Rauh Study
Associate Professor Joshua Rauh and Yael Hochberg, Assistant Professor of Finance, both with the Kellogg School of Management at Northwestern University, released a new paper on May 3rd entitled “Local Overweighting and Underperformance: Evidence from Limited Partner Private Equity Investments.” This paper considers the asset allocation choices of institutional investors, and more specifically, how they choose particular investments within asset classes, doing so in the context of private equity (PE) and examining allocations to and performance of limited partner (LP) investments. The goal, according to the authors, is to “attempt to quantify the extent and costs of a particular investment bias, the preference for home-state investments. “
They make the following findings:
- While institutional investors of all types (endowments, foundations, public and corporate pension funds) exhibit substantial home bias in their PE portfolios – on average, an excess 8.1 percentage points of the investments in institutional PE portfolios are in funds headquartered in their own state, relative to a given state’s share in the population of investments by out-of-state LPs -- public pension funds make a substantially larger over-allocation to instate investment funds.
- Public pension funds perform worse by 5.5 percentage points on average on their in-state PE investments than on the investments they make in out-of-state funds, with the overweighting and underperformance of public pension funds largest in venture capital and real estate.
- A similar analysis for other types of institutional investors does not reveal similar significant performance differences, “suggesting that despite evidence of some level of home-bias in their investment choices, their performance is not adversely affected.”
They then presume that these political pressures may be higher “in states where self-dealing, corruption and quid pro quo activity is more commonplace.” Relating overweighting in home-state investments to “commonly accepted measures of state-level corruption,” the two professors find that “home-state overweighting by public pension funds is indeed higher in states with greater corruption” and that higher state-level corruption appears to be unrelated to home bias for public institution endowments and foundations, and is actually associated with lower home-state overweighting for private institution endowments.
Later in their paper, they do acknowledge that recent work by others -- while suggesting that public pension funds exhibit substantial home bias in their investment choices, and that this home bias is larger in states with higher levels of corruption -- also finds that public pension funds outperform on their in-state investments, whereas Rauh and Hochberg find that public pensions perform worse on their in-state investments. Their conclusion, however, is that the corruption results of both papers “suggest that further examination of the relationship between pension fund (and state-level) governance and public pension investments is warranted.”
Finally, they quantify the cost of such home bias by public pension funds, and state that their calculations “suggest that if each public pension LP performed as well on its in-state investments as out-of-state public pension LPs performed on investments in the same state, the public pension LPs would reap $1.23 billion annually in additional returns.”
Interestingly, Rauh and Hochberg do not address what they refer to as “the welfare implications of home-state investments.” That is, they note that public pension funds “may face political pressures to invest in in-state funds in an effort to support the local economy even if doing so reduces return on investment.” However, although they concede that it is possible that there are “positive externalities” for residents, taxpayers and public sector retirees due to the local economic development resulting from these investments which may offset the lower returns earned by the public pension fund -- and they therefore “cannot say unilaterally that the home bias and underperformance on home-state investments documented by our analysis is suboptimal” -- they nevertheless “leave explorations of net welfare to future research.”
They conclude that they have made a contribution on public pension fund governance. They go on to state that public pension systems are underfunded by $3 trillion and “operate under an accounting regime that rewards the taking of risks that allow funds to assume high expected returns.” “This might be expected to push funds towards riskier investment categories,” they surmise. Furthermore, they announce that “[a]n important question that we are addressing in ongoing research is the extent to which our state level corruption measures are correlated with poor governance features at the level of the public pension funds.”
Biggs Study
Andrew Biggs is a Resident Scholar at the American Enterprise institute (AEI). AEI is a private, nonpartisan, not-for-profit conservative think tank, dedicated to research and education on issues of government, politics, economics, and social welfare.
As part of a recent Wharton School/Pension Research Council conference, Biggs analyzed the target investment portfolios of 30 large public pension plans holding over half of total pension assets. He looked at target investment portfolios because he believes that, unlike day-to-day portfolios,” which can appear low-risk simply because all the high-risk assets lost value,” target portfolios indicate the broad direction plan managers wish to take.
Biggs begins by asserting that public pensions’ losses of 27 percent of the value of their investments from 2007 to 2008 “stemmed from a decades-long trend toward riskier investments, which began with a shift toward equities in the 1980s, and today toward so-called alternative investments such as private equity and hedge funds.” (Perhaps it could also have had something to do with the unprecedented global financial crisis, in which, according to research from Credit Suisse Global Investment Returns, global stock market losses totaled $21 trillion or $21,000 for every individual in the developed world, between the market peak of October 2007 and the trough of November 2008?)
Biggs then states that “Since target investment returns, usually around 8 percent, are often imposed by state legislatures—who are reluctant to pay the increased contributions that a lower return would require—plan managers often have no choice but to construct a portfolio that will generate the desired return, without regard to risk.” Biggs believes that “If projected asset returns fall, then pensions have to take more risk to maintain a targeted 8 percent return”
(For a slightly different view on how investment return assumptions are set and subsequently reviewed, please see the NASRA Issue Brief on “Public Pension Plan Investment Return Assumptions.” This Issue Brief explains that (1) public retirement systems employ a process for setting and reviewing their actuarial assumptions, including the expected rate of investment return; (2) most systems review these assumptions regularly, pursuant to statute or system policy; (3) the process for establishing and reviewing the investment return assumption involves consideration of various factors, including financial, economic, and market data; and (4) this process also is based on a very long‐term view, typically 30 to 50 years.)
Biggs estimates that, from 2007 to 2010, the typical plan shifted around 7 percent of assets out of equities into higher-returning—“but riskier,” Biggs asserts —alternative investments. “Some plans have gone much further—Maryland, Pennsylvania, and South Carolina increased the alternative investment shares of their portfolios by up to 25 percentage points, and New Jersey’s pension board recently voted to allow its plans to hold up to 38 percent of assets in alternatives,” Biggs reported. He does not, however, note if these plans have invested up to these limits.
Biggs concludes that public-sector pensions have responded to the recent financial crisis by “doubling down.” (For you non-gamblers, “doubling down” refers to a blackjack player’s option to double his original bet by turning over his first two cards and placing an amount equal to the original bet on the new layout. The phrase has come to also mean engaging in risky behavior, particularly when in an already risky situation.) “By taking more risk” Biggs warns, “pensions impose a contingent liability on taxpayers to bail out pension funds if investments fall short.”
Biggs also testified before Congress in April, at a hearing of the House Government Oversight and Reform Committee on “State And Municipal Debt: Tough Choices Ahead." At that time, he also was critical of what he saw as increased risk-taking by public pension plans, stating that, “In their search for higher returns, states and localities are increasingly shifting to riskier and more exotic investments.” He went on to note that this not only increases their sensitivity to shifting market returns but, “with the trend toward so-called ‘alternative investments,’ raises the possibility that governments are taking on risk that they do not fully understand.”
Noting his Wharton research finds that public sector pensions have actually increased the risk in their target portfolio allocations since the financial crisis of 2007, Biggs says that “We should worry about states becoming like a late-night gambler, hoping to recoup prior losses by doubling down.” He went on to observe that “state and local government finances are coming to resemble hedge funds, with the worrying exception that they are being run by elected officials rather than by hedge fund managers.”
Biggs’ conclusions are contrary to the findings in a November 2008 report from the National Institute on Retirement Security (NIRS) entitled “In it for the Long Haul: The Investment Behavior of Public Pensions.” The NIRS study was based on U.S. Federal Reserve and U.S. Census Bureau public pension data from 1993 to 2005, and concluded that public pension plans are prudent investors because they:
- Actively rebalance investments in response to price changes.
- Do not get caught up in a “herd mentality,” but rather follow the best investment practices in the industry. State plans, in particular, systematically follow the practices of performance leaders.
- Hold higher risk assets when funding levels are higher, and assess their financial situation before modifying the plan’s asset allocation. If anything, public pensions are somewhat overly cautious following periods of lower funding, indicating they avoid “chasing returns.”
- Hold smaller amounts of stocks when employers face higher contribution rates. This trend continued even after the 2000 bear market. This indicates that public pensions avoid pressure to invest more aggressively after experiencing losses.
GAO Study
The GAO is in the process of conducting a review of both public and private defined benefit pension plan investments in alternatives. The study was requested by Congressman Robert Andrews (D-NJ), the ranking member on the Subcommittee on Health, Employment, Labor, and Pensions of the House Committee on Education and the Workforce.
GAO is looking at the following questions:
- What is known about the experiences of private DB plans with alternative investments, especially in recent years;
- What lessons have plan fiduciaries learned from their experience with alternative investments, and how have they changed investment practices as a result; and
- What actions has the Department of Labor taken to aid fiduciaries in effectively making and monitoring alternative investments, including the disclosure of information, and what additional actions might be warranted?
Conclusions
It is true that public pensions are expected to increase their investments in hedge funds in 2011, based on a number of studies. However, this is often a result of portfolio rebalancing, and not “doubling down.” As was recently noted by Ronnie Jung, Executive Director of the Teachers Retirement System of Texas, in Institutional Investor, recent fund-level changes at Texas Teachers, including expanding the hedge fund allocation from 5 to 10 percent and looking at emerging markets, were done in part to reduce dependency on public markets and make the fund as diversified as possible.
Nevertheless, claims regarding increased risk-taking to chase returns, hints of corruption resulting in plan investment losses, and suggestions that some plans are not capable of managing sophisticated alternative investments will inevitably serve to erode public confidence in state and local government plans, and suggest to Congress that, absent federal intervention, plan failures – and federal bailouts – are imminent. Public plan investment practices, which have been an “on-again, off again” concern for some in Congress, look like they could be about to be “on” again.
