedge funds invested in equities and used
             leverage and short selling to protect, or “hedge” the portfolio from its




             6
               In both the hedge fund and private equity industries, the entity that is responsible for
             management of the fund is commonly referred to as the general partner, and an investor
             in the fund is commonly referred to as a limited partner. In this report, except where other
             terminology is appropriate, we refer the general partner as the fund manager, and the
             limited partners as co-investors.




             Page 4                                            GAO-12-324 Defined Benefit Pension Plans
exposure to the stock market. 7 Over time, hedge funds diversified their
investment portfolios and engaged in a wider variety of investments
strategies. As GAO reported in 2008, defined benefit pension plans have
invested in hedge funds for a number of reasons, including the desire for
investment returns that exceed the returns available in the stock market
or obtaining steadier, less volatile returns.

Likewise, there is no commonly accepted definition of private equity
funds, but such funds are generally privately managed pools of capital
that invest in companies, many of which are not listed on a stock
exchange. Unlike many hedge funds, private equity funds typically make
longer-term investments in private companies. Private equity funds also
seek to obtain financial returns through long-term appreciation based on
active management. Strategies of private equity funds vary, but most
funds target either venture capital or buy-out opportunities. Venture
capital funds invest in young companies that often are developing a new
product or technology. Private equity fund managers may provide
expertise to a fledgling company to help it become suitable for an initial
public offering. Buy-out funds generally invest in larger established
companies in order to add value, in part, by increasing efficiencies and, in
some cases, consolidating resources by merging complementary
businesses or technologies. For both venture capital and buy-out
strategies, investors hope to profit when the company is eventually sold,
either when offered to the public or when sold to another investor or
company. Unlike stocks and bonds, which are traded and priced in public
markets, plans have limited information on the value of private equity
investments until the underlying holdings are sold.

Traditionally, hedge funds and private equity funds and their managers
have been exempt from certain registration, disclosure and other
requirements under various federal securities laws. The presumption is
that investors in such vehicles have the sophistication to understand the
risks involved in investing in them and the resources to absorb any losses
they may suffer. However, as a result of the Dodd-Frank Act, the
managers of such investment vehicles will be regulated in ways that they



7
 Leverage involves the use of borrowed money or other techniques to potentially increase
an investments’ value or return without increasing the capital invested. A short sale is the
sale of a security that the seller does not own or a sale that is consummated by the
delivery of a security borrowed by, or for, the account of the seller. Short selling is
generally used to profit by the decline in the price of a security.




Page 5                                            GAO-12-324 Defined Benefit Pension Plans
have not been previously. 8 For example, hedge fund and private equity
managers will generally now be required to register with the SEC,
establish a specific regulatory compliance program, and comply with
various record-keeping requirements. 9 While these fund managers must
now register with the SEC, the funds they manage will remain
unregistered. Unlike other investment funds—such as mutual funds—that
register with the SEC, hedge funds and private equity funds are thus not
subject to certain requirements, such as limitations on leverage and
minimum requirements relating to corporate governance.

Private sector pension plan investment decisions must comply with
provisions of Employee Retirement Income Security Act (ERISA), which
set forth fiduciary standards based on the principle of a prudent standard
of care. Under ERISA, plan sponsors and other fiduciaries must (1) act
solely in the interest of the plan participants and beneficiaries and in
accordance with plan documents; (2) invest with the care, skill, and
diligence of a prudent person familiar with such matters; and (3) diversify
plan investments to minimize the risk of large losses. Under ERISA, the
prudence of any individual investment is considered in the context of the
total plan portfolio, rather than in isolation. 10 Public sector plans, such as
those at the state, county, and municipal levels, are not subject to
funding, vesting, and most other requirements applicable to private sector
defined benefit pension plans under ERISA, but must follow requirements
established for them under applicable state law. Many states have
enacted standards comparable to those of ERISA.


8
 15 U.S.C. § 80b-20 note, section 401-419 of the Dodd-Frank Wall Street Reform and
Consumer Protection Act (Pub. L. No. 111-203, 124 Stat. 1376 (2010)).
9
 Some hedge fund and private equity managers will remain exempt under the new law.
For example, certain fund managers with less than $150 million in assets under
management will not be required to register with the SEC. Exemption for Advisers to
Venture Capital Funds with Less than $150 Million in Assets Under Management, and
Foreign Private Advisers No. 57-37-10, 76 Fed. Reg. 39646 ( 2011).
10
  ERISA’s “prudent man” standard with respect to investment duties is treated under 29
C.F.R. § 2550.404a-1(b). In general, it provides that that the prudent man standard is
satisfied if the fiduciary has given appropriate consideration, among other facts and
circumstances, to the following factors (1) the composition of the plan portfolio with regard
to diversification of risk; (2) the volatility of the plan investment portfolio with regard to
general movements of investment prices; (3) the liquidity of the plan investment portfolio
relative to the funding objectives of the plan; (4) the projected return of the plan
investment portfolio relative to the funding objectives of the plan; and (5) the prevailing
and projected economic conditions of the entities in which the plan has invested and
proposes to invest.




Page 6                                             GAO-12-324 Defined Benefit Pension Plans
In 2008, we reported on plan investments in hedge funds and private
equity, including a discussion of the benefits that plan fiduciaries seek
and challenges they face in doing so. We concluded that, because these
investments require a degree of fiduciary effort well beyond that required
by more traditional investments, doing so can be a difficult challenge,
especially for smaller plans. Such plans may not have the expertise or
financial resources to be fully aware of these challenges, or have the
ability to address them through negotiation, due diligence, and
monitoring. Further, we noted that, while plans are responsible for making
prudent choices when investing in any asset, the Department of Labor
(Labor) also has a role in helping to ensure that pension plan sponsors
fulfill their fiduciary duties in managing pension plans that are subject to
ERISA. This can include educating employers and service providers
about their fiduciary responsibilities under ERISA. In light of these duties,
and the risks and challenges of investing in hedge funds and private
equity, we recommended that the Secretary of Labor issue guidance
specifically designed for qualified plans under ERISA. We specifically
called for guidance that would (1) outline the unique challenges of
investing in hedge funds and private equity; (2) describe steps that plans
should take to address these challenges and help meet ERISA
requirements; and (3) explain the implications of these challenges and
steps for smaller plans. To date, Labor has not implemented this
recommendation. In responding to GAO’s 2008 recommendation, Labor
noted that while it would consider the recommendation, the lack of
uniformity among hedge funds and private equity funds could make
development of comprehensive and useful guidance difficult.




Page 7                                   GAO-12-324 Defined Benefit Pension Plans
Selected Pension
Plans Reported Mixed
Experiences with
Hedge Funds and
Private Equity
Investments, and
Some Faced
Significant Losses and
Other Challenges

Hedge Fund and Private      Hedge fund and private equity indexes show that these investments were
Equity Investments Were     significantly affected by the financial market turbulence of recent years,
Affected by the Financial   and plans and experts we contacted indicated that pension plan
                            investments were not insulated from losses. According to a composite
Crisis, but Most Selected   hedge fund index, in the midst of the financial crisis, hedge funds
Plans Indicated These       produced quarterly losses as great as 16 percent in the last quarter of
Investments Met             2008. 11 Similarly, a private equity index measured losses throughout most
Expectations                of 2008, with losses of a little more than 15 percent in the last quarter. 12 In
                            comparison, the stock market, as measured by the Standard and Poor’s
                            500 index, declined in value by close to 40 percent in 2008 (see table 1
                            for a comparison of recent data from various indexes). Our in-depth
                            discussions with plan representatives were largely consistent with these
                            national trends. Although not all plan sponsor representatives we
                            interviewed reported specific performance data, a number of plan
                            representatives disclosed peak annual hedge fund losses in 2008 or 2009
                            ranging from about 12 percent to about 25 percent. Pension plan
                            representatives we interviewed generally reported more favorable
                            performance for private equity. Although a few plan representatives
                            reported private equity returns that were somewhat lower than in previous


                            11
                              Hedge Fund Research, Inc., HFRI Fund Weighted Composite Index. According to this
                            index, hedge funds produced quarterly losses in 3 of the 4 quarters in 2008.
                            12
                               Cambridge Associates LLC, U.S. Private Equity Index, June 30, 2011. The index is an
                            end-to-end calculation based on data compiled from 899 U.S. private equity funds
                            (buyout, growth equity, private equity energy, and mezzanine funds), including fully
                            liquidated partnerships, formed between 1986 and 2011.




                            Page 8                                         GAO-12-324 Defined Benefit Pension Plans
              years, one plan reported a close to 20 percent loss for their private equity
              portfolio in 2009.

              Table 1: Recent Data from Hedge Fund, Private Equity, and S&P 500 Indexes

                                                                  Historical performance (in percentages)
               Index                                     1 year (2011)          3 year (2009-2011) 5 year (2007-2011)
               HFRI Fund Weighted
               Composite                                           (5.02)                              7.9                         2.27
               Cambridge Private
               Equity                                               13.76                            7.32                          8.11
               S&P 500                                                2.11                         14.11                         (0.25)
              Sources: Hedge Fund Research, Inc., HFRI Fund Weighted Composite Index; Cambridge Associates LLC, U.S. Private Equity Index;
              and S&P 500 Index.



              Note: Numbers in parentheses are negative. Hedge Fund Research, Inc., HFRI Fund Weighted
              Composite Index and S&P 500 Index data are as of December 31, 2011. Cambridge Associates LLC,
              U.S. Private Equity Index data are as of September 30, 2011.


              Despite experiencing some significant losses during the financial crisis,
              representatives of selected plan sponsors we contacted generally told us
              that both their hedge fund and private equity investments met their
              expectations over the last 5 years given their reasons for investing.

Hedge Funds   Most of the 22 pension plan representatives we contacted indicated that
              hedge fund investments met their expectations given their reasons for
              investing. In 2008, we reported that many plans had invested in hedge
              funds in response to prior significant stock market losses, and because
              they were seeking specific benefits such as achieving (1) lower volatility;
              (2) a more diversified portfolio by investing in a vehicle that would not be
              correlated with other asset classes in the portfolio; and (3) returns greater
              than those expected in the stock market. Given these reasons for
              investing in hedge funds, most of the 22 plan representatives we
              interviewed for this report said that these investments met plan
              expectations (see table 2 for an overview of the responses).




              Page 9                                                              GAO-12-324 Defined Benefit Pension Plans
Table 2: Performance of Hedge Fund and Private Equity Investments Compared to
Selected Plans’ Expectations

                                                            Number of plans
 Plan response                                              Hedge fund           Private equity
 Met expectations                                                      12                     20
 Did not meet expectations                                              5                       0
 Mixed                                                                  1                       2
 Total                                                                 18                     22
Source: GAO analysis of interview responses.

Note: Four plans we interviewed had not invested in hedge funds when we interviewed them for our
2008 report and therefore could not provide an assessment.


Representatives of several plans stressed the moderating impact of
hedge fund investments by noting their ability to provide less price
volatility than other investments. One plan representative observed, that
even with hedge fund fees, their losses of 14 percent were still preferable
to stock market losses of 40 percent. Representatives from another plan
explained that, although hedge fund performance more closely paralleled
the stock market during the period than desired, there was generally no
safe haven and that hedge fund investments have generally performed
well. A few plan representatives noted that hedge funds delivered lower
volatility than other investments. 13 Representatives from one plan were
particularly satisfied with how the plan’s hedge fund investments helped
limit overall portfolio risks, noting that although returns were below
benchmarks, the hedge funds provided much less volatility than the plan’s
publicly traded stock holdings. Similarly, representatives from another
plan noted that, since 2002, hedge funds have provided adequate
returns, but with much less volatility than publicly traded stocks.
Additionally, representatives from one plan, who had not invested in
hedge funds when we interviewed them for our 2008 report, have recently
begun implementing a relatively small hedge fund allocation that they



13
   Volatility refers to the propensity of the price of a security to move up or down over time;
if the price of a security moves up or down rapidly over a short period of time, it is
considered to have higher volatility. Stocks offer relatively high expected long-term returns
at the risk of considerable volatility, that is, the likelihood of significant short-term losses or
gains. Plan sponsor representatives may invest in hedge funds that employ a specific
investment strategy to meet plan goals, such as lower volatility. Because some hedge
fund strategies are not solely dependent on equity and fixed income markets for their
returns, they may produce significantly less volatility.




Page 10                                              GAO-12-324 Defined Benefit Pension Plans
believe will complement the rest of their portfolio and provide greater
diversification benefits, including reducing overall portfolio volatility.

Some plan sponsor representatives stressed the positive long-term
performance of their hedge fund investments, despite intervals of poor
performance. While these plan representatives would have preferred
better hedge fund performance during the 2008-2009 financial crisis,
hedge funds have nonetheless filled an important long-term role in these
plans’ portfolios. Representatives from one plan noted hedge fund losses
of about 12 percent during 2009 but indicated that overall since 2004
these investments have performed well. Representatives from one plan
told us that while they were disappointed by the size of hedge fund losses
in 2008-2009, these investments have generally beaten long-term
benchmarks and have recovered since the crisis. Moreover, they noted
that compounded over the last 15 years, the plan’s hedge fund
investment returns are about twice those of the stock market. These plan
representatives also emphasized the importance of hedge funds, as well
as other alternative investments, to long-term investment returns by
noting that investing solely in fixed income investments would not have
sustained the plan’s funding needs, particularly given that the plan
sponsor had not made plan contributions in over 20 years.

In contrast, a number of plan sponsor representatives and experts noted
that hedge funds did not perform as expected. Representatives from one
plan explained that they expected these investments to provide an
absolute return—positive return regardless of the conditions in the stock
market—in exchange for muted returns in robust markets. Another plan
representative noted that while he understood these “absolute return”
funds may not always generate positive returns in all market
environments, he expected their hedge funds to deliver better than the
more than 20 percent losses they experienced from 2008-2009. Similarly,
a representative from one plan expected hedge fund investments to
perform more independently of stock market trends and was surprised
and disappointed by the magnitude of the negative returns. This
representative told us that for every dollar of loss in the 2008-2009 stock
market, their hedge fund investments lost two-thirds of a dollar. A few
experts noted that pension plan hedge fund investments were more
correlated than expected with the public markets during the financial
crisis, resulting in what one expert referred to as exacerbated losses. For
example, one expert noted that some plan representatives may have




Page 11                                    GAO-12-324 Defined Benefit Pension Plans
                 overpaid for mediocre returns when they paid hedge fund performance
                 and management fees to obtain returns similar to the stock market. 14
                 Further, one specific hedge fund strategy performed poorly. Several plans
                 singled out the so-called “portable alpha” strategy, which typically
                 employs hedge funds in order to generate returns that exceed common
                 market benchmarks. 15 A representative of one plan told us that the plan’s
                 portable alpha program was hugely disappointing and consequently being
                 dismantled. Specifically, in 2008-2009, a portion of the investment lost
                 considerable value when the stock market fell by more than 30 percent.

                 Some plan representatives and one surveyed expert singled out the
                 impact of fees on net performance. One expert cited the extra layer of
                 fees charged by funds of funds managers, asserting that these fees
                 substantially lowered plans’ net returns. 16 Similarly, a plan representative
                 we spoke with found hedge fund fees at the individual fund level to be
                 eroding investment returns. This representative noted while the plan’s
                 hedge fund gross return has been outperforming the rest of the portfolio,
                 the investment has underperformed after fees have been deducted for the
                 last few years. For this reason, the plan is consciously lowering its
                 investment allocation in hedge funds. A representative from another plan
                 noted dissatisfaction with the plan’s hedge fund of funds investment as
                 one of the reasons that the plan had chosen not to reinvest and was
                 considering firing the fund manager.

Private Equity   The experience of plans with private equity investments should be
                 considered in the context of the long-term nature of these investments,
                 which require lengthy financial commitments and delayed financial returns
                 (see fig. 1). Given the long-term nature of private equity investments,


                 14
                   Whereas mutual fund managers reportedly charge a fee of about 1 percent of assets
                 under management, hedge fund managers often charge a flat fee of 2 percent of total
                 assets under management, plus a performance fee, of about 20 percent of the fund’s
                 profits. While this fee structure may vary slightly among funds, it has been a common
                 structure in both the hedge fund and private equity industries.
                 15
                   The portable alpha strategy is designed to deliver better returns than traditional
                 benchmarks. Typically, the strategy involves using derivatives to replicate benchmark
                 returns (beta), which leaves excess cash that can be invested in hedge fund strategies to
                 obtain returns above the stock market (alpha).
                 16
                   Funds of funds’ managers charge fees above those of the hedge fund manager. For
                 example, funds of funds managers may charge a 1 percent flat fee and a performance fee
                 of between 5 and 10 percent of profits—on top of the substantial fees that the fund of
                 funds pays to the underlying hedge funds.




                 Page 12                                         GAO-12-324 Defined Benefit Pension Plans
nearly all of the 22 pension plan representatives we interviewed were
generally satisfied with their private equity investments over the last 5
years. Based on findings from our 2008 report, plans we interviewed
generally invested in private equity to attain higher returns than the stock
market offered, in exchange for greater risk. Given these reasons for
investing in private equity, 20 of 22 plan representatives reported that the
plan’s private equity investments met plan expectations. Further, nearly
half of plan representatives indicated that their plans’ private equity
investments outperformed public equities over the last 5 years. For at
least one plan, private equity was the highest performing asset class. In
particular, several plan representatives and surveyed experts noted that
opportunistic investments, those investments that take advantage of
underperformance during market cycles, such as distressed debt,
performed relatively well during the last 5 years. 17 Representatives from
at least one plan said they were disappointed to have had insufficient
capital available to invest more heavily in some of these opportunities.
Like many of the plan representatives we interviewed, experts we
surveyed largely found private equity investment performance for the
period to be positive.




17
  A few plan officials indicated that opportunistic private equity investments such as
distressed debt are shorter in duration than traditional private equity investments, such as
leveraged buy-outs and venture capital. For example, private equity distressed debt
investment involves the fund purchasing severely discounted corporate bonds of
companies that have filed for bankruptcy or appear likely to do so in order to become a
major creditor. The fund is then positioned to control the company’s liquidation or
reorganization. In the event of a bankruptcy, as a major creditor, the fund will likely
recover all their money, if not a profit, as part of the liquidation of assets. Alternatively, in a
typically more desirable outcome, the company will reorganize and come out of
bankruptcy, and the fund will forgive the company’s debt obligation in exchange for
enough equity to compensate them.




Page 13                                              GAO-12-324 Defined Benefit Pension Plans
Figure 1: Typical Private Equity Long-term Investment Profile




                                         Note: This information is most relevant to more long-term private equity investments, such as
                                         leveraged buy-outs. Other types of private equity investment, such as distressed debt, may have a
                                         shorter financial commitment.


                                         Although plan representatives we interviewed almost unanimously
                                         reported favorable results regarding private equity, this has not
                                         necessarily been true of all plans over the last 5 years. As we reported in
                                         2008, compared with other asset classes, performance varied widely
                                         among private equity funds. For this reason, plan representatives


                                         Page 14                                               GAO-12-324 Defined Benefit Pension Plans
                             emphasized the importance of investing in the top funds, some noting that
                             they would not invest in private equity unless they could invest in funds
                             considered to be in the top quartile. Three of the experts we surveyed in
                             2011 also noted varying performance among private equity funds. One
                             expert noted a wide dispersion among the performance of private equity
                             funds, and that this dispersion likely is reflective of the broad experiences
                             of pension plans over time. Similarly, two other experts cited evidence
                             that, over the long-term, broad private equity fund returns did not
                             outperform the stock market, and one of these experts reported that lower
                             performance may be attributable to the typically riskier equities held in
                             these investments. A representative from one plan, for example,
                             remarked that the plan’s venture capital investments did not perform well.
                             In this particular case involving the biotech industry, the representative
                             noted that this was less a direct result of the financial crisis and more a
                             function of the decline in this industry as a whole. Representatives from
                             one large plan told us that venture capital investment performance had
                             been problematic for them in the last 10 years. Similarly, we found that a
                             number of plans we interviewed had lowered or eliminated their venture
                             capital investment in recent years.


Some Selected Plans          Pension plan representatives we contacted experienced some challenges
Faced Specific Challenges    in hedge fund and private equity investing beyond those of more
with Hedge Fund and          traditional investing, including limited liquidity and transparency, and the
                             negative impact of the actions of other investors in the fund—sometimes
Private Equity Investments   referred to as co-investors.
in Recent Years
Liquidity Limitations        A number of plan representatives we interviewed experienced challenges
                             with investment liquidity—a plan’s limited ability to redeem investment
                             shares on demand—in order to meet plan obligations. Although hedge
                             funds typically have limitations on the timing and magnitude of investor
                             redemptions, a few plan representatives we contacted were surprised and
                             financially harmed by “discretionary gates”—limitations on redemptions




                             Page 15                                  GAO-12-324 Defined Benefit Pension Plans
imposed at a fund manager’s discretion. 18 For example, a representative
from one large plan told us that some hedge fund managers imposed
discretionary gates based on what was best for the fund’s business model
and not what was in the best interests of the investors. This
representative was concerned that hedge fund managers lacked
incentives to seek returns and were focused on gathering assets, locking
them up, and collecting the fees. Public documents from this plan noted
the possibility that a hedge fund manager can earn tens of millions of
dollars in performance fees in 1 year and then experience sizable losses
in another, resulting in only a minimal capital gain or even net loss for the
investor, but sizable profits for the fund manager at the end of the
partnership. 19 Also, because plan representatives from at least one plan
intended to use hedge fund redemptions to pay for plan obligations,
unexpected discretionary gates forced them to instead sell public equities
at a significant loss. Specifically, representatives from one plan told us
that when the market was down more than 30 percent, they were unable
to access their hedge fund investments due to gates imposed by the fund
manager after other co-investors began liquidating their holdings.
Representatives from this plan told us they were then compelled to sell
public equities at a price well below their assessment of the equities’
intrinsic value, in order to meet plan obligations, including benefit
payments to plan participants.

Some plans also faced challenges meeting requests for committed
capital—money they have committed to the fund manager for



18
  As we reported in 2008, hedge funds offer investors relatively limited liquidity, that is,
investors may not be able to redeem a hedge fund investment on demand because of a
hedge fund’s redemption policy. Hedge funds often require an initial “lockup” of a year or
more, during which an investor cannot cash out of the hedge fund. After the initial lockup
period, hedge funds offer occasional liquidity, sometimes with a prenotification
requirement. Occasional liquidity may be limited by a fund manager’s right to limit the
amount of redemptions in a stated period. Limitations on redemptions, including
discretionary gates, can be important to hedge funds because sudden liquidations could
disrupt a carefully calibrated investment strategy and because some of the hedge fund’s
underlying assets may themselves be illiquid.
19
  The effect of such performance fee structures can be moderated by “clawback”
provisions—which provide investors the right to reclaim a portion of a fund manager’s
performance fee based on significant losses from later investments in the fund’s
portfolio—in the investment contract. Similarly, “high water mark” provisions can
moderate the effect of such performance fee structures by ensuring that investors will not
pay a performance fee unless the value of the investment passes a previous peak value of
the fund shares.




Page 16                                           GAO-12-324 Defined Benefit Pension Plans
                                 investment—from private equity fund managers. A few plan
                                 representatives relied on a “self funding” private equity program in which
                                 private equity investment proceeds are sufficient to pay for a portion or all
                                 of the program’s committed capital. However, in some cases, the severe
                                 market decline during this period limited investment proceeds.
                                 Consequently, a few plans had to look for liquidity in their portfolio in
                                 order to fund capital commitments. While the plan representatives we
                                 spoke with were able to meet these financial commitments, a number of
                                 plans said they limited new private equity investment during this period.

Limited Transparency             A small number of plans we interviewed noted challenges with hedge
                                 fund transparency during this period. One plan representative we
                                 interviewed invested in a fund of hedge funds 20 with very limited
                                 transparency, but that promised access to certain high-quality hedge
                                 funds. As transparency improved after the 2008-2009 financial crisis, the
                                 plan sponsor learned that the various funds of funds had considerable
                                 overlapping investments, which likely amplified the funds’ of funds
                                 negative performance. A few plan representatives were unpleasantly
                                 surprised by the extent to which their plans’ hedge funds were invested in
                                 “side pockets”—separate side accounts holding illiquid investments, such
                                 as private equity or real estate. For example, representatives from one
                                 plan told us they were not fully aware of the way some of their funds were
                                 invested in these side pockets and consequently were surprised by the
                                 illiquidity of the investment. A representative from another plan was
                                 similarly surprised by how embedded some of their hedge fund
                                 investments were with side pockets, which proved problematic when the
                                 plan looked to these hedge fund investments for liquidity during the
                                 financial crisis and it was not available. Representatives of another plan
                                 expressed an aversion to such side pocket investments and preferred to
                                 invest in private equity directly rather than doing so unbeknownst to them
                                 through a hedge fund manager.

Negative Impact of the Actions   A few of the plan representatives noted challenges related to co-
of Co-Investors                  investors’ actions. Under commingled investments arrangements, each



                                 20
                                    Individuals and institutions may also invest in hedge funds through funds of hedge
                                 funds, which are investment funds that buy shares of multiple underlying hedge funds.
                                 Fund of funds managers invest in other hedge funds rather than trade directly in the
                                 financial markets and thus offer investors broader exposure to different hedge fund
                                 managers and strategies. Like hedge funds, funds of funds may be exempt from various
                                 aspects of federal securities laws and regulations.




                                 Page 17                                        GAO-12-324 Defined Benefit Pension Plans
                        investor owns a certain number of shares in a fund. During the recent
                        financial crisis, the significance of these arrangements became
                        particularly challenging for a few plan representatives. For example,
                        representatives from one plan reported that while they were able to meet
                        all of their private equity capital calls—a request from the fund manager
                        for the investors to provide a portion of the money they have committed to
                        investing—they were concerned about the ability of other co-investors to
                        do so. In response to these concerns, the representatives felt compelled
                        to take the time to call each of their fund managers to confirm the ability
                        of all the investors to meet their financial commitments. Representatives
                        of another plan noted that the actions of co-investors can impact an
                        investment strategy, which may ultimately impact returns. For example,
                        representatives of this plan said they had invested with a private equity
                        fund manager who was implementing a strategy involving an investment
                        in 10, $1 billion companies. However, because not all investors could
                        meet their financial commitments, the fund manager had to restructure
                        the investment strategy. The plan representatives were troubled by the
                        strategy changes—involving investments in different companies—the
                        fund manager had to make as a result.

                        At least one plan representative also indicated that an onslaught of hedge
                        fund redemptions by other co-investors damaged their investments. For
                        example, representatives of one plan told us that many of their co-
                        investors, alarmed by large losses during the financial crisis, moved
                        quickly to cash out investments. Because co-investor redemptions led to
                        further fund losses, plan representatives felt it was necessary to cash out
                        as well. However, they were unable to do so, because the fund manager
                        had imposed a discretionary gate to prevent further losses.


                        Available data reveal that plan investments in hedge funds and private
Plans Continue to       equity have continued to increase, and our contacts with 22 public and
Invest in Hedge Funds   private defined benefit (DB) plan sponsors also reveal a continued
                        commitment to these investment vehicles. Nonetheless, some plans have
and Private Equity,     reduced their allocations or made significant changes to their strategic
but Some Plan           approach as a result of experiences in recent years. In addition, plan
Sponsors Have Taken     representatives we contacted took significant steps to improve the terms
                        of their investments, including negotiating lower fees or more
Steps to Address        advantageous fee terms, and obtaining greater liquidity or transparency.
Challenges              Not all plans may be able to make such improvements, however.




                        Page 18                                 GAO-12-324 Defined Benefit Pension Plans
Plans Have Continued to     Available data and discussions with plan representatives indicate that DB
Invest in Hedge Funds and   plans have continued to invest in hedge funds and private equity in recent
Private Equity              years. The percentage of large plans investing in both hedge fund and
                            private equity has increased since the onset of the 2008 financial crisis.
                            According to a Pensions & Investments survey, the percentage of large
                            plans (as measured by total plan assets) investing in hedge funds grew
                            from 47 percent in 2007 to 60 percent in 2010 (see fig. 2). Over the same
                            time period, the percentage of large plans that invested in private equity
                            also grew—from 80 percent to 92 percent. For both hedge funds and
                            private equity, as figure 2 shows, these trends are a continuation of a
                            decade-long upward trend. Data from the same survey reveal that
                            investments in hedge funds and private equity typically constitute a small
                            share of plan assets. The average allocation of portfolio assets to hedge
                            funds among plans with such investments was a little over 5 percent in
                            2010. Similarly, among plans with investments in private equity, the
                            average allocation of portfolio assets was a little over 9 percent.

                            Figure 2: Share of Large DB Plans Investing in Hedge Funds and Private Equity
                            from 2001 to 2010




                            Note: These data represent plans with $1 billion or more in total assets.




                            Page 19                                                 GAO-12-324 Defined Benefit Pension Plans
We reported in 2008 that available survey data showed larger plans were
more likely to invest in hedge funds and private equity than midsize plans
and, according to a survey by Greenwich Associates, that seemed to be
the case in 2010 as well. The survey found that 22 percent of midsize
plans—those with $250 million to $500 million in total assets—were
invested in hedge funds compared with 40 percent of the largest plans—
those with over $5 billion in total assets (see fig. 3). Survey data on plans
with less than $200 million in assets are unavailable, so the extent to
which these smaller plans invest in hedge funds and private equity is
unclear. 21




21
  In addition, Pyramis Global Advisors conducted a survey of plans with $200 million or
more in total assets, but we found analysis of the Pensions & Investments and Greenwich
Associates surveys sufficient for our purposes. See GAO-08-962 for analysis of the
Pyramis Global Advisors survey data. According to Labor estimates, individual private DB
plans with less than $200 million in total assets comprised about 15 percent of the total
assets of all private DB plans in 2005. These small plans also comprised of about 97
percent of all DB plans in 2005.




Page 20                                         GAO-12-324 Defined Benefit Pension Plans
Figure 3: Pension Plans with Investments in Hedge Funds and Private Equity by
Size of Total Plan Assets in 2010




Note: The figure above includes public and corporate plans and does not include investments of
collectively bargained plans.

Comments made to us by representatives of selected plan sponsors
generally paralleled these national data. Of the 18 plans participating in
our review that had invested in hedge funds, 17 told us they had either
maintained or increased their allocations since our original contact in
2007 or 2008. For example, one public plan that already had invested a
substantial percentage of its assets in hedge funds increased its
investments by about another 10 percent of the total portfolio.
Representatives of this plan explained that hedge fund investments, while
not immune to stock market declines, had nonetheless performed much
better than stocks during the financial crisis. Similarly, of the 22 plans
participating in our review that had invested in private equity at the time of
our original contact in 2007-2008, 19 told us that they had either
maintained or increased their target allocation. Each of the 10 plans that
had increased their allocations also cited positive performance returns.
For example, one plan representative explained that the allocation to
private equity had increased even though the overall allocation to publicly



Page 21                                              GAO-12-324 Defined Benefit Pension Plans
                           traded stocks has decreased. The representative explained that the plan
                           was lowering its allocation to stocks as part of a broad risk reduction
                           strategy, and that the additional return expected from private equity would
                           therefore be essential. As the representative explained, this change was
                           made with the belief that the increase in private equity will produce
                           relatively high risk-adjusted returns and will therefore compensate for the
                           lower expected yield resulting from the shift out of publicly traded stocks
                           to bonds.


Most Plans Have Modified   Experiences of recent years have led most plans we contacted to make
Investment Strategies in   significant changes to their hedge fund or private equity strategies, and in
Recent Years               three cases, reductions in the overall allocation to hedge funds or private
                           equity. For example, representatives of the one plan participating in our
                           review that had reduced its overall allocations to hedge funds said that
                           the plan’s poor experience with hedge funds was tied to illiquidity. These
                           representatives explained that they had expected that their hedge fund
                           investments would not be difficult to cash in when they needed to pay
                           obligations, but they were prevented from doing so by discretionary gates
                           imposed by the fund manager. As a result, the plan was forced to sell
                           stocks during the crisis when values were depressed, resulting in
                           significant losses.

Changes to Hedge Fund      Several plans also discontinued or reduced the use of certain hedge fund
Strategies                 strategies. For example, representatives of three plans told us that they
                           had discontinued so-called “portable alpha” strategies, which commonly
                           use hedge funds to help achieve returns that exceed those of the public
                           equities market. According to industry press, this technique largely fell out
                           of favor as a result of substantial investment losses during the 2008-2009
                           financial crisis. However, plan representatives indicated that
                           disenchantment with the portable alpha technique did not necessarily
                           mean abandonment of hedge funds generally. For example, after one of
                           these three plans discontinued the portable alpha strategy, it opted to
                           retain the hedge fund portion of the portable alpha investment. 22 Several
                           other plans indicated that they invested in less aggressive hedge fund
                           strategies. For example, a representative of one plan explained that the
                           plan had shifted from hedge funds designed to deliver investment returns


                           22
                             Portable alpha strategies can employ both hedge funds and other investment
                           techniques in an effort to obtain returns above those of traditional benchmarks, such as
                           the S&P 500.




                           Page 22                                          GAO-12-324 Defined Benefit Pension Plans
                            that exceed the overall stock market to strategies that will deliver returns
                            comparable to the stock market but with less risk.

                            In contrast to the general trend toward greater investments in hedge
                            funds, some plans eliminated or substantially reduced their use of funds
                            of hedge funds. Representatives of one plan explained that this step was
                            part of a planned evolution—the plan had invested in funds of funds as a
                            first step, and planned on using its relationships with funds of funds
                            managers to develop the expertise to make direct hedge fund
                            investments. By 2011, this plan had accomplished that objective, and 80
                            percent of its hedge fund investments were direct hedge fund
                            investments. Another plan, however, discontinued funds of funds
                            investments, concluding that funds of funds added an unnecessary layer
                            of fees, offered the plan little opportunity to influence fees of underlying
                            hedge funds, limited the plan’s ability to conduct manager due diligence,
                            and led to some overlapping investments in underlying individual hedge
                            funds. A representative of this plan told us that one of the funds of funds
                            had emphasized its unique access to top tier hedge funds, and the plan
                            sponsor later learned that some of its other funds of funds were invested
                            in the same vehicle, diminishing the diversification benefits of the fund of
                            funds. However, funds of funds may be necessary for smaller pension
                            plans and plans that lack well-developed internal investment and risk
                            management that wish to invest in alternatives such as hedge funds and
                            private equity.

Changes to Private Equity   Several plans indicated that they have adjusted their private equity
Strategies                  strategies in recent years. For example, representatives of several plans
                            noted that as a result of the experiences during the financial crisis, they
                            preferred investing in private equity buyout funds that rely more on the
                            implementation of operational improvements in portfolio companies,
                            rather than funds that rely on so-called financial engineering—using
                            leveraging techniques to enhance the value of the stock. One plan
                            representative explained that many private equity firms using financial
                            engineering techniques had suffered severe losses during the financial
                            crisis. As a result, this representative said the plan now prefers private
                            equity funds that add value to portfolio companies through means such as
                            better control of costs, improved marketing, and a more efficient
                            distribution chain. Also, because of the diminished returns of venture
                            capital funds in recent years, representatives of several plans said they
                            have reduced investments in such funds. Finally, several of the plans we
                            contacted had made relatively short term, opportunistic investments in
                            distressed debt as a result of the financial crisis. One plan representative
                            explained that the financial crisis gave rise to this opportunity because


                            Page 23                                  GAO-12-324 Defined Benefit Pension Plans
                          distressed debt oriented funds tend to perform well in bad economic times
                          as the universe of troubled companies grows and other investors become
                          more risk-averse.


Some Plans Have           Steps plan sponsors have taken to obtain more advantageous terms
Improved Contractual      when investing in hedge funds and private equity include lower fees,
Terms or Changed          greater control and transparency, and changed liquidity terms.
Investment Arrangements   More advantageous fee terms. A little more than half of the plans included
                          in our review have taken steps to obtain more advantageous fee terms for
                          both hedge fund and private equity investments. For example, as part of a
                          broad policy change regarding its relationship with hedge fund managers,
                          one large public plan has determined that it will seek to avoid investing in
                          hedge funds that insist on the traditional “2 and 20” fee structure, under
                          which investors pay an annual management fee of 2 percent of assets
                          under management, and a performance fee of 20 percent of profits.
                          Instead, the plan will seek to limit both management and performance
                          fees and ensure that performance fees are paid not on an annual basis,
                          but for more sustained, long-term performance. Representatives of
                          another plan explained that they had obtained lower fees in exchange for
                          trade-offs related to other aspects of investment terms. Specifically, for
                          some hedge fund investments, this plan pays a flat fee of 1.5 percent of
                          assets under management, instead of the formerly standard 2 percent
                          fee. In exchange, the plan opted to sacrifice liquidity by agreeing to a 2-
                          year lockup of its investment, thus providing the fund manager with
                          greater assurance that its capital and investment strategies would not be
                          disrupted. While illiquidity by itself may be perceived as a disadvantage to
                          an investor, this plan believed less liquidity was a worthwhile trade-off for
                          lower fees.

                          Principles developed by private equity investors. Large pension plans and
                          other institutional investors in private equity have, through the Institutional
                          Limited Partners Association (ILPA), taken significant steps to promote
                          more advantageous terms of investment, including lower fees and better
                          fee terms. The ILPA Private Equity Principles address in some detail how
                          fees should be aligned to the interests of investors. For example, ILPA
                          principles advocate a fee arrangement that would help ensure that
                          investors get back all invested capital, plus a specified return on
                          investment as soon as these returns are available. Sometimes referred to
                          as a “European waterfall”, this arrangement dictates that investors
                          recover their full initial investment plus a specified return on investment—
                          such as an annualized 8 percent—before the fund manager obtains any


                          Page 24                                   GAO-12-324 Defined Benefit Pension Plans
share of the profits. 23 This arrangement contrasts with an “American
waterfall”, under which the fund manager may collect profits
corresponding to the sale of individual portfolio companies on a “deal by
deal” basis, regardless of whether investors have obtained any return on
their total investment in the fund. The overall advantage of the European
waterfall for investors is that they can recapture their initial invested
capital plus a specified return, as soon as that return exists, taking into
account any losses. Further, because the fund manager does not obtain a
share of the profits until after the investors have received the specified
return, the need for reclamations of disbursements that have been made
to the fund manager are minimized. Such reclamations—commonly
referred to as “clawbacks”—may be necessary if profits paid to the fund
manager based on the sale of portfolio companies early in the life of a
fund are negated by subsequent losses. The ILPA Principles also
address other issues, including notification of management changes and
the fund management’s financial stake in the fund.

Enhanced transparency, control, and liquidity through separate accounts.
Many of the plans we contacted told us that some of the challenges of
hedge fund investing could be addressed though the use of separate
accounts in place of commingled funds. Under a commingled hedge fund
arrangement, the investor owns a certain number of shares in the fund,
but the hedge fund manager determines what assets to invest in, and the
partnership collectively owns the underlying assets (see fig. 4). In
contrast, under a separate account, the hedge fund manager essentially
serves as a consultant who manages the assets in a way that generally
parallels the hedge fund itself, but the investor may specify investment
guidelines that result in differences between the commingled hedge fund
and separate account. Plan representatives and financial industry experts
cited multiple benefits of separate accounts, including (1) precise
knowledge of the nature of underlying assets, (2) ability to exclude certain
assets in the commingled hedge fund from its share of the rest of the
hedge funds assets, and (3) much greater liquidity because plan
sponsors own and can sell the underlying assets at will. 24 Separate


23
  A distribution “waterfall” is the method by which capital is distributed to funds investors
as underlying investments are sold. The so-called “European” and “American” waterfalls
are labeled as such because they reflect common practices in the respective markets.
24
  Plan officials explained that separate accounts can also be established for funds of
hedge funds, or funds of private equity funds, in order to obtain benefits comparable to
these described. For example, if a plan invests in a fund of hedge funds through a
separate account, it can exclude an underlying hedge fund if it wishes.




Page 25                                            GAO-12-324 Defined Benefit Pension Plans
account arrangements are, however, more costly than commingled funds,
and hedge fund managers generally will not offer such arrangements
unless the size of an investment exceeds a certain threshold.

Figure 4: Comparison of Commingled and Separate Accounts




Note: Separate accounts may be established through a variety of arrangements. For example, in
some cases the underlying assets will be held in the name of the investor and in other cases in the
name of the fund manager in a dedicated account.

Other steps. Plan sponsor representatives also mentioned other steps
they took to address difficulties of the last several years. Some plans now
seek specific contractual terms that affect liquidity or other aspects of the
investment. For example, representatives of one plan explained that they



Page 26                                                GAO-12-324 Defined Benefit Pension Plans
                           now seek investor level gates, under which cash-out limitations would be
                           triggered once an investor has liquidated more than a specified amount of
                           their investment. Other co-investors would not be affected and could still
                           cash out under the normal terms of the hedge fund. Other plans have
                           established certain criteria for selecting hedge fund or private equity
                           funds. A representative of one plan, for example, said that the plan avoids
                           hedge funds that have so-called side pockets—illiquid investments held
                           separate from the primary fund—such as a hedge fund that has an
                           investment in a private equity fund. A representative of one plan, which
                           had been surprised by the existence of such side-pocket illiquid
                           investments, noted that such investments can exacerbate illiquidity during
                           stressful times. A representative of another plan noted that the plan
                           prefers to select its own private equity investments and avoid locking in to
                           one of a hedge fund manager’s choosing. Finally, a few plans made
                           changes to overall portfolio management practices as a result of
                           experiences with hedge funds and private equity. For example, one plan
                           established a larger cash reserve and representatives of two plans
                           described steps to enhance or monitor liquidity.


Some Plans Described       A few plan representatives and experts described other improvements to
Investment Selection and   their selection or monitoring processes for hedge funds or private equity
Due Diligence              investments. For example, two plan sponsors said they are much more
                           focused on how fund managers establish the value of invested shares.
Improvements, but          One plan representative noted that, in the past, the plan took valuations
Practices May be Uneven    provided by the fund manager at face value, but they now examine
                           valuations much more closely. Representatives of other plans said that,
                           as a result of massive hedge fund cash-outs by other co-investors, they
                           consider the nature of other co-investors before investing. One plan
                           representative explained that he prefers investors who will ride out market
                           volatility and not flee the fund during episodes of volatility. Several
                           surveyed experts cited diligence improvements, including better
                           operational due diligence. 25




                           25
                             Operational due diligence involves examining operational risk, that is, the risk of
                           investment loss due not to a faulty investment strategy, but from inadequate or failed
                           internal processes, people and systems, or problems with external service providers.
                           Such risk can arise from inexperienced operations personnel, inadequate internal controls,
                           lack of compliance standards, or outright fraud.




                           Page 27                                         GAO-12-324 Defined Benefit Pension Plans
Some public plans have also taken significant steps to improve and
oversee the process of selecting hedge funds, private equity, and other
investments. For example, a special review undertaken by one large
public plan we contacted found significant problems involving the role of
placement agents and accompanying malfeasance by public officials,
which significantly compromised the plan’s selection of private equity
funds and other investment vehicles. 26 Among other things, the report
raised the possibility that some private equity investments had been
based on a relationship with a placement agent, rather than on the quality
of the investment. Consequently, potentially superior investments may
have been bypassed in favor of those with better connections, and the
fund ultimately paid excessive fees that bore little or no relationship to the
services rendered by the placement agent. The report’s conclusions
emphasized that plan officials must increase vigilance on those portions
of the plan—such as hedge funds and private equity—that have not
traditionally been subject to as great a degree of public scrutiny as other
types of investments. The review also offered numerous
recommendations designed to prevent a recurrence of these events, and
the plan has taken some actions. For example, the plan has advocated,
and the California state legislature has enacted, a state law that imposes
on placement agents the same disclosure and registration requirements
that apply to lobbyists, and obtained over $200 million in fee reductions
and an agreement from elite money management firms to avoid using
placement agents for new plan investments. Further, partly as a result of
the review, the plan developed a comprehensive new policy designed to
ensure that it had more advantageous terms of investment with its hedge
fund managers. According to a representative of the National Association
of State Retirement Administrators, other public plans have experienced
similar problems and have made comparable reforms. 27




26
  Report of the CalPERS Special Review, Steptoe and Johnson LLP and Navigant
Consulting Inc., March 2011. Placement agents are intermediaries or middlemen paid by
external money managers to help gain access to capital from institutional investors.
27
  The National Association of State Retirement Administrators is a nonprofit organization
whose members are the directors of the nation’s state, territorial, and largest statewide
public retirement systems.




Page 28                                         GAO-12-324 Defined Benefit Pension Plans
Plans May Have Limited    Although some plans have taken significant steps to improve the terms of
Ability to Take Certain   hedge fund and private equity investments in recent years, not all plans
Steps                     may be able to take such steps, and it is not clear how extensive such
                          changes have been. For example, separate accounts may not be a
                          practicable option for all plan sponsors. Separate accounts impose
                          additional duties on hedge fund managers and, therefore, the fees
                          associated with them are often somewhat higher. In addition, they impose
                          additional burdens on the investor, such as ensuring that the
                          management of the separate account matches that of the commingled
                          fund. Further, according to plan sponsors and experts, hedge fund
                          managers will establish and operate separate accounts only for
                          investments of a certain magnitude; hedge fund managers may not
                          establish separate accounts for investments of less than approximately
                          $100 million. As a result, separate accounts would not be an option for
                          plans unable to make an investment of this magnitude.

                          Although our survey of experts identified some of the same actions that
                          plan representatives described, the narrative responses revealed no clear
                          pattern or consensus regarding these actions. Further, plan
                          representatives and some experts indicated that not all plans would be
                          able to take the steps described above. For example, plans’ ability to
                          obtain better fee terms is not universal. One plan representative noted
                          that his plan is not large enough to have much negotiation power with
                          fund managers, and the plan generally accepts the manager’s standard
                          fee structure. Another plan representative noted that the top fund
                          managers have not had to adjust fees. Also, with regard to due diligence
                          steps, some surveyed experts indicated that difficulties are likely to be
                          among smaller plans or plans with lesser resources. For example, one
                          respondent stated that while the use of best practices is becoming more
                          widespread, failure to observe them occurs among smaller funds that lack
                          resources or plans that are influenced by a salesperson.

                          Finally, it is not clear whether some of the changes in recent years will
                          permanently change the landscape. One of the leading plan consultants
                          noted that, since the financial crisis, plans have gained significant
                          bargaining power with hedge fund managers who desire plan
                          investments. However, representatives of two plans also indicated that
                          this development may be cyclical, and an outgrowth of the troubled
                          financial markets in recent years. These representatives also speculated
                          that, when financial markets heat up again, the environment may change
                          to a “seller’s” market, and fund managers may be able to reassert fee
                          structures and other investment terms that are less advantageous to
                          investors.


                          Page 29                                 GAO-12-324 Defined Benefit Pension Plans
                       Various entities have developed guidance applicable to plan investments
Federal Entities and   in hedge fund and private equity, ranging from broadly applicable
Others Have            guidance issued by Labor to detailed guidance issued by federal advisory
                       and industry bodies. While Labor has not developed guidance specifically
Developed Guidance     addressing hedge funds or private equity, departmental officials cited a
Addressing Hedge       1996 information letter from Labor to the Comptroller of the Currency that
Funds and Private      discusses the application of ERISA principles regarding the use of
                       alternative investments. 28 The letter does not refer to hedge funds or
Equity                 private equity, but departmental officials said that its basic principles
                       could be applied to these types of investments. The letter addresses
                       pension plans’ use of derivatives in their investment portfolios and states
                       that investments in derivatives are subject to ERISA fiduciary
                       responsibility rules, just as any other investment. 29 In light of this, the
                       letter emphasizes several key considerations, including

                       •     Sophistication. Such investments may require more sophistication and
                             a deeper understanding on the part of fiduciaries than other
                             investments.

                       •     Adequate information. Fiduciaries are responsible for obtaining
                             sufficient information to understand such investments and, if the
                             investment is in a pooled fund managed by another entity, the
                             fiduciary should obtain sufficient information to determine the nature
                             of the pooled fund’s uses of derivatives.

                       •     Understanding of investment risk. The market risks of these
                             investments should be understood and evaluated in terms of, among
                             other considerations, the effect they have on the portfolio’s overall
                             risk.

                       •     Understanding operational and legal risk. The fiduciary must
                             determine whether it has adequate information and risk management
                             systems in place given the nature, size, and complexity of the
                             investment, and must ensure proper documentation of a derivative
                             transaction.




                       28
                           Letter from Department of Labor to the Comptroller of the Currency, March 21, 1996.
                       29
                         Derivatives are financial instruments that are based on the price movements of
                       underlying assets. Common types of derivatives include futures and options.




                       Page 30                                          GAO-12-324 Defined Benefit Pension Plans
While Labor has issued this general guidance applying to investments in
derivatives, other organizations have published guidance specifically
encompassing or targeted at hedge fund and private equity. In December
2011, the Organisation for Economic Cooperation and Development
(OECD) and the International Organisation of Pension Supervisors
(IOPS) published a set of good practices for pension plans’ use of
alternative investments, including hedge funds and private equity. 30
Based on a survey of OECD and IOPS members, this document offers
recommended good practices on issues such as investment policy, risk
management, and contractual terms, as well as best practices for pension
fund regulators. In 2009, the President’s Working Group on Financial
Markets 31 issued a report detailing important considerations and best
practices for hedge fund investors, including specific guidance for
fiduciaries. 32 This document provides basic background information about
hedge funds, distinguishes them from more traditional investments, and
outlines some of the basic considerations a fiduciary should make in the
earliest stages of considering a hedge fund investment. The document
also provides extensive guidance and suggestions for best practices
related to due diligence steps, risk management, and various challenges
involved in hedge fund investing, including valuation, fees and expenses,
and legal and regulatory considerations, among other issues. Similarly,
the Greenwich Roundtable, a nonprofit research and educational
organization for investors in alternative assets, has issued a document
that outlines due diligence best practices for alternative investments,
including hedge fund and private equity investments. 33 This document



30
  OECD/IOPS, Good Practices on Pension Funds’ Use of Alternative Investments and
Derivatives, Organisation for Economic Cooperation and Development and International
Organisation of Pension Supervisors (December 2011). IOPS is an international body
representing those involved in supervision of private pension arrangements. Membership
includes representatives from about 60 countries and territories. OECD consists of 34
member countries, and seeks to promote policies that will improve economic and social
well-being.
31
 Established by executive order in 1988, the President’s Working Group on Financial
Markets is composed of top officials of the Department of the Treasury, the Board of
Governors of the Federal Reserve, the SEC, and the Commodity Futures Trading
Commission. (53 Fed. Reg. 9421, 3 C.F.R., 1988 Comp., p. 559).
32
 Principles and Best Practices for Hedge Fund Investors: Report of the Investors’
Committee to the President’s Working Group on Financial Markets (Jan. 15, 2009).
33
 Best Practices in Alternative Investments: Due Diligence, Education Committee of the
Greenwich Roundtable (2010).




Page 31                                        GAO-12-324 Defined Benefit Pension Plans
describes basic considerations in the process of considering any
alternative investment, and it separately provides in-depth guidance on
specific steps that should be taken in making hedge fund, private equity,
and other illiquid investments.

In addition to these guidance documents, other organizations have
published briefer guidance documents. In 2008, the Government Finance
Officers Association published a brief advisory on the use of alternative
assets by public employee retirement systems. 34 This three-page
document presents a condensed explanation of the risks inherent in
investing in hedge funds, private equity, and other alternative assets. It
also highlights key due diligence considerations and recommends that
state and local governments use extreme prudence in making such
investments. More recently, the ILPA published a set of principles aimed
at defined benefit pension plans and other institutional investors in private
equity. This document details important aspects of the terms of
investment between fund managers and investors, and best practices that
fund managers and investors should observe during the course of the
investment relationship.

In recent years, we and the ERISA Advisory Council have separately
recommended that Labor take steps to help ensure that plans wishing to
invest in hedge funds and private equity do so carefully. 35 In 2008, we
recommended that the Secretary of Labor provide guidance to fiduciaries
of ERISA Title I plans that would, among other things, outline the unique
challenges of such investments, outline the steps plans should take to
address these challenges, and highlight the implications of these
challenges for smaller plans. 36 The ERISA Advisory Council has twice
made comparable recommendations. In 2006, the council recommended
that Labor publish guidance about the unique features of hedge funds



34
  The Use of Alternative Investments for Public Employee Retirement Systems and Other
Post Employment Benefit (OPEB) Established Trusts (2000 and 2008) (CORBA),
Government Finance Officers Association (October 2008).The Government Finance
Officers Association is a professional association of state, provincial, and local finance
officers in the United States and Canada.
35
  The Advisory Council on Employee Welfare and Pension Benefit Plans, commonly
referred to as the ERISA Advisory Council, was created by ERISA to provide advice to the
Secretary of Labor. 29 U.S.C. § 1142.
36
 GAO-08-692.




Page 32                                          GAO-12-324 Defined Benefit Pension Plans
               and matters for consideration in their adoption for use by qualified plans. 37
               While the council concluded that hedge funds may be an acceptable form
               of investment, its report noted that certain aspects of hedge fund
               investments should be brought to the forefront in educating plan
               fiduciaries and others. Among these are investment styles, liquidity
               issues, and potential conflicts of interest. In 2008, the council reviewed
               hard-to-value assets, which can include hedge funds, private equity, and
               other alternative assets. 38 39 As a result of related hearings and
               deliberations, the council recommended that Labor issue guidance
               addressing the complex nature and distinct characteristics of such assets.
               The council further specified that the guidance should define hard-to-
               value assets and describe ERISA obligations when selecting, valuing,
               accounting for, monitoring, and reporting on these assets. To date, Labor
               has implemented neither our recommendations nor the council’s
               recommendations. In responding to our 2008 recommendation, Labor
               noted that while it would consider the recommendation, the lack of
               uniformity among hedge funds and private equity funds could make
               development of comprehensive and useful guidance difficult.

               In 2011, the ERISA Advisory Council specifically revisited the issue of
               pension plans’ investments in hedge funds and private equity. The 2011
               sessions of the council’s hearings prominently considered the potential
               role of hedge fund and private equity investments in retirement plans. The
               council’s report has not yet been published, but according to a Labor
               official, publication is expected in early 2012.


               Plans and their hedge fund and private equity investments have not been
Concluding     immune to the effects of the financial market turbulence in recent years.
Observations   Despite significant losses, however, DB plan sponsors and experts we
               contacted generally indicated that these alternative assets had met
               expectations and still had a significant role to play in the plans’ investment




               37
                 U.S. Department of Labor ERISA Advisory Council, Report of the Working Group on
               Prudent Investment Process (November 2006).
               38
                U.S. Department of Labor ERISA Advisory Council, Report on Hard to Value Assets and
               Target Date Funds (2008).
               39
                 Hard-to-value assets are those that are not listed on any national exchanges or over-
               the-counter markets, or for which quoted market prices are not available.




               Page 33                                         GAO-12-324 Defined Benefit Pension Plans
portfolios. Data from surveys of public and private plans clearly indicate
that the appetite for such investments is continuing to grow.

Nonetheless, the events of the last 4 years have reinforced our 2008
observation that hedge funds and private equity also pose risks and
challenges beyond those posed by more traditional investments.
Representatives of some of the plans that we contacted indicated that
hedge fund investments were less resilient than expected. As a result of
poor performance or other issues related to hedge funds and private
equity, some plans have taken significant steps to adjust the nature or
terms of such investments. These steps will likely benefit the plans and,
therefore, the plan participants and beneficiaries, in coming years.

Although some plans have taken significant actions, it is not clear how
extensive such changes have been and whether such changes would be
practical for those DB plans that lack both the resources and the
negotiating power available to other plans. Our selection of 22 DB plans
included some of the largest retirement plans in the nation, some of which
manage tens of billions of dollars. Yet despite their size and expertise,
some of these plans encountered significant difficulties with their
alternative investments in recent years, resulting in substantial
adjustments to plan investment practices. It is worth asking, if such large,
sophisticated institutions can have difficulties that result in significant
changes in the nature or terms of their investment in these alternative
asset classes, how much more difficult it might be for medium and smaller
plans.

In 2008, we recommended that the Secretary of Labor issue guidance
designed for qualified plans under ERISA concerning alternative
investment practices. We specifically called for guidance that would (1)
outline the unique challenges of investing in hedge funds and private
equity; (2) describe steps that plans should take to address these
challenges and help meet ERISA requirements; and (3) explain the
implications of these challenges and steps for smaller plans. We still
believe that providing such guidance would be beneficial. In fact, in light
of the guidance documents issued by other national and international
organizations in the intervening years, this task might now prove easier
for Labor than it would have been 4 years ago. Such guidance still has
the potential to help plan sponsors, and our work suggests a continued
need for such assistance.




Page 34                                  GAO-12-324 Defined Benefit Pension Plans
                  We provided a draft of this report to the Department of Labor, Department
Agency Comments   of the Treasury, the Pension Benefit Guaranty Corporation, and the
                  Securities and Exchange Commission (SEC) for review and comment.
                  Labor, the Department of the Treasury, and SEC provided technical
                  comments which we incorporated as appropriate.


                  As agreed with your office, unless you publicly announce the contents of
                  this report earlier, we plan no further distribution until 30 days from the
                  report date. At that time, we will send copies of the report to the
                  appropriate congressional committees, the Secretary of Labor, Secretary
                  of the Treasury, the Director of the Pension Benefit Guaranty Corporation,
                  Director of the SEC, and other interested parties. This report will also
                  available at no charge on the GAO website at http://www.gao.gov.

                  If you or your staff have any questions regarding this report, please
                  contact Charles Jeszeck at (202) 512-7215 or jeszeckc@gao.gov .
                  Contact points for our Offices of Congressional Relations and Public
                  Affairs may be found on the last page of this report. Key contributors are
                  listed in appendix II.

                  Sincerely yours,




                  Charles Jeszeck, Director
                  Education, Workforce
                     and Income Security Issues




                  Page 35                                 GAO-12-324 Defined Benefit Pension Plans
Appendix I: Objectives, Scope, and
              Appendix I: Objectives, Scope, and
              Methodology



Methodology

              Our objectives were to answer the following research questions:

              •   What is known about the experiences of defined benefit pension plans
                  with investments in hedge funds and private equity, including recent
                  lessons learned?

              •   How have plan sponsors responded to lessons learned from recent
                  experiences with such alternative investments?

              •   What steps have federal agencies and other entities taken to help
                  plan sponsors make and manage investments in such alternative
                  assets, and what additional steps might be warranted?

              To answer all of the research questions, we conducted in-depth
              interviews with plan representatives of the private and public sector
              pension plans that were selected for our 2008 report examining the extent
              to which pension plans invest in hedge funds and private equity. 1 While
              26 plans were interviewed for the 2008 report, 22 plans participated in
              follow-up interviews for our report (see table 3 for a list of plan officials we
              interviewed). We conducted interviews with representatives from June
              2011 to September 2011 and, we obtained and reviewed available
              supporting documentation. These interviews were conducted using a
              semistructured interview format, which included open-ended questions on
              the following topics, asked separately about each plan’s hedge funds or
              private equity investments: history of investment in hedge funds or private
              equity; experiences with these investments to date; lessons learned with
              these investments; changes made to address these lessons, including
              due diligence and ongoing monitoring; and actions federal agencies, such
              as Labor, should take to ensure that pension plan fiduciaries better make
              and manage their hedge fund and private equity investments. Four of the
              plans, who did not invest in hedge funds when we interviewed them for
              our 2008 report, were included in our in-depth interviews to determine
              whether plan representatives subsequently invested in hedge funds and
              to determine their experience given that decision. The results of the plan
              sponsor interviews were limited by plan representatives’ willingness to
              speak with us.




              1
               GAO-08-692.




              Page 36                                    GAO-12-324 Defined Benefit Pension Plans
Appendix I: Objectives, Scope, and
Methodology




Table 3: List of Pension Plans Interviewed

 Interviewed for 2008 report                               Interviewed for 2012 report
 Private plans
 1.   American Airlines                                                  √
 2.   Boeing
 3.   Exxon Mobil                                                        √
 4.   GE Asset Management                                                √
 5.   International Association of Machinists National                   √
      Pension Fund
 6.   John Deere
 7.   Macy’s                                                             √
 8.   Northrop Grumman                                                   √
 9.   Prudential                                                         √
 10. Target                                                              √
 11. United Mine Workers of America Health and                           √
     Retirement Funds
 12. United Technologies                                                 √
 13. Walt Disney                                                         √
 Public plans
 14. California Public Employees’ Retirement System                      √
 15. California State Teachers’ Retirement System                        √
 16. Illinois State Board of Investment                                  √
 17. Los Angeles County Employee Retirement
     Administration
 18. Massachusetts Pension Reserves Investment                           √
     Management Board
 19. Missouri State Employees’ Retirement System                         √
 20. National Railroad Retirement Investment Trust                       √
     Fund
 21. New York State Common Retirement Fund
 22. Pennsylvania Public School Employees’                               √
     Retirement System
 23. Pennsylvania State Employees’ Retirement                            √
     System
 24. San Diego County Employees’ Retirement                              √
     Association
 25. South Dakota Retirement System                                      √
 26. Washington State Investment Board                                   √
Source: GAO.




Page 37                                          GAO-12-324 Defined Benefit Pension Plans
Appendix I: Objectives, Scope, and
Methodology




Note: Four of the plans interviewed did not invest in hedge funds when we interviewed them in 2008.
One of these plans subsequently decided to invest in hedge funds.


The plans we interviewed were selected based on several criteria
identified in our 2008 report. Specifically, when these plans were selected
for our prior report, we attempted to select plans that varied in the size of
allocations to hedge funds and private equity as a share of total plan
assets. We also attempted to select plans with a range of total plan
assets, as outlined in table 4. We identified these plans using data from
the 2006 Pensions & Investments survey of the largest 200 pension plans
and through our interviews with industry experts. While we selected plans
representing a range of total plan assets and varying size of allocations to
hedge funds and private equity as a share of total plan assets, these plan
representatives’ responses do not represent a statistically generalizeable
sample of all pension plans.

Table 4: Criteria Used in 2008 Selection of Plans for In-Depth Interviews

                                                                      Hedge funds      Private equity
 Size of allocation to hedge funds or private equity
 None                                                                             5
 5% or less                                                                      10                 5
 >5 to 10%                                                                        3                 6
 >10%                                                                             2                 2
 Total plan assets
 $10 billion or less                                                              8                 5
 >$10 to $100 billion                                                             9                 5
 >$100 billion                                                                    3                 3
Source: GAO analysis of Pensions & Investments 2006 survey.


To further address the research questions, we surveyed a selected group
of 20 experts in the areas of pension plan hedge fund and private equity
investment. We asked these experts five questions related to
performance and management of these funds during the past 5 years and
also requested suggestions, if any, for regulatory improvements.
Specifically, we asked how pension plans’ hedge fund and private equity
investments have performed; lessons learned with respect to pension
plan hedge fund and private equity investments; changes to pension plan
hedge fund and private equity investment practices; the extent to which
pension plans observe best practices in hedge fund and private equity
due diligence; and actions federal agencies, such as Labor, should take
to ensure that pension plan fiduciaries better make and manage their



Page 38                                                       GAO-12-324 Defined Benefit Pension Plans
Appendix I: Objectives, Scope, and
Methodology




hedge fund and private equity investments. We used a Web-based form
to collect responses. This group of experts was selected from a number
of sources, including experts from our 2010 GAO Retirement Security
Advisory Panel, referrals from interviews and other experts, and
recommendations from GAO subject matter experts. To ensure we had a
range of views we invited participants from several different backgrounds
to participate in our survey including academics, representatives of public
and private plan sponsors, representatives of plan participants, pension
consultant groups, and other key national organizations and subject
matter experts. Of the 20 experts who agreed to participate in the survey,
19 completed the questionnaire within the requested time frame. The
survey was conducted in August 2011.

To quantitatively address national hedge fund and private equity
investment performance for the first question, we obtained and reviewed
broad industry performance data from two private organizations,
Cambridge Associates LLC and Hedge Fund Research, Inc. 2 Data from
these organizations captured historical hedge fund and private equity
investment performance, including performance at the peak of the
financial crisis. We used these data to determine broad hedge fund and
private equity performance over the last 5 years.

While the data from each of these organizations are limited in some ways,
we conducted data reliability assessments for each data source and
determined that the data were sufficiently reliable for purposes of this
study. Data from these organizations are not specific to pension plan
hedge fund and private equity investments, which may have different
investment performance due to specific investment terms and industry
access. Moreover, because these data were from broad investment
indexes, they neither illustrated differences in performance for various
investment strategies within hedge fund and private equity investments,
nor did they distinguish performance of fund of funds investment. While
the most informative way to assess how well investments have performed
is to analyze actual portfolio investment data, we were unable to
quantitatively analyze specifically how pension plans’ investments in
hedge funds and private equity have performed over the past 5 years. We
attempted to obtain detailed investment performance data from selected


2
 Cambridge Associates LLC is a private and institutional investment consulting and
research firm and Hedge Fund Research, Inc. is an investment research firm specializing
in the areas of indexation and analysis of hedge funds.




Page 39                                        GAO-12-324 Defined Benefit Pension Plans
Appendix I: Objectives, Scope, and
Methodology




custodian banks and investment consulting firms. These two groups have
data on the largest pension plan investments in the country. However,
because of the proprietary nature and considerable cost, both in
resources and expense, we were not able to conduct this analysis.

To address the second question, we obtained and analyzed survey data
of private and public sector defined benefit plans on the extent of plan
investments in hedge funds and private equity from two private
organizations, Greenwich Associates and Pensions & Investments. 3 We
identified these two surveys from prior work and obtained updated 2010
data. 4 As seen in table 5, the surveys varied in the number and size of
plans surveyed. Using available survey data, we determined the
percentage of plans surveyed that reported investments in hedge funds or
private equity. Using data from Greenwich Associates, we also
determined the percentage of surveyed plans that invested in hedge
funds or private equity by category of plan size, measured by total plan
assets. We further examined data from each survey on the size of
allocations to hedge funds or private equity as a share of total plan
assets. Using the Pensions & Investments data, we analyzed allocations
to these investments for individual plans and calculated the average
allocation for hedge funds and private equity, separately, among all plans
surveyed that reported these investments. The Greenwich Associates
data reported the size of allocations to hedge funds or private equity as
an average for all plans surveyed.

While the information collected by each of the surveys is limited in some
ways, we conducted a data reliability assessment of each survey and
determined that the data were sufficiently reliable for purposes of this
study. These surveys did not specifically define the terms hedge fund and
private equity; rather, respondents reported allocations based on their
own classifications. Data from both surveys are reflective only of the
plans surveyed and cannot be generalized to all plans.




3
 Greenwich Associates is an institutional financial services consulting and research firm
and Pensions & Investments is a money management industry publication.
4
GAO-08-692.




Page 40                                          GAO-12-324 Defined Benefit Pension Plans
Appendix I: Objectives, Scope, and
Methodology




Table 5: Number and Size of Pension Plans Observed in Recent Surveys

                                          Greenwich Associates             Pensions & Investments
                                          (2010)                           (2010)
 Sample size                              564 pension plans                131 pension plans
                                                            a
 Total assets of plans in                 $4.3 trillion                    $3.1 trillion
 survey
 Range of total plan assets               $250 million or more             $1.7 billion or more
Sources: Greenwich Associates and Pensions & Investments.


Note: Pensions & Investments surveyed the largest 200 plans, ranked by combined defined benefit
and defined contribution plan assets. Of the top 200 plans, 131 were defined benefit plans that
completed the survey and provided asset allocation information. Greenwich Associates surveyed 590
plans; however, we excluded 24 unions and 2 endowments and foundations from our analysis.

a
 Total assets for the 564 surveyed private and public plans projected to approximately 1,200 private
plans and 325 public plans.

To address the third question, we first reviewed relevant literature and
spoke with federal officials from relevant agencies, including the Labor,
the SEC, and the Pension Benefit Guaranty Corporation to understand
federal agency action to date. In addition, we interviewed key national
organizations and pension industry experts to understand the perspective
of plan officials and their participants regarding federal actions to date, as
well as then need for additional federal action. Key national organizations
included representatives from organizations that represent plan
participants, such as AARP, and an organization that represents plan
officials, the American Benefits Council. In addition, we interviewed
academic and national experts in the pension and alternative investment
area and pension plan consultants. We also attended and participated in
Labor’s ERISA Advisory Council 2011 hearings on pension plan
investments in private equity and hedge funds, including the use of these
investments in defined contribution plans. 5 We reviewed and analyzed the
detailed information collected through the literature review, discussions,
and hearings to determine actions taken to date by federal agencies and
other entities to help plan sponsors make and manage hedge fund and
private equity investments.

We conducted this performance audit from February 2011 to February
2012 in accordance with generally accepted government auditing
standards. Those standards require that we plan and perform the audit to


5
 GAO-11-901SP.




Page 41                                                         GAO-12-324 Defined Benefit Pension Plans
Appendix I: Objectives, Scope, and
Methodology




obtain sufficient, appropriate evidence to provide a reasonable basis for
our findings and conclusions based on our audit objectives. We believe
that the evidence obtained provides a reasonable basis for our findings
and conclusions based on our audit objectives.




Page 42                                 GAO-12-324 Defined Benefit Pension Plans
Appendix II: GAO Contact and Staff
                  Appendix II: GAO Contact and Staff
                  Acknowledgments



Acknowledgments

                  Charles A. Jeszeck, Director, (202) 512-7215, or jeszeckc@gao.gov
GAO Contact
                  David Lehrer, Assistant Director, and Michael Hartnett, Analyst-in-
Staff             Charge, managed this review.
Acknowledgments
                  Amber Yancey-Carroll also led portions of the research and made
                  significant contributions to all portions of this report.

                  Kathleen van Gelder helped develop the structure of the report, and
                  Luann Moy provided methodological assistance. Sheila McCoy and
                  Roger Thomas provided legal assistance. Ashley McCall assisted in
                  identifying relevant literature. James Bennett developed the report’s
                  graphics. Caitlin Croake and Lauren Gilbertson verified our findings.




(131062)
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