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5500 Preparer's Manual for 2012 Plan Years
The premier resource in the field of Form 5500 preparation, 5500 Preparer's Manual will help you handle the required annual Form 5500 filings for both pension benefits and welfare benefit plans.
Defined benefit plans have been increasingly investing in hedge funds since 2000, according to a Congressional Research Service (CRS) report. The proportion of U.S. corporate defined benefit pension plans investing in hedge funds has increased to 24% in 2006, up from 19% in 2004 and 12% in 2000, according to the report. Total corporate pension fund assets allocated to hedge funds in 2006 was approximately 2.1%. Concern exists, however, as to whether hedge funds are appropriate investments for employee retirement plans because of their risky nature, rapid growth, lack of oversight by government agencies, and recent losses.
“Hedge fund” generally refers to an entity that holds a pool of securities or other assets and whose interests are not sold in a registered public offering. Such entities may sell their interests to “accredited investors,” which includes individuals with a minimum annual income of at least $200,000 ($300,000 with spouse) or $1 million in net worth and most institutions with at least $5 million in assets. Alternatively, they may sell to “qualified purchasers,” a standard with significantly higher financial requirements than those necessary for accredited investors. Hedge funds are not registered as investment companies under the Investment Company Act of 1940 and do not, therefore, come under the scrutiny of the Securities and Exchange Commission (SEC).
Hedge funds trade in a variety of investment vehicles such as equity and fixed income securities, currencies, derivatives, futures contracts and other assets. Hedge funds often seek to profit by using leverage (investing borrowed money, which can increase gains or losses) and other speculative investment practices that may increase the risk of investment loss.
Fee structure. The fee structure of hedge funds differs from other investments. Typically, advisers receive 1% to 2% of assets as a management fee and a share of the capital gains and capital appreciation, commonly 20%. Hedge funds often rely on a “lockup period” during which investors may not liquidate their investments.
Growth. The hedge fund industry has been experiencing rapid growth in both the number of hedge funds and the amount of assets associated with them. In 2006, there were approximately 8,800 hedge funds managing about $1.2 trillion in assets, which represents a 3,000% increase in assets over 16 years.
Risk and performance. Hedge funds are characterized as high-risk, high-return operations because they pursue high returns by taking risks. Often they seek an “alpha return,” which means, returns that are not related to market performance. Thus, hedge funds can be profitable when the market in general is not. For that reason, successful hedge funds provide not only high returns to their investors, but they also contribute to financial markets’ efficiency, liquidity, and stability. On the other hand, hedge funds that tank can cost investors their entire investment.
Significant recent losses. For example, in 1998, Long-Term Capital Management’s (LTCM’s) capital shrank from $4 billion to $360 million in a matter of weeks, which led to an unusual bailout engineered by the Federal Reserve Bank of New York. In September 2006, Amaranth Advisors fund lost $6.4 billion from a peak of $9 billion. Amaranth’s losses were attributed to ill-timed speculation in natural gas prices. The losses did not affect the overall market, as was feared with LTCM, and did not trigger action by the Federal Reserve. In the period between the LTCM and Amaranth losses, the industry saw several major hedge fund losses and failures due to financial issues and fraud.
Some people have questioned the appropriateness of pension plan investments in hedge funds, given their capacity for volatility and lack of regulatory scrutiny. It is important, however, to distinguish between the riskiness of a single investment and the risk to a portfolio. Individual hedge fund investors seek high returns, but they risk losing their entire investment. As the LTCM and Amaranth collapses show, this can happen in a short period of time. Hedge fund investments can also mitigate risk when combined with a diversified portfolio, as well as enhance returns, reduce volatility and increase risk-adjusted returns, especially during bear markets.
The Pension Protection Act of 2006 (PPA; P.L. 109280) changed the rules by which hedge funds may become fiduciaries of pension plans. The PPA provides that investment funds and limited partnerships (including hedge funds) will not be treated as plan fiduciaries under ERISA if investments by ERISA-covered plans account for less than 25% of assets of the investment fund or limited partnership. Unlike prior law, investments of governmental and foreign plans, which are not subject to ERISA, will not be taken into account in this calculation.
ERISA does not currently require pension plan sponsors to report the number of hedge funds in which they invest or the amount of money invested in them. Some suggest that this information could enable policymakers to quantify the portion of pension assets that are being invested in hedge funds. It could also help differentiate pension funds whose hedge fund investments are concentrated in one or two funds versus those whose risks are diversified, that is, spread over a larger number of hedge funds.
For more information on this and related topics, consult the CCH Pension Plan Guide.
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