More pension money is flowing into “alternative investment vehicles” like risky hedge funds.

Recently Pando Daily broke a story about Governor Christie’s Administration violating pay to play laws by rewarding political donors with New Jersey Pension Fund contracts. The gist being that after General Catalyst employee Charles Baker donated money to the NJ GOP, General Catalyst received roughly $15 million to invest on behalf of retirees.

While the focus of the story was on violations of New Jersey’s pay to play laws, another facet of the scandal worth exploring is the increasing role alternative investment vehicles like General Catalyst – which is a venture capital firm – play in managing pension wealth. Private equity and hedge funds have begun to play an increasing role in pension investments as a recent Pew study points out.

The previously boring and safe strategy of buying government and top tier corporate bonds has been supplanted by the high flying big risk strategy of hedge funds.

In a bid to boost investment returns, public pension plans in the past several decades have shifted funds away from fixed-income investments such as government and high-quality corporate bonds. During the 1980s and 1990s, plans significantly increased their reliance on stocks, also known as equities. And during the past decade, funds have increasingly turned to alternative investments such as private equity, hedge funds, real estate, and commodities to achieve their target investment returns….

In short, increased investments in equities and alternatives could result in greater financial returns but also increased volatility and the possibility of losses on these assets. Even relatively small differences in returns resulting from investment performance or fees can have a major effect on the asset values of pension funds. A difference of just one percentage point in returns in a single year on $3 trillion equates to $30 billion.

So yes, you can gain a lot more with this riskier strategy but you can also lose a lot more. And for those living off a pension those loses are going to be hard to take, if not ruinous. There was a reason pension funds were previously involved in boring and safe investments, they can not afford to take huge loses.

And that is where the Pando story comes back into play. Much of Wall Street’s corruption emanates from something called the principal-agent problem – people managing other people’s money do not have as strong an interest in providing for their clients as they do for themselves. Hence, the scene in the Wolf of Wall Street where the senior stock broker explains to a young Jordan Belfort that the point is not to make the clients money, it is to generate activity in order to get commissions – even if that activity hurts the client. A classic principal-agent problem.

In the pension fund case the problem could be even more sinister. Politicians running (and re-running) to lead state governments may make promises to wealthy alternative investment vehicle managers in exchange for campaign contributions (or may already have). The politicians, like the stock brokers, have a stronger interest in gaining campaign cash than being good stewards of the pension fund. Not to mention those who make decisions for the state pension fund – appointed by politicians in many cases – will have a much stronger incentive to align with wealth managers who can offer them a lucrative job after they look favorably on a high risk alternative investment vehicle in their public institutional role.

Meanwhile state pension funds that people rely on to live are increasingly steered to riskier and riskier investment strategies which can only end one way (see 2008 for details). Former Prime Minister Gordon Brown once joked there were two kinds of Finance Ministers in the UK – those that failed and those that got out just in time. Presumably the politicians that do any such deal with their Wall Street contributors would hope to be the latter. But what happens to the pensioners when the system fails?