Remember the good old days when federal budget shortfalls and the national debt were “just numbers” – figures we knew were out there, and in the back of our minds we knew they were bad, but could not really fathom a reality where they would really matter? Unfortunately, over the last year that bliss has been shattered with the knowledge that – thanks to TARP, Too-Big-To-Fail, health care reform, and the “PIIGS” – sovereign fiscal prudence is essential to preserve social and political order in our democracies. We should have worried sooner about budget deficits and national debt.

Today we have our chance to start worrying about yet another obscure “figure” running out of control: the US pension deficit. This is a growing cancer that threatens the financial well-being of much of America’s middle class and the ability of states to properly manage their fiscal affairs.

In a January 2010 interview with The Financial Times, Orin Kramer, then Chairman of the New Jersey Investment Council, estimated that the deficit facing public pension plans in the US was $2 trillion. This was fully twice the estimate of the Pew Center for the States in their report The Trillion Dollar Gap, which would be issued a month later. Neither number is a pleasant reality to confront, and hopefully the fact that Mr. Kramer, just four months after articulating his view, threw in the towel and resigned from the New Jersey Investment Council “for personal reasons” is not a further statement on how dire the situation may be.

To properly frame the severity and breadth of this problem, consider that half of US states had a fully funded pension plan in 2000. By 2006 that figure had fallen to just six states, and by 2008 it was down to four (NY, FL, WA, and WI). Nearly every state’s pension plan is underfunded to some degree. For eight states, their shortfall is greater than 1/3 of their future obligations, and for two of them, they have funded less than 60% of their future obligations. The private pension sector also suffers from its own massive shortfalls. The 100 largest corporate pensions alone are some $324 billion underfunded in the aggregate. According to SEI, the average corporate pension plan has recently generated returns 1.5 percentage points below their target rate of return of 7.8% – with no sign of interest rates rising in the near future. Something has to be done immediately to change the paradigm and avert future calamity.

Although hedge fund investing (including either direct hedge fund investing or access through funds of funds) is not the panacea, it deserves a central role in the solution set. Hedge funds over the last decade – a decade that included both the 2001-2002 tech meltdown and the 2008 global recession – have delivered an annualised rate of return of 6.6%, far superior to the S&P500 rate of return of -1% over the same period. Pensions can no longer accept a core equity portfolio that is subject to sharp corrections of 38% (2008) and 22% (2002), particularly so close together. A completely different approach to hedge funds would add measurably to pension funds’ ability to (1) protect against such sharp swings in performance, and (2) generate a stream of returns consistently closer to their target objectives.

Some forward-thinking pensions are already making the paradigm switch to more fully incorporate hedge funds into their mainstream investing strategy. The Florida State Board of Administration took the decision this year to allocate to hedge funds in the hopes of averting a future shortfall, as did the State of Wisconsin. By creating a portfolio of hedge fund exposures, the allocator is able to create some downside protection via the long and short nature of hedge fund holdings. To be sure, there are detractors – those who are concerned with the complexity of hedge funds, the lack of transparency, and the use of leverage among hedge funds. Fortunately, all of these concerns can be mitigated. Complexity can be a selected attribute – some hedge fund strategies are extremely complex while others are quite easy to understand. Likewise, leverage usage varies from strategy to strategy and fund to fund. There are plenty of hedge funds which feature low or moderate leverage in their strategy. So it’s quite possible to construct a portfolio of hedge funds which offer long/short investing, but whose strategies are simple to understand, and utilise very little leverage. Low transparency has always been a concern among hedge fund investors. But coming out of the crucible of the 2008 market difficulties, hedge funds today are much more institutional and understand they need to offer a degree of transparency which greatly exceeds what had been offered in prior years. And the pension investors’ capital is so fiercely sought, that their ability to achieve enhanced transparency is greater than ever before. Consequently, the benefits of adopting or meaningfully increasing a target exposure to hedge funds or funds of hedge funds in an alternative investments bucket should be a key element of a pension plan sponsor’s strategy for reducing or preventing a funding shortfall.

That said, I would take this case even one step further, and suggest that certain specific hedge fund strategies do not belong in an alternative investments category at all – rather, they should be incorporated into the pensions’ core equity or fixed income portfolios. As controversial as this may sound, some pension funds have already begun to explore such a shift. And there is a logical underpinning to such a move. To the extent a pension hires an active long-only manager for their core equity portfolio, they are selecting a team that offers superior stock-picking along with proper infrastructure, reporting and client service. A long/short equity hedge fund or fund of funds can offer those same characteristics; however, by virtue of selecting stocks both long and short, the strategy has the opportunity to register positive returns in both a rising and falling market. Critics would naturally point to 2008 as an example of when that did not happen, but this is a straw man fallacy – consider that 2008 was only the third time in 20 years that the Hedge Fund Research Index (HFRI) has posted a negative return (1998 and 2002, previously), and that in each of those three cases the negative HFRI performance was markedly better than the S&P500 index. The bottom line – a proper allocation to long/short equity hedge funds – can reduce losses and overall volatility within a core equity portfolio.

Likewise, in the core fixed income portfolio the same could occur. A properly devised strategy of long/short credit hedge funds featuring low-to-moderate leverage usage could help to reduce the “noise” of sharp beta moves like we observed in 2008 (down) and 2009 (up).

As I indicated at the outset of this piece, “something’s gotta give”. The consequences of inaction or half-measures are immense. The Pension Benefit Guarantee Corp. ran a deficit of $22 billion in 2009, following a deficit of$11 billion in 2008. This is not sustainable, and the federal government’s appetite and ability to sustain entitlements (including pensioner bailouts) is rapidly wearing thin. Dynamic departures from past pension management practices are needed. Prudent hedge fund investing should play a larger role than ever before in that new vision for meeting the promises which public and corporate pensions have made to their employees and their families.

ABOUT THE AUTHOR

Prior to forming FletcherBennett, Eisen was Managing Director in UBS Prime Services. There he held a variety of roles including US Head of Capital Introduction and Joint US Head of Prime Brokerage Sales. Previously, Eisen was a Managing Director at Spear, Leeds & Kellogg, and was Regional Director of Market Development for the American Stock Exchange.