This is so cliche that the state of NJ has a pension problem. It's like saying Illinois has a governor problem. Here's the latest word.
Why is it Congress's fault? Well, not entirely of course, but here's a convoluted start. UBIT. Unrelated Business Income Tax. What, you say? UBIT is a federal tax that prevents retirement plans (pension plans, your 401(k), etc.) from using leverage. In a nutshell, if these typically not taxed investment entities use leverage (that is, borrow money to fund their investing) they suddenly become taxable. Because, apparently, financing investments is an unrelated business to investing, which is the business of a pension plan.
What does this mean? In order to juice returns via leverage, rather than borrow money themselves, pension plans make investments in partnerships that may use leverage. These leverage using partnerships are normally called "hedge funds." The hedge funds hide the leverage within the partnership so everyone can comfortably say "this pension plan uses no leverage."
How does this work in practice? Suppose you are a completely competent pension plan manager who does not invest in hedge funds. You invest in a diversified, globally balanced portfolio of lots of different assets. You manage to earn, over time, for your pension plan 6%-9% annually with not very much volatility. Remember, you are highly diversified across asset classes and geographies.
Guess what: You don't exist! If you did exist, you'd do the following: You'd take your same investment strategy, leverage it up 2x-3x, making it riskier, but still attractive, you'd call yourself a hedge fund, and you'd own a 20% performance fee on what you used to do for $250k/yr.
Let's look at the math: Say the strategy has a 7% expected return, with 4% volatility. That's not bad. Suppose you borrow at 3%. Thus, you leverage the portfolio 3x, you now have a 7% + 2 x (7%-3%) = 15% expected return strategy. Yes, you have 3x the risk too. But, you've just hit the hedge fund sweet spot. Anyone who has ever met with a hedge fund manager knows they have to claim 15% gross returns to get in the door. It's in the hedge fund marketing manual. You now have a hedge fund with "higher expected returns than the equity market, and lower risk."
How's that you say? Well, the 20% performance fee means your performance, net of 2% management fee and 20% performance fee is still 10.4% [=(15% - 2%)x 0.80]. This easily beats the target your old pension plan guys need to meet their goals, so they are in! And, it gets better. That 20% performance fee, (or, as I like to say 20% at the money call your investors give you) actually reduces the volatility of the outcomes, which makes your 3x leveraged strategy not really look quite that volatile. (The performance fees "dampen" the upside volatility you see.)
Now, suppose instead you could use leverage without having to hide it in a hedge fund. Well, if that not particularly credit worthy hedge fund can borrow at 3%, say whatever you like about NJ, but it is more credit worthy than that fund. So, let's say it borrows at 2.5%. Oh, and it doesn't have to pay hedge fund fees anymore to get it's leverage. Let's go crazy and say the management fees are cut in half (only) and the performance fees are cut in half (only!) That makes for seriously well paid, highly qualified pension staff, trust me! (Remember, good investment people all HATE their clients, no matter what they say. They like investing, they don't like talking to clients. So, one big client beats many small ones...especially when the one big one is captive!)
Do the math again: 7% + 2 x (7% - 2.5%) = 16% gross return, and a (16% - 1%) x 0.9 = 13.5% net return. So, same strategy, same risk, generous fees to boot, picks up 3.1% incremental return. Assuming no UBIT.
Oh, and as a side effect, hedge fund fees come down, as HFs lose their lock on providing leverage to pension plans and the landscape becomes more competitive.
In another post, we'll go into why this same analysis should apply to pension plan's evaluation of their decisions to invest in hedge funds.
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