A Wall Street Coup

Thousands of Kentucky public school teachers swarmed the state Capitol earlier this year, angry not about low salaries, but about their shrinking pensions. Among their concerns: the high portion of their money that has ended up in the hands of Wall Street in opaque, high-cost products that seem to benefit no one aside from the people who sold them. Rising pension costs helped to send teachers in Colorado into the streets in protest a few weeks later. In the last year, pension woes have also prompted teachers in Ohio and Oklahoma to march. And police, firefighters, and other public employees in Michigan have been staging protests since at least 2016 to preserve their public pensions, more than one-third of which is invested in “alternatives”: private equity, hedge funds, commodities, distressed debt, and other opaque Wall Street investment vehicles.

A “Wall Street coup” — that’s how pension expert Edward “Ted” Siedle describes it. Public pensions across the country now squander tens of billions of dollars each year on risky, often poor-performing alternative investments — money public pensions can ill afford to waste. For all the talk of insolvency, $4 trillion now sits in the coffers of the country’s public pensions. It’s a giant pile of money of intense interest to Wall Street — one generally overseen by boards stocked with laypeople, often political appointees. “Time and again,” Siedle has written, “hucksters successfully pull the wool over these boards’ eyes.”

In 1974, in the wake of the spectacular collapse of the Studebaker car company and its pension plan, Congress passed a piece of landmark legislation, the Employee Retirement Income Security Act. Under ERISA, companies are required to adequately fund their pensions and follow what was then called the “prudent man” rule, which barred those in charge from putting pension dollars into overly risky investments. The departments of Labor, Treasury, and Commerce were charged with overseeing the country’s pensions and a new body was created, called the Pension Benefit Guaranty Corporation, that would backstop pensions should a business default.

Except Congress left out public employees entirely — with a yawning loophole that granted an exemption to public pensions. ERISA expressly exempts public pensions operated by state and local governments — the plans that provide for the country’s teachers, firefighters, police officers, and librarians in their retirement. Forty-four years after the passage of ERISA, these public workers comprise the majority of active employees still contributing to pension plans. And they have been left largely unprotected.

Siedle calls it “the loophole that is swallowing America.”

The public pensions loophole helps explain why we read a lot more about underfunded state or municipal pensions teetering on the edge of default than we do dangerously underfunded pensions in the private sector. Thanks to ERISA, private pensions are better funded, and when they do face default, the federal benefit guaranty kicks in.

Because ERISA’s adequate funding requirement exempts governments, there are some half a dozen states with pension systems at the breaking point, including Illinois, where lawmakers are wrestling with unfunded pension liabilities of $129 billion, and Kentucky, where the state’s unfunded public pension liabilities top $27 billion.

That ERISA’s fiduciary oversight rule also exempts governments helps explain how Wall Street pulled off its coup, according to Siedle, a former Securities and Exchange Commission lawyer who for decades has been investigating public pensions. Instead of the strong protections imposed on the private sector by Congress, Siedle notes, “public pensions are regulated by a thin patchwork quilt of state and local laws,” and many don’t even submit to an annual audit. “No federal or state regulator, or law enforcement agency, is policing these plans for criminal activity,” according to Siedle. “No worries about the Department of Labor or FBI.”

Until the 21st century, public pensions generally invested in a standard blend of stocks and bonds. The more daring or community-minded among them may have invested a small fraction of their holdings in real estate projects or other exotic investments, yet alternatives averaged only 5 or 6 percent throughout the 1980s and 1990s. Yet as alternative investment structures grew in recent decades, and as pension funds sought desperately to make up for funding shortfalls, more and more of those trillions of dollars made their way to the country’s hedge funds and private equity managers. When, in 2017, the Pew Charitable Trusts looked at 73 of the country’s largest public pensions, researchers found that a full 25 percent of the pension money was invested in these high-fee alternatives.

The irony is that pensions don’t need to be 100 percent funded to be sound, as employees don’t all retire at once. Rating agencies and government monitors typically consider 70 to 80 percent to be adequate. And the country’s public pensions are generally hitting that mark, averaging 76 percent funding as of 2015, according to a survey by the National Conference on Public Employee Retirement Systems. “To suggest that there’s some nationwide crisis is simply not true,” says Bailey Childers, former director of the National Public Pension Coalition.

Yet public pensions continue to make desperate investments — and the competition for a piece of that action is so intense that it’s often involved outright fraud. It was in part a pension sting operation that helped take down Illinois Gov. Rod Blagojevich, who was back in the news earlier this year when President Donald Trump floated the idea of commuting the sentence of his former “Apprentice” star. In New York, Comptroller Alan Hevesi, who oversaw a $125 billion pension fund, confessed in court in 2010 that he had signed off on a $250 million pension investment in exchange for nearly $1 million in illegal gifts from a man named Elliott Broidy. Broidy, who ultimately pleaded guilty to a misdemeanor, is a major political donor with close ties to Trump; so close, in fact, that he resigned as deputy finance chair of the Republican National Committee this past April after it was revealed that Trump’s personal lawyer, Michael Cohen, arranged a $1.6 million payoff to a pregnant former Playboy model, allegedly on his behalf. Pension scandals have touched the Carlyle Group, a well-feathered landing spot for retired public officials (including former President George H. W. Bush and former British Prime Minister John Major), and also some of the biggest names in money management on Wall Street. In July 2018 alone, the SEC sanctioned private equity firms and other investment advisers for violating its “pay-to-play” rules — in Texas, Wisconsin, Indiana, Illinois, Rhode Island, and Los Angeles.

A scandal in California didn’t involve any high-profile elected officials but was, if anything, even more outrageous. There, the CEO of the country’s largest public pension was brought down by a pay-to-play scheme involving a former trustee and billions of dollars in public funds. Fred Buenrostro ran the California Public Employees’ Retirement System from 2002 to 2008. Alfred J.R. Villalobos, a former CalPERS trustee who became a placement agent, allegedly paid for Buenrostro’s wedding, took him on a trip around the world, and paid him hundreds of thousands of dollars stuffed in paper sacks and a shoebox. In exchange, prosecutors charged, Villalobos secured more than $3 billion in CalPERS investments for his client, Apollo Global Management, a giant of the private equity world. Over a five-year period, Villalobos earned around $50 million for helping his private equity clients win deals with CalPERS; he pleaded not guilty but took his own life before trial. Apollo’s punishment was the additional $550 million it received from CalPERS in 2017.

Alfred R. Villalobos, center, exits LA County Superior Court, West District in Santa Monica after a judge ruled the receivership will stay in order and his assests will remain frozen as ordered by the court. Villalobos contends that nothing about his commissions was hidden from the California Public Employees' Retirement System, a claim that is part of his aggressive defense of a state Attorney General's civil lawsuit against him.  (Photo by Allen J. Schaben/Los Angeles Times via Getty Images)

Alfred J.R. Villalobos, center, exits the L.A. County Superior Court in Santa Monica, Calif., after a judge ruled his assets would remain frozen as ordered by the court.

Photo: Allen J. Schaben/Los Angeles Times via Getty Images

Yet much of what Siedle called the “looting” of the country’s public pensions takes place through perfectly legal investments with exorbitantly high fees. As an example, he brings up Rhode Island, where he spent time in 2013 after one of the big public employees’ unions, AFSCME, hired him to investigate the state pension there. Rarely was the wealth transfer from workers to Wall Street as vivid. The new state treasurer, whose campaign had been bankrolled by several New York hedge fund managers, championed a plan that cut employee benefits by roughly 3 percent several years back — and then gave most of the money the system saved to a trio of hedge funds to which it had entrusted a big chunk of its investments. “It wasn’t an austerity program,” Siedle said. “It wasn’t reformed. It was simply about paying lower benefits so Wall Street could get paid.”

The High Price of Hedge Funds

Hedge funds and other more exotic investments come at a steep price. A pension fund seeking to own a diverse basket of technology stocks, say, or invest in promising, mid-sized European companies may hire a stockbroker to handle that aspect of its portfolio for around 0.5 percent annually, or $500,000 a year for every $100 million invested. By comparison, hedge funds and private equity charge fees that work out closer to 5 percent annually, according to Howard Pohl, an investment consultant who has been advising public pension managers for more than four decades. Yves Smith, the pen name of management consultant Susan Webber, puts that figure closer to 7 percent a year on private equity investments. That’s $5 million to $7 million each year on every $100 million a pension invests with a firm. The deal has worked out well for some of Wall Street’s best-known billionaires, including Stephen Schwarzman, CEO of the Blackstone Group, who pocketed $787 million last year; Henry Kravis and George Roberts, the co-founders of Kohlberg Kravis Roberts, who took home a combined $343 million in 2017; and Steve Cohen, the disgraced hedge fund king worth an estimated $13 billion. All of them included public pension funds among their major clients.

The pensions haven’t fared nearly as well. The 2017 Pew study found that those funds that had recently and rapidly invested in alternatives reported the weakest 10-year returns. A 2018 report by the conservative Maryland Public Policy Institute put a price tag on those mediocre results. The group compared the actual performance of the $49 billion Maryland State Retirement and Pension System against a model with a straightforward “60-40” approach, in which 60 percent of a portfolio is invested in stocks and 40 percent in bonds. Despite the hundreds of millions of dollars in additional fees the pension system had paid to private equity firms and hedge funds, it would have earned an additional $5 billion over the prior 10 years had it adopted the more judicious 60-40 strategy. A 2015 study commissioned by the then-$15 billion Kentucky Retirement System found that overexposure to hedge funds contributed to more than $1 billion in lost returns over five years when compared to the returns earned by its more cautious peers. A study that same year by the liberal Roosevelt Institute and American Federation of Teachers found that poor returns on hedge fund investments had cost 11 of the country’s larger statewide public pensions $8 billion in lost revenue over the previous decade because most of the profits were eaten up by the steep fees hedge funds charge their investors.

“I could never figure out why somebody working at a hedge fund is worth 10 times more than the guy at Fidelity,” Pohl said.

Citizens United, the landmark Supreme Court decision that ushered in a boom in political dark money, also accelerated the siphoning off of billions of pension dollars into inappropriate investments. “Since Citizens United, investments in alternatives have absolutely exploded,” said Chris Tobe, a former trustee for the Kentucky Retirement System. Wall Street firms can now write big checks to a political or party committee to curry favor among elected officials who control pension fund appointments — completely out of the public view. A new SEC rule that year imposed tight restrictions on political contributions by hedge funds, private equity firms, and others to any public official who could have sway over an investment decision. Yet Citizens United effectively made the rule irrelevant, as money flooded in to proxies instead. Executives at firms managing state pension money gave $6.8 million to the Republican Governors Association in the 2014 election cycle, according to the nonprofit MapLight, and $151,000 to its Democratic equivalent.

Much of the overreliance on private equity and hedge funds boils down to what Ted Siedle sees as a mismatch between the civil servants, who work for the public pensions, and the salespeople, who show up with their sophisticated marketing materials and pitches that make it sound as if only a small elite is fortunate to get a piece of the hot, new fund they are peddling.

“You’ve got Wall Street marketers with virtually unlimited expense accounts, under orders by their bosses to do anything necessary to win over these government pension officials who control trillions,” Siedle said. “So people living these mundane lives are being flown to five-star hotels in Maui, in Honolulu, in Phoenix, in Puerto Rico, in Bermuda. They’re being flown to New York, where they see the hottest Broadway shows, or they’re in Las Vegas at Cirque du Soleil. I’ve seen everything from trips to strip clubs to helicopter rides over Maui to hot-air balloon rides in Albuquerque.”

United States District Attorney Preet Bharara announces charges, Wednesday, Dec. 21, 2016 in New York, against Navnoor Kang, a former portfolio manager at the New York State Common Retirement Fund, and two broker-dealers, Deborah Kelley and Gregg Schonhorn, for participating in a "pay-for-play" scheme. The indictment alleges Kang took bribes that included prostitutes, strippers, cocaine, a $17,000 wristwatch, travel, and tickets to Broadway shows, the U.S. Open tennis tournament and a Paul McCartney concert. (AP Photo/Mark Lennihan)

U.S. Attorney Preet Bharara announces charges against Navnoor Kang, a former portfolio manager at the New York State Common Retirement Fund, and two broker-dealers, Deborah Kelley and Gregg Schonhorn, for participating in a “pay-for-play” scheme on Dec. 21, 2016 in New York.(AP Photo/Mark Lennihan)

Photo: Mark Lennihan/AP

Violations of Trust

Persuading a pension fund to invest requires a money manager to win over the two main groups guarding money promised to retirees. There’s the staff that makes the investment recommendations. “For the most part, these are very hardworking, good people who sometimes are in above their heads,” Pohl, the consultant, said. There’s also the boards appointed to oversee a fund.

Who sits on a board of trustees, and how well they’re positioned to oversee the staff, varies widely from jurisdiction to jurisdiction. Some boards are designed to be political. The body overseeing New York City’s Employees’ Retirement System, for instance, consists of 11 political players: the city’s five borough presidents, the city comptroller and public advocate, a mayoral appointee, and the heads of the three unions who represent the largest number of participating employees. New York state’s Common Retirement fund, the third-largest public pension in the country, with more than $200 billion under management, is overseen by a single individual: the state’s elected comptroller. In Chicago, the teachers run the show, with teachers and former teachers constituting a majority on the board overseeing the Chicago teachers’ pensions.

Technically, the trustees determine asset allocation: the portion of a fund’s money that is invested in stocks and bonds and alternative assets. But it’s typically the staff that recommends any changes, or proposes that a fund choose a new money manager or steer more money to an existing one.

In theory, the trustees serve as a check on staff. But only in rare circumstances do they aggressively exercise that authority. After major losses at the Chicago Teachers’ Pension Fund following the 2008 crash, an insurgent group of public school teachers ran for and won the two open board seats the following year. One of those insurgents, high school English teacher Jay Rehak, who today serves as board president, said, “Unfortunately, a lot of these people on boards are essentially bobbleheads” — built to nod their heads yes. The insurgents, who now run the city’s teachers union, removed the remaining bobbleheads in subsequent elections, according to Rehak. Though roughly 3 percent of the $10.1 billion is in the hands of private equity managers, he said, “we’re now 100 percent out of hedge funds.” But it wasn’t without pushback from staff.

“We’d fire fund X, Y, and Z,” Rehak said, and invariably someone on the pension staff would complain,“‘But they’re our friend.’ I tell them, ‘Don’t worry, they’ll land on their feet.’ It might sound crazy, but these people are very good at selling themselves.”

SACRAMENTO, CA - JULY 21:   The California Public Employees' Retirement System building in Sacramento, California July 21, 2009. CalPERS, the state's public employees retirement fund, reported a loss of 23.4%, its largest annual loss. (Photo by Max Whittaker/Getty Images)

The California Public Employees’ Retirement System (CalPERS) building in Sacramento, Calif., on July 21, 2009.

Photo: Max Whittaker/Getty Images

Pension investment staff typically earn dramatically more than the civil servants whose money they are investing. CalPERS, for instance, paid its chief investment officer $867,000 last year — while the state’s chief executive, its governor, earned a fraction of that, $190,000. The CIO of the Teacher Retirement System in Texas is paid $450,000 a year; four others on his staff (like him, all white men) are paid annual salaries exceeding $325,000 — more than twice that of the state’s governor. Idaho’s CIO was paid just over $300,000 last year — two-and-a-half times as much as the governor. “Some of these salaries are out of control,” said Tobe, who calculated, based on performance data from Boston College’s Center for Retirement Research, that there was no correlation between how well a CIO is paid and performance.

Tobe learned the hard way how conflicted pension fund staff can be during his four years as a trustee of the Kentucky Retirement System. The staff was particularly adept, Tobe said, at keeping secrets from their ostensible bosses, the trustees. Only near the end of his tenure did Tobe learn that one key staffer who helped push the state more aggressively into alternative investments sat on more than a half-dozen advisory committees created by the private equity partnerships and hedge funds he had been paid to assess. “Funds create advisory committees and then put staffers from the public pensions on them, along with union people and people from the endowments and foundations, whose money they also want,” according to Tobe, who added that committee members don’t typically receive a stipend, but rather extravagant perks, such as complimentary stays at $1,000-a-night hotels in exotic locales. “It’s basically a boondoggle,” he said. “They’ll take them offshore, show them a good time, buy them expensive meals.” The quid pro quo is that a pension fund will invest with that firm.

Former Kentucky Retirement Systems trustee Chris Tobe sits for a portrait at his parents' house in Floyds Knobs, Indiana, U.S., on Friday, Oct. 19, 2018. Photographer: Luke Sharrett for The Intercept

Former Kentucky Retirement Systems trustee Chris Tobe, photographed at his parents’ house in Floyds Knobs, Indiana, on Oct. 19, 2018.

Photo: Luke Sharrett for The Intercept

The third important players in pension decision-making are the consultants that pension funds hire to guide their decisions and vet the money managers seeking a piece of their business. Investment consultants, too, are often conflicted. While Siedle speaks approvingly of And Co, where consultants such as Pohl help pension funds “make sure they’re not a bunch of sheep at the mercy of the wolves,” in Pohl’s words, sometimes the investment consultant is the wolf. Recently, Siedle completed a job for Orange County, in Florida, whose comptroller hired him to evaluate seven investment consultants who had applied to advise the fund. “I concluded that six out of the seven were conflicted,” Siedle said. They were being paid on the side to help one money manager or another market its services to funds such as Orange County’s, if not earning a commission whenever a pension invests in funds they peddle. “Only one was not in the money-manager business,” Siedle said, noting, “that’s typically the case.”

Yet even those pension consultants without direct financial ties to a hedge fund or private equity firm have a troubling conflict of interest that not incidentally drives up the fees that pensions pay. Pension consultants advise funds on its optimal mix of assets and often recommend the best managers to handle those assets. A consultant taking into account a pensions’ best interests might steer clients into inexpensive options, such as index funds, which let investors own a diverse portfolio of stocks at a very low cost. (A Standard & Poor’s 500 index fund, for instance, follows the price movement of the country’s 500 largest publicly traded companies.) Index funds typically charge annual fees well below 0.5 percent, but don’t require much in the way of billable hours for the ambitious pension adviser. Helping a pension fund choose among the thousands of hedge funds peddling its services, however, could lead to hundreds of hours of charges. “In the consulting business, you’re not making much selling clients on low-fee index funds,” Siedle said. Suggesting that a pension hand over a portion of its cash to hedge funds and private equity is far more lucrative, he said. The consultant earns fees helping a pension navigate a complex world of options — and then potentially earns much more serving as the indispensable gatekeeper who gets them into a fund.

Even the most well-meaning consultant may have trouble protecting a pension fund from alternatives, Siedle said. “They have clients insisting on being in alternatives,” Siedle said — pension fund managers who are convinced that alternative investments add octane, despite the risks and the record. So the consultants “can’t be talking in the press about how pension managers are idiots if they own this shit.”

A Lucrative Source of Profits

It wasn’t that long ago that public pensions were cautious players almost afraid of the stock market, let alone the dice-rolling of investments in hedge funds. Teresa Ghilarducci was a labor economist at Notre Dame when, in 1997, Indiana’s governor named her to the state’s Public Employment Retirement Fund’s board of trustees. “The big debate then was whether we should go beyond bonds and invest in stocks,” said Ghilarducci, who now teaches at the New School in New York. “I was a detractor who thought we were moving too fast.”

By the time she left the board in 2002, the trustees were already considering hedge funds and private equity. Today, nearly 37 percent of Indiana Public Retirement System assets are invested in alternatives. According to Pew, it was the single worst-performing pension fund in the country over the decade ending in 2015.

The health of public pensions in the United States more or less peaked around 2000. On average, state and local pensions were 103 percent funded that year, according to Boston College’s Center for Retirement Research, with more money on hand than they even needed. At that point, only 3 percent of public pension dollars were invested in alternatives. But then the dotcom crash caused a steep fall in the stock market, with the Nasdaq index dropping by 77 percent and the S&P 500 by 43 percent. Pensions that had been more than fully funded in 2000 now had only 90 percent of the money they needed on hand. What happened next is what Ghilarducci describes as “chasing returns” — dialing up the risk to fill the gap. “I’ve seen it a lot: funds shooting for the moon because they’re trying to catch up” said Ghilarducci, co-author of a 2016 book, “Rescuing Retirement.”

As the hedge funds and private equity firms moved in, so did another actor: the placement agent. Pensions were such a potentially lucrative source of profits for any hedge fund or private equity firm — able to invest tens of millions, if not hundreds of millions of dollars, at a time — that money managers began to hire intermediaries to help convince pension funds to invest with them. At their most benign, placement agents are well-compensated salespeople, helping public pensions gain access to better investments. Time and again, though, “placement agents” have been shown to function more as political fixers who use their connections, campaign contributions, and even outright bribes to influence the staff, trustees, advisers, or elected officials who have the capacity to help steer pension dollars into the coffers of one of their clients.

**ADVANCE FOR SUNDAY, MARCH 2 - FILE** Antoin "Tony" Rezko, a fundraiser and political confidant for Gov. Rod Blagojevich, leaves the federal building in Chicago in this Oct. 19, 2006, file photo. Jury selection begins Monday, March 2, 2008, at federal court in Chicago for Rezko who is charged with using political clout to run a multimillion-dollar extortion scheme. (AP Photo/Nam Y. Huh, File)
Millionaire campaign contributor Stuart Levine, center, who has become an issue in the Illinois governor's race, leaves federal court Friday, Oct. 27, 2006, in Chicago. The businessman who funneled thousands of dollars into Gov. Rod Blagojevich's campaign pleaded guilty Friday to using his seats on two state boards in a bid to collect millions of dollars in kickbacks. (AP Photo/M. Spencer Green)

Top/left: Tony Rezko, a fundraiser and political confidant for Illinois Gov. Rod Blagojevich, leaves the federal building in Chicago on Oct. 19, 2006. Bottom/right: Millionaire campaign contributor Stuart Levine leaves federal court in Chicago on Oct. 27, 2006.Photos: Nam Y. Huh, M. Spencer Green/AP

In fact, the federal wiretap that caught Blagojevich trying to sell Barack Obama’s soon-to-be-vacated Senate seat for $1.5 million had been put in place during an investigation of the influence of placement agents inside the Illinois teachers’ pension fund (as well as possible kickbacks related to state health facilities). Among those that Operation Board Games — as the U.S. Attorney’s Office and FBI dubbed their investigation — targeted was Tony Rezko, who was found guilty in 2008 of scheming with Teachers’ Retirement System trustee Stuart Levine to get kickbacks from a money management firm seeking some of the pension fund’s money. (Levine also went to jail.) Blagojevich aide Christopher Kelly killed himself after being indicted as part of a conspiracy to block a $220 million investment with Capri Capital already approved by the TRS board unless Capri donated to Blagojevich’s re-election campaign. A third man, William Cellini Sr., delivered the threat by giving Capri a choice: raise $1.5 million for Blagojevich or kiss the $220 million deal goodbye. Cellini was found guilty in 2011. The probe also uncovered evidence that the Carlyle Group had paid $4.5 million to a lobbyist to gain a share of the union’s retirement money as well. Carlyle was never charged with a crime.

By 2009, the problems with placement agents had become so visible that the SEC proposed a ban on them. But after intense lobbying by the likes of Blackstone and Morgan Stanley, both of which have placement agent divisions, the SEC backed down. New York, California, and New Mexico imposed restrictions on the use of placement agents that year. But a 2014 study found that placement agents were still being used by 41 percent of the North American-based private equity firms raising funds that year.

In the late 1990s, Siedle thought there was money to be made consolidating the pension consultant market and convinced Bruce Rauner, then a big-time private equity manager in Chicago, to commit up to $250 million to the idea. But the business never went anywhere. The small consultancies he imagined buying up with Rauner’s cash had no interest in selling, he said; many of them had devised their own pay-to-play schemes and were making too much money. It turned out that the fees they were paid for their guidance — the part of the business Siedle wanted to own — represented only a fraction of their earnings. Consultant after consultant told him how they were making more money on commissions by acting as a pension’s broker and hosting conferences for the pension’s money managers, who paid as much as $50,000, Siedle said, to “market their wares to the consultants and pensions in the crowd.” Others were making their money by doing dual duty as consultant and broker. Siedle figured that they stood to earn far more money charging brokerage fees than they earned for their advice. The Chattanooga Pension Fund in Tennessee accused a pension consultant of costing them $20 million from its fund through “churn”— buying and selling shares to produce higher trading commissions. A similar controversy in Nashville led to a $10.3 million settlement between the city and its consultant.

The 2008 financial crisis proved another accelerant for alternative investments. The crash caused the country’s public pensions to lose billions of dollars in value, due in part to their heavy exposure to mortgage-backed securities and other subprime-related products. By 2009, public pensions across the country were only 79 percent funded. In a later blog post, Siedle calculated that because of the subprime meltdown, $660 billion in state workers’ retirement savings “have been taken off the radar — swept into the highest-cost hedge, private equity, venture and real estate funds ever devised by Wall Street.” By his estimation, it was “a heist 40 times greater” than Bernie Madoff’s Ponzi scheme. A few years later, Siedle uncovered evidence that JPMorgan Chase had failed to disclose conflicts of interest to some of its wealth management clients, leading the bank to pay a $300 million fine — earning Siedle $78 million in whistleblower awards from the federal government.

One rationale reaction to 2008 would have been for pension fund managers to swear off exotic investments and go back to plain vanilla stocks and bonds. Instead, many doubled down, hoping higher returns would help make up for their severe losses. Siedle calls this the “Hail Mary,” the football term when a team that’s behind late in the game throws a desperation pass in the hope of a big score. It’s a vicious circle; the more some locales fall behind, the more its people gamble on alternatives — and it’s taxpayers who are on the hook for any shortfalls.

People walk past the New York Stock Exchange (NYSE) building in New York on November 17, 2017.  / AFP PHOTO / Jewel SAMAD        (Photo credit should read JEWEL SAMAD/AFP/Getty Images)

People walk past the New York Stock Exchange building in New York on Nov. 17, 2017.

Photo: Jewel Samad/AFP/Getty Images

Gambling, Not Investing

Despite the steep fees, some financial experts believe that hedge funds and private equity are appropriate for a pension fund — in moderation. One is Ghilarducci, the former Indiana trustee who is now a trustee for two union funds. She said, “It would be a violation of my fiduciary duty if we did not invest in hedge funds or private equity.” But she cautions that only a small universe of money managers in those categories can be trusted with a pension’s money, and that even so, they are appropriate only for larger pensions with the requisite staff. “The evidence is showing that most hedge funds aren’t worth the risk or the high fees,” she said. “And most private equity isn’t, either.”

Mark Hoffman is another believer. As the head of alternative investments for PNC Asset Management, he advises wealthy individuals, as well as institutional investors like pension funds, on how they should invest their money. “Twenty years ago, you could get a 7.5 percent return investing in bonds,” Hoffman said. “Today, it’s almost impossible to achieve a 7.5 percent return without doing something in the alternative space.” But at PNC, he said, they hold to a hard-and-fast rule: no more than 30 percent in what Hoffman calls “private investments” — private equity, hedge funds, and real estate.

A partial list of states that have blasted through that cap is long and includes Illinois, Kentucky, Massachusetts, Michigan, Ohio, South Carolina, Texas, Utah, and Vermont, each of which recently had at least one-third of its portfolio in alternatives, according to the 2017 Pew study. Two states have large pension funds with more than half their money in alternatives: the Missouri State Employees’ Retirement System (51 percent) and the Arizona Public Safety Personnel Retirement System (56 percent). “At that point,” Siedle said, “that’s what I’d call gambling, not investing.” The consultant in charge of Arizona’s public safety pension released a statement declaring that the move into alternatives was about reducing the risk of an overreliance on stocks — even as he acknowledged that three-quarters of its peers had outperformed the fund.

The founders of hedge funds and private equity partnerships tend to be Wall Street refugees who were making millions a year working for a Goldman Sachs or Morgan Stanley, but figured out that they could make even more in alternatives. The key to that wealth is the “2 and 20,” as it is called within the industry. Hedge funds and private equity alike typically collect a 2 percent management fee ($2 million for every $100 million invested) and then take 20 percent of any profits before distributing them to investors. Double that $100 million over a 10-year period, and reward yourself with a $20 million performance fee. The beauty of the “2 and 20” is even if a $5 billion fund makes no money for its investors, it still walks away with $100 million in management fees.

Hedge funds and private equity are lumped together in the alternatives category for good reason. Both are giant pools of opaque money that are largely unregulated, precisely because they are open only to so-called qualified investors — the very rich or large institutional investors like pension funds.

Yet there are big differences between the two. Private equity buys companies, or large pieces of companies, and often requires investors to lock in their money for 10 years or more. Hedge funds, by contrast, basically do what they want. They can buy stocks or short stocks (that is, bet that a stock’s price will fall) or simply invest everything in a money market. They can make a $1 billion bet against the British pound, as George Soros famously did in 1992, or invest everything in collateralized debt obligations and other esoteric subprime-related products, as a pair of Bear Stearns hedge funds fatally chose to do before their collapse in 2007. Since hedge funds tend to invest in things bought and sold on the open market, a pension fund wanting out can usually extract its money within 30 to 90 days.

Of the two, private equity is the easier investment for a trustee to rationalize. Despite the steep fees, private equity has proven a good investment. Private equity firms have generally outperformed the stock market, even factoring in the enormous fees. Yet Siedle still questions their inclusion in a public pension portfolio, as they mean that a pension has no say over how its money is invested. Private equity might provide the needed capital to help a business grow and allow everyone to prosper. It might also hollow out a company and sell it off for parts, leading to the loss of thousands of jobs. At least 11 public pensions are helping to fund the Trump family as investors in the CIM Group, a private equity partnership that owns the Trump SoHo and pays the Trump Organization to run it. In August, the AFT released a report identifying 26 hedge funds that have billions of dollars invested in private prisons and urging public pension trustees to divest in order to avoid “rely[ing] on incarcerating people to turn a profit.”

Hedge funds, on the other hand, barely offer an upside. In 2008, famed investor Warren Buffett bet $1 million that a passive investment in an S&P 500 stock index fund would outperform hedge funds when factoring in fees and other expenses. Buffet collected his wager several months early, in the fall of 2017, because the contest wasn’t even close. The S&P 500 had generated a return of more than 7 percent a year since the start of 2008, compared to 2.2 percent earned by a basket of hedge funds.

The exposure of so many pensions to hedge funds is a tribute to the influence of marketing departments and placement agents — and the intense pressure that trustees and staff feel to rev up returns with the high-octane investments they crave.

Some pensions around the country have long bucked the alternatives trend. Oklahoma has no money in alternatives and yet has posted a 10-year return of 6.99 percent per year, according to Pew’s 2017 study of the country’s largest funds. Neither does the Georgia Employees’ Retirement System or its Teachers Retirement System, yet both show a 10-year return of nearly 7 percent. Both fared better than Arizona’s public safety fund, the state pension with the greatest exposure to alternatives, which earned only 5.2 percent a year.

A handful of other locales that were once heavy users of alternatives have recently cut back. One is the New York City pension system, which, at $192 billion, is the fourth-largest in the country. A 2015 study released by Scott Stringer, the city’s comptroller, found that the city had paid billions to those he called “Wall Street money managers” — and yet he found that those fees and underperformance had cost the pension system $2.5 billion over the previous decade. In 2016, trustees of the New York City Employees’ Retirement System voted to shed its hedge fund holdings. That followed a 2014 decision by CalPERS to liquidate its $4.1 billion hedge fund portfolio. (CalPERS has hardly sworn off its addition to alternatives. Earlier this year, Bloomberg reported that its trustees were reviewing proposals from six firms, including BlackRock, the giant investment management company, to oversee nontraditional investments. Smith, the financial blogger, points out that this approach “flies in the face of what every other major investor in private equity is doing, which is to do more in-house, both to reduce fees directly and, over time, to gain more leverage over private equity.”)

The pushback has also extended into North Carolina, where in 2017 Dale Folwell took over as state treasurer, the first Republican to hold the position in 140 years. Folwell ranked as one of the legislature’s most conservative members during his eight years in the North Carolina House, where he was a vocal opponent of same-sex marriage and civil unions. Yet as treasurer, he has been an outspoken critic of high-priced alternative investments and has sought to shift most of the state’s $96 billion pension fund to a mix of low-cost index funds. He found that the state had paid $600 million in fees in 2016 — seven times more per dollar under management than it had paid in 2000 when it had fewer alternative investments — yet had posted only a 5.1 percent return over the previous 10 years.

Folwell, as treasurer, has sole discretion over how the pension invests its money; the North Carolina pension system’s board of trustees has no authority to curb his instincts. But he’s found that change isn’t easy when it comes to private equity. His predecessors, he discovered, had signed long-term contracts that locked up the pension’s money. Though in 2017 the fund pledged to invest no new money in private equity, extracting the state from its prior private equity commitments would require selling in the secondary market at fire-sale prices. As a frustrated Folwell told the Wall Street Journal earlier this year, “It’s hard to come into a culture where no one thinks anything is wrong.”

This article was reported in partnership with The Investigative Fund at The Nation Institute.