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.

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.

Status Legend:

Status will change from "In process" to "Open," "Closed - implemented," or "Closed - not implemented" based on our follow up work.

• In Process
• Open
• Closed - implemented
• Closed - not implemented

Recommendations for Executive Action

Recommendation: To ensure that all plan fiduciaries can better assess their ability to invest in hedge funds and private equity, and to ensure that those that choose to make such investments are better prepared to meet these challenges, the Secretary of Labor should provide guidance specifically designed for qualified plans under the Employee Retirement Income Security Act (ERISA). This guidance should include such things as (1) an outline of the unique challenges of investing in hedge funds and private equity; (2) a description of steps that plans should take to address these challenges and help meet ERISA requirements; and (3) an explanation of the implications of these challenges and steps for smaller plans. In doing so, the Secretary may be able to draw extensively from existing sources, such as the finalized best practices document that will be published in 2008 by the Investors' Committee formed by the President's Working Group on Financial Markets.

Agency Affected: Department of Labor

Status: Open

Comments: Labor generally agreed with this recommendation. The agency stated that providing more specific guidance on investments in hedge funds and private equity may present challenges. Specifically, Labor noted that given the lack of uniformity among hedge funds, private equity funds, and their underlying investments, it may prove difficult to develop comprehensive and useful guidance for plan fiduciaries. Nonetheless, the agency agreed to consider the feasibility of developing such guidance. Based on the Department of Labor's November 2009 update, no action has been taken to date on this recommendation. According to the update, the Department continues to believe that it would be worthwhile, within the context of its other regulatory and interpretive priorities, to consider the feasibility of developing guidance that describes the ERISA obligations that apply when plan fiduciaries are selecting, valuing, accounting for, and monitoring hedge fund, private equity, and other hard to value investments. In FY 2010, Labor stated that EBSA's Office of Chief Accountant's (OCA) reviewed several hedge funds and master trusts to determine the policies and procedures used to value "hard to value" assets within several hedge funds and master trusts. However, in order to respond to this recommendation, Labor will need to provide guidance for qualified plans under ERISA to help plan fiduciaries better assess their ability to invest in hedge funds and private equity, and to better prepare potential investors. In FY11, Labor stated that in responding to the subject report, the Department shared a number of concerns about the issuance of the suggested guidance. While this is not currently a Secretarial priority, the Department will continue to be sensitive to changes that may alter our views.