When Democrats Love Hedge Funds

by Patrick Brennan

The Manhattan Institute’s Public Sector Inc. notes that the New York state legislature is likely going to lift the cap on the share of the state’s public pension funds that can be devoted to alternative asset classes — a fairly broad term but one that mostly comprises hedge funds and private-equity firms. The idea is pretty simple: Legislators don’t want to make the contributions they need to make to fund public-employee pensions and health care, so they boost their investments in alternative assets, which in theory have higher returns than other asset classes. Ambitious universities have done the same thing with their endowments.

Whether this is a prudent financial decision or not is kind of a complicated question: Such investments often do see higher returns than other asset classes and offer diversification (i.e., they don’t necessarily go down when the stock market does, etc.)  One problem with the temptations of alternative assets, the fact that they’re highly illiquid, isn’t that big a deal for public pension funds in the way it can be for, say, universities.

And legislatures micromanaging public-pension funds isn’t a great idea, so a higher cap may well make sense in that light. But the policy change reflects the constant efforts by legislators to game the system and reduce the contributions they have to make to public pension funds. In some instances, politicians have used a bigger allocation for alternative assets to justify raising their expected return rate — which is already way too high — reducing the contributions they have to make. ​That doesn’t appear to be part of the New York bill, so future contributions aren’t going to be automatically smaller. But lawmakers certainly hope that returns will increase, nearing the 7 percent or so they assume — whether that’s going to happen or not. And as the author of the piece about New York, Ilya Atanasov, points out, it’s often exceedingly difficult to value alternative assets, so this opens up another way to game contributions to the system and avoid paying the bills that are eventually going to come due. 

For these reasons, and because pension funds have tended not to hit their expected returns (since they’re too high — corporations are required by law to assume returns something like 4 percent, public funds get to use around 7 percent), more and more public funds are flocking to alternative assets. The share of public-pension dollars in alternative assets has gone from 11 percent in 2006 to 23 percent in 2012. Alternative assets have gotten bigger as a share of the whole investing world over that time, but not that much bigger.

The New York state senate, which is controlled by a coalition of Republicans and conservative Democrats, has already passed the bill, and the solidly Democratic house is expected to pass it too. New York’s pension situation isn’t quite as dire as many states: Government accounting is optimistic, but at least by that metric, the state’s pension funds are close to 100 percent covered. Expect other blue states, including those in more dire straits, to start making their fund management more Mitt Romney–friendly in the future.