Iowa

Pension-Gate Continues: Some Good Advice for the Hawkeye State

Iowa

At Index Fund Advisors, we are always gratified to read articles such as this one which give a good airing of the arguments in favor of indexing pension funds for public employees. One fund that would clearly benefit is the $27 billion Iowa Public Employees’ Retirement System (IPERS) which covers 340,000 current, former, and retired employees. Currently, only one-quarter of it is invested in index funds.

Officially, IPERS’ estimated investment costs for fiscal year 2012 were $95 million. Unofficially, they were much higher due to trading costs incurred by the funds that are not included in the official tally. As we saw a few weeks ago with North Carolina, the actual expenses for hedge funds can be a multiple of the reported expenses.

Perhaps the single best argument in favor of indexing comes from IPERS Chief Investment Officer, Karl Koch who said, “I’m not denying we’ve had some trouble with our active strategies—IPERS’ active stock managers have failed, as a group, to consistently outperform the markets, despite our efforts to find skillful managers.” This statement comes on the heels of IPERS underperforming its benchmark for the one, three, five, and ten-year periods ending 12/31/2013. As for their efforts to find skillful managers, we ask them to read this article which shows that the amount of time needed to establish that a manager’s outperformance is due to skill is on the order of decades, not years. Koch mentioned one specific fund (a high yield bond fund managed by AEGON) that supposedly outperformed its benchmark by 1% per year. We were able to find only one high yield bond fund managed by AEGON (i.e., Transamerica), and when we compared its returns to its Morningstar analyst-assigned benchmark, we found that it had a negative average alpha, and its recent performance was nothing to write home about (see below).

Unfortunately, Iowa’s subpar experience with active management is not unique, as the charts below demonstrate that none of them beat a portfolio of index funds.

 

 

In Warren Buffett’s 2013 letter to Berkshire Hathaway shareholders, he revealed his estate plan of advising his heirs invest their inheritance in index funds. As he put it, “I believe the long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.” The IPERS investment board would do well to heed the wise words from the Oracle of Omaha.

While switching from active to passive will definitely not solve the pervasive problem of underfunding of state pensions, cutting the unnecessary expenses incurred by these funds would be an important step in the right direction. We will continue to monitor this important story and keep you informed.