GUY RAZ, host:

We're back with ALL THINGS CONSIDERED from NPR News. I'm Guy Raz.

As the recession ricocheted throughout the country's financial markets, it didn't just affect personal retirement accounts like 401(k)s. The market volatility also hit big public pension funds, funds that were supposedly safe.

Now, most state and local governments have huge nest eggs they've set aside to pay retirement benefits for their employees, and they invest that money in everything from government bonds to real estate.

In a moment, we'll speak with Los Angeles Mayor Antonio Villaraigosa about that city's soaring pension costs and its impact on a massive budget deficit.

First, though, to NPR's Jim Zarroli who takes a look at the high-stakes world of pensions and whether some funds might be taking on too much risk in search of higher returns. It's part of our series on pensions airing throughout the week.

JIM ZARROLI: Stuyvesant Town is an 89-building apartment complex that sprawls across Manhattan's east side. At the height of the housing boom, the commercial real estate firm Tishman Speyer paid a record $5.4 billion for it and a sister complex across the street. Soni Fink of the tenants' association sits on a park bench in Stuyvesant Town and explains how the deal fell apart.

Ms. SONI FINK (Tenants' Association, Stuyvesant Town): Well, it's still owned by Tishman Speyer, who bought it in 2006, but they defaulted on the loans and have more or less walked away from the place.

ZARROLI: So Tishman Speyer was the lead investor, and were there other investors, as well?

Ms. FINK: There were Fannie Mae and Freddie Mac and the Church of England - poor thing - and the government of Singapore and a number of retirement funds.

ZARROLI: Among the investors hurt in Stuyvesant Town were the Florida State Retirement Fund and the California Public Employees' Retirement System or CalPERS which lost some $500 million. Joe Dear, CalPERS chief investment officer, says CalPERS took a serious risk by investing in the deal.

Mr. JOE DEAR (Chief Investment Officer, California Public Employee Retirement System): Hindsight tells us clearly that that was gravely in error, and frankly the people that were responsible for that decision aren't at CalPERS anymore.

ZARROLI: All told, CalPERS' real estate portfolio lost half its value during the market crash. With $200 billion in assets, CalPERS can absorb the loss. Still, the transaction illustrates how pension fund investing has changed.

Once, pension funds tended to invest in safe assets like Treasury bills. In the 1980s, many shifted their money into stocks, which promised higher returns over time. But when the dot-com bubble burst, many funds took a big hit, says Keith Brainard of the National Association of State Retirement Administrators.

Mr. KEITH BRAINARD (Research Director, National Association of State Retirement Administrators): And so a lot of these funds came out of the 2002 market decline believing that they needed to further diversify their holdings.

ZARROLI: Today, some funds have less than a fifth of their money in safe investments like Treasury bills. The rest goes into international stocks, private equity, even hedge funds. In some ways, diversification is a smart strategy: Invest in a wide range of assets, and you're less vulnerable if one of them loses value. CalPERS' Joe Dear says diversification makes sense for another reason.

Mr. DEAR: One of the principal advantage of a pension fund, particularly a public pension fund, is a very long investment horizon. It's completely different from what individuals face on their own individual retirement planning.

ZARROLI: In other words, pension funds go on indefinitely, collecting money and paying out benefits only gradually, and that means they have some leeway to take chances. They can put money in assets like real estate and private equity. These assets are risky because they can't be sold off quickly, but they can be very profitable over time.

But as Stuyvesant Town shows, pension funds can still get burned, and Dear says funds have to assess how much risk they want to take on very carefully. The danger is that some funds will go too far.

Joshua Rauh, associate professor of finance at Northwestern University's Kellogg School, says many states and cities face budget deficits right now, and with less money available, many funds are under pressure to take on more risk than is good for them.

Mr. JOSHUA RAUH (Associate Professor of Finance, Kellogg School of Management, Northwestern University): Many funds are investing in strategies that people might classify as risky. You know, they're investing money in private equity and other investment vehicles that may have a higher expected return on average but also more risk.

And, you know, as I said, I mean, one of the reasons why they're trying to do this is that they're trying to gamble their way out of the problem.

ZARROLI: In general, pension funds have plenty of money to keep sending checks to retirees for the foreseeable future. But it's also true that many have become comfortable with a level of risk that once was unthinkable, and they're vulnerable to market forces in a way they didn't used to be.

Jim Zarroli, NPR News.

RAZ: You can follow our series on the pension crisis this week on ALL THINGS CONSIDERED, MORNING EDITION and online at npr.org.

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