How Not to Save for Retirement

Time's ticking away in the fourth quarter and you're down, but not out. Is it time to throw caution to the wind, put in the spread offense, and start throwing long to the end zone?

If we're talking about football, the answer may indeed be yes. However, if we're talking about your retirement, you'd better think again. A financial advisor with your best interests in mind would likely counsel you to be realistic about your retirement -- that is, if funds are short, smart moves might be increasing your current contributions, planning to retire later, or adjusting your expected budget in retirement. Drastically increasing your portfolio's risk profile, on the other hand, would almost certainly be a gamble not worth taking.

Yet when it comes to the country's major pension funds, many are doing just that in an attempt to overcome recent poor returns and sizable funding gaps. As Reuters reported yesterday, many major pension funds are ditching stocks and bonds, the traditional mainstay of pension funds, and turning to riskier alternative investments like hedge funds, venture capital, and even catastrophe reinsurance.

There may be some upside to the shift -- for instance, many alternative investments aren't correlated to stocks, which means that when stocks zig the alternatives may zag, increasing stability for the funds. But alternative investments tend to be far more expensive, with many hedge funds and private equity funds charging something near the classic "2 and 20" that hits investors for 2% of assets for management and also grabs 20% of profits. Alternative investments also tend to be riskier. As Brad Pacheco of the giant California Public Employees' Retirement System, or CalPERS, fund put it: "There is a premium that goes with investing in alternative investments because they typically are a little bit riskier."

For some funds, like CalPERS, the turn to alternatives has been fairly measured. Reuters noted that CalPERS upped its exposure to alternatives to 14% in 2011, up from 12.5% in 2010. For other funds though, the move has been far more drastic.

South Carolina's South Carolina Retirement System, the largest pension fund in the state, faces a 35% funding gap with assets more than $13 billion short of its liability based on actuarial assessments. Back in 2006, that fund had more than 40% of its funds in various flavors of bonds, and 53% in equities through common stocks and trust funds. The 7% of the fund in "Financial & Other" was a small part of the picture. That was hardly the case in 2011, as the SCRS fund is now more than half alternative investments. Stocks now make up just over 12% of the portfolio.

Not only is this change an expensive one -- thanks to the high fees involved with alternatives -- and a risky one -- because of the higher risk involved with the asset class -- it also appears to have been an ill-timed one. Though the fund's annual report lauded hedge-fund and private-equity returns of 11.6% and 20.2%, respectively, as a highlight of fiscal 2011, the return on its U.S. stock portfolio roundly topped both with a 39% return.

Looking at the entire investment universe, it was a pretty terrible year overall to be heavily weighted toward hedge funds. A handy table included in the SCRS' annual report showed that the HFRX Global Hedge Fund Index returned 4.2% for the fiscal year, while the S&P 500 (INDEX: ^GSPC) delivered 31% and the Barclays Capital Global Aggregate fixed income index returned 10.5%. Heck, the Barclays Capital U.S. Aggregate bond index nearly matched the hedge funds with a 3.9% return.

I can't sit here and say that the shift that SCRS made absolutely isn't going to work -- if for no other reason than the fact that even a low-probability gamble can pay off if you're lucky enough. But the moves that they've made provide a good opportunity for retirement investors to remind themselves of a couple of key points:

  1. Ratcheting up risk is not the answer to a savings shortfall as you get close to retirement.

  2. Stick to tried-and-true investment strategies, and if you encounter bumps in the road, the answer isn't to jump ship and adopt a completely different investment strategy. As CalPERS' chief investment officer put it: "The key to having a strategy is working with it. The worst mistake is to abandon the strategy when it appears to have some trouble."

For the sake of South Carolina public employees -- of which my sister is one -- I hope that the current SCRS portfolio works out. But investors saving for retirement on their own probably don't want to take their cues from its hail-mary approach.

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