1). 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

According to several recent surveys, investments in hedge funds and  private equity are typically a small portion of total plan assets—about 4 to  5 percent on average—but a considerable and growing number of plans  invest in them. Survey data on plans with less than $200 million in assets are unavailable  and, thus, the extent to which small plans invest in hedge funds and  private equity is unknown. While More Pension Plans Invest in Private Equity, the Number of Plans with Investments in Hedge Funds Has Experienced Greater Growth in Recent Years

Two recent surveys of pension plans indicate that a considerable number  of plans invest in hedge funds or private equity. Hedge Funds Pose Significant Challenges and Risks, Beyond Those Posed by Traditional Investments

Pension plans face a number of challenges in hedge fund investing beyond  those of more traditional investing, including specific investment risks,  limited transparency and liquidity, and risks related to the operations of  the hedge fund. Private Equity Investments May Provide Important Benefits, but Pension Plans Face Limited Access to Top- Performing Funds and Other Challenges

According to plan representatives, investment consultants, and other  experts we interviewed, pension plans invest in private equity primarily to  attain returns superior to those attained in the stock market in exchange  for greater risk, but such investments pose several distinct challenges. Taking Steps to Address the Challenges and Risks of Investing in Private Equity May Be Too Costly and Complex for Some Plans

Plan representatives said that they take several key steps to address the  challenges of investing in private equity funds. The Federal Government Does Not Specifically Limit or Monitor Private Sector Plans’ Investments in Hedge Funds and Private Equity, but Some States Do So for Public Sector Plans through Various Approaches

The federal government does not specifically limit or monitor private  sector pension investments in hedge funds or private equity, and state  approaches for public plans vary. To date, Labor has not acted on this  recommendation. This official noted that, for example,  blanket prohibitions on investments such as international stocks or real  estate have given way to permission for a wider range of investments. Among these seven states, the restriction may  be in the form of (i) a provision applicable to investments in hedge funds  or private equity funds specifically, (ii) an exclusive list of permissible of  investments that is not likely to capture hedge funds or private equity  investments, or (iii) a provision that restricts investments in certain  categories of assets that, because of the typical structure or investment  strategy of hedge funds or private equity funds, are likely to apply to  investments in such funds. For example, in 2006, the ERISA Advisory Council  recommended that Labor publish guidance about the unique features of  hedge funds and matters for consideration in their use by qualified plans. 2. 3. What mechanisms regulate and monitor pension plan investments in  hedge funds and private equity funds? To answer the first question, we obtained and analyzed survey data of  private and public sector defined benefit (DB) plans on the extent of plan  investments in hedge funds and private equity from three private  organizations: Greenwich Associates, Pensions & Investments, and  Pyramis Global Advisors.
Why GAO Did This Study

Millions of retired Americans rely on defined benefit pension plans for their financial well-being. Recent reports have noted that some plans are investing in 'alternative' investments such as hedge funds and private equity funds. This has raised concerns, given that these two types of investments have qualified for exemptions from federal regulations, and could present more risk to retirement assets than traditional investments. To better understand this trend and its implications, GAO was asked to examine (1) the extent to which plans invest in hedge funds and private equity; (2) the potential benefits and challenges of hedge fund investments; (3) the potential benefits and challenges of private equity investments; and (4) what mechanisms regulate and monitor pension plan investments in hedge funds and private equity. To answer these questions GAO interviewed relevant federal agencies, public and private pension plans, industry groups and investment professionals, and analyzed available survey data.

What GAO Found

According to several recent surveys of private and public sector plans, investments in hedge funds and private equity generally comprise a small share of total plan assets, but a considerable and growing number of plans have such investments. Available survey data of mid to large-size plans indicate that between 21 and 27 percent invest in hedge funds while over 40 percent invest in private equity; such investments are more prevalent among larger plans, as shown below. The extent of investment in hedge funds and private equity by plans with less than $200 million in total assets is unknown. Pension plans invest in hedge funds to obtain a number of potential benefits, such as returns greater than the stock market and stable returns on investment. However, hedge funds also pose challenges and risks beyond those posed by traditional investments. For example, some investors may have little information on funds' underlying assets and their values, which limits the opportunity for oversight. Plan representatives said they take steps to mitigate these and other challenges, but doing so requires resourcesbeyond the means of some plans. Pension plans primarily invest in private equity funds to attain returns superior to the stock market. Pension plan officials GAO spoke with generally had a long history of investing in private equity and said such investments have met expectations for returns. However, these investments present several challenges, such as wide variation in performance among funds, and the resources required to mitigate these challenges may be too substantial for some plans. The federal government does not specifically limit or monitor private sector plan investment in hedge funds or private equity, and state approaches to public plans vary. Under federal law, fiduciaries must comply with a standard of prudence, but no explicit restrictions on hedge funds or private equity exist. Although a federal advisory council recommended that the Department of Labor (Labor) develop guidance for plans to use in investing in hedge funds, Labor has not yet done so. While most states also rely on a standard of investor prudence, some also have legislation that restricts or prohibits plan investment in hedge funds or private equity. For example, one state prohibits plans below a certain size from investing directly in hedge funds.