The Peril of Public Pension Funds

One of the mildly surprising things about the Stuyvesant Town debacle is the kinds of investors the deal attracted.  What were entities like CalPers and the Church of England doing plowing their money in along with real estate moguls like Tishman Speyer?

The answer is "looking for alpha".  Underfunded pension funds have been looking for extra return in order to make up the holes . . . and the problem is worst among public pension funds, because until recently, their accounting wasn't very good, so politicians were fond of making unfunded promises in lieu of wages.

Needless to say, public pension funds cannot necessarily afford to attract top investment talent, particularly since appointments tend to have a political as well as financial component.  They're thus vulnerable to making investments that aren't in their best interest--not just in real estate, but in things like derivatives, as Felix Salmon notes:

In reality, it's not the pension funds which are engaging in "derivatives abuse", but rather the investment bankers who sell the pension funds complex over-the-counter derivatives which make the broker lots of money and which rarely do any good for the end client. As Clavell says,

Let's assume you work at a Pennsylvania school board, or a Swiss private bank, an Australian life insurance company, a German corporate treasury, a UK Pension administrator or any one of thousands of other buyside entities, supposedly with sufficient expertise that an investment bank can classify you as a non-retail customer.

The more complex the structured product, the more opportunity for agents to extract fees at your expense...

Admitting you don't know is pure alpha; you will not claim to have any edge and this may put you off involvement in the product. If you claim you do know where the fees are, banks want you as a customer. You don't know. Really, you don't. Hang on, I hear you shouting that you're actually smarter than that, so you do know. Read carefully: Listen. Buster. You. Don't. Know.

The fees are hardly the worst part; more worrying is that many public pension funds and other public trusts are assuming risks they don't necessarily understand.  They think they're gaining alpha--higher expected value on their investments.  But often they're confusing alpha with beta, which is to say they're getting higher returns not because they're making good investments, but because they're taking on more risks.

I don't think I need to convince many people that high-risk, high-return investments are a bad way for public pensions to try to deal with their massive unfunded liabilities.

Felix is right that the investment bankers who push these sorts of things on public pension funds are, at the very least, doing something unsavory.  But they don't deserve all the blame.  Public pension funds shouldn't be trying to make up their deficiencies by chasing unrealistically high returns.  Of course, if politicians and their appointees had the courage to pay for the gifts they gave public employees, rather than looking for loopholes, we wouldn't be in this mess in the first place.