	A Growing Number of Pension Plans Are Investing in Hedge Funds or Private Equity, but Such Investments Are Generally a Small Portion of Plan Assets

We reported in 2008 that DB plan investments in hedge funds and private  equity have grown, but such investments are generally a small portion of  plan assets. According to a Pensions &  Investments survey, the percentage of large plans (as measured by total  plan assets) investing in hedge funds grew from 11 percent in 2001 to 60  percent in 2010 (see fig. 1). Over the same time period, the percentage of  large plans that invest in private equity grew at a much slower rate—71  percent to 92 percent—likely because of the fact that a much larger  percentage of plans were already invested in private equity in 2001. The  average allocation 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 was a little over 9  percent. 2). 3). Survey data on plans with less than $200  million in assets are unavailable and, in the absence of this information,  the extent to which these smaller plans invest in hedge funds and private  equity is unclear. Hedge Fund and Private Equity Investments Pose Various Risks and Challenges for Plan Sponsors

		Valuation Risk

One of the major challenges that both hedge fund and private equity  investments pose to plan sponsors is uncertainty over the current value of  the sponsors’ investment. Because many hedge funds may own thinly traded securities  and derivatives whose valuation can be complex and subjective, a plan  official may not be able to obtain timely information on the value of assets  owned by a hedge fund. For example, both hedge  fund and private equity managers may use leverage—that is, borrowed  money or other techniques—to potentially increase an investment’s return  without increasing the amount of capital invested. Leverage can magnify profits, but can also magnify losses to the fund if  the market goes against the fund’s expectations. Lack of Liquidity

Hedge funds and private equity are also relatively illiquid investments— that is, investors generally cannot easily redeem their investments on  demand. Operational Risk

We reported that pension plans investing in hedge funds are also  exposed to operational risk—that is, the risk of investment loss because  of inadequate or failed internal processes, people, and systems, or  problems with external service providers. Plan Sponsors Take a Number of Steps to Address the Risks of Hedge Fund and Private Equity Investing

Pension plan officials we spoke with take a number of steps in an attempt  to mitigate the risks and challenges of investing in hedge funds and  private equity. First, plan sponsors noted the importance of making careful and  deliberate fund selection when investing in hedge funds and private  equity. They said in the  case of hedge funds, such terms can include fee structure and conditions,  degree of transparency, valuation procedures, redemption provisions, and  degree of leverage employed. Due diligence and ongoing monitoring, beyond those required for  traditional investments, are also important. The Federal Government Can Help Educate Plans on the Challenges of Investing in Hedge Funds

According to plan officials, regulators, and others, some pension plans— especially smaller plans—may find it particularly difficult to address the  various demands of hedge fund investing. In light of these challenges, and as predecessors to this 2011 ERISA  Advisory Council have concluded, the Department of Labor (Labor) can  play a role in helping to ensure that plans fulfill their Employee Retirement  Income Security Act of 1974 (ERISA) fiduciary duties when investing in  hedge funds and private equity. In 2008, we recommended that Labor provide guidance for qualified plans  under ERISA on the unique challenges of investing in hedge funds and  private equity and the steps plans should take to address these  challenges. Although Labor generally agreed with our recommendation, the agency  explained that the lack of uniformity among these investments could  complicate the development of comprehensive guidance for plan  fiduciaries.
Why GAO Did This Study

Millions of Americans rely on retirement savings plans for their financial well-being in retirement. Plan sponsors are increasingly investing in assets such as hedge funds (privately administered pooled investment vehicles that typically engage in active trading strategies) and private equity funds (privately managed investment pools that typically make long-term investments in private companies). Given ongoing market challenges, it is important that plan fiduciaries apply best practices, and choose wisely when investing plans assets to ensure that plans are adequately funded to meet future promised benefits. This statement addresses (1) what is known about the extent to which defined benefit plans have invested in hedge funds and private equity, (2) challenges that such plans face in investing in hedge funds and private equity, (3) steps that plan sponsors can take to address these challenges, and (4) the implications of these challenges for plan sponsors and the federal government.

What GAO Found

A growing number of private and public sector pension plans have invested in hedge funds and private equity, but such investments generally constitute a small share of total plan assets. According to a survey of large plans, the share of plans with investments in hedge funds grew from 11 percent in 2001 to 60 percent in 2010. Over the same time period, investments in private equity were more prevalent but grew more slowly--an increase from 71 percent of large plans in 2001 to 92 percent in 2010. Still, the average allocation of plan assets to hedge funds was a little over 5 percent, and the average allocation to private equity was a little over 9 percent. Available data also show that investments in hedge funds and private equity are more common among large pension plans, measured by assets under management, compared with midsize plans. Survey information on smaller plans is unavailable, so the extent to which these plans invest in hedge funds or private equity is unknown. Hedge funds and private equity investments pose a number of risks and challenges beyond those posed by traditional investments. For example, investors in hedge funds and private equity face uncertainty about the precise valuation of their investment. Hedge funds may, for example, own thinly traded assets whose valuation can be complex and subjective, making valuation difficult. Further, hedge funds and private equity funds may use considerable leverage--the use of borrowed money or other techniques--which can magnify profits, but can also magnify losses if the market goes against the fund's expectations. Also, both are illiquid investments--that is they cannot generally be redeemed on demand. Finally, investing in hedge funds can pose operational risks--that is, the risk of investment loss from inadequate or failed internal processes, people, and systems, or problems with external service providers rather than an unsuccessful investment strategy. Plan sponsors GAO spoke with address these challenges in a number of ways, such as through careful and deliberate fund selection, and negotiating key contract terms. For example, investors in both hedge funds and private equity funds may be able to negotiate fee structure and valuation procedures, and the degree of leverage employed. Also, plans address various concerns through due diligence and monitoring, such as careful review of investment, valuation, and risk management processes. The Department of Labor (Labor) has a role in helping to ensure that private plans fulfill their fiduciary duties, which includes educating employers and service providers about their fiduciary responsibilities under Employee Retirement Income Security Act of 1974 (ERISA). According to plan officials, state and federal regulators, and others, some pension plans, such as smaller plans, may have particular difficulties in addressing the various demands of hedge fund and private equity investing. In light of this, in 2008, GAO recommended that Labor provide guidance on the challenges of investing in hedge funds and private equity and the steps plans should take to address these challenges. Labor generally agreed with our recommendation, but has yet to take action. The agency explained that the lack of uniformity among these investments could complicate the development of comprehensive guidance for plan fiduciaries.