Pen-State Pension

Pension-Gate — More Good News from Pennsylvania

Pen-State Pension

A little more than a year ago, we reported on how the stewards of the pension fund for Montgomery County, Pennsylvania came to the wise decision of moving away from high-cost actively managed funds in favor of low-cost index funds from Vanguard, whose founder Jack Bogle played a pivotal role in motivating this change. It now appears that their wisdom is contagious and has spread to Pennsylvania’s governor, Tom Wolf who said in a recent budget address:

“Our state has been wasting hundreds of millions of taxpayer dollars on Wall Street managers to handle state pension accounts. Studies have shown simply investing this money in a safe, conservative account would produce a similar return over the long term without the fees.”

Of course, a similar return without the fees equates to a higher return which accrues to the benefit of both plan beneficiaries and the taxpayers ultimately responsible for funding the plan. The two primary Pennsylvania pension plans comprise over $80 billion in assets. State Representative John McGinnis who holds a PhD in finance quantified the impact of the potential savings when he said, “Those managers who actively manage the assets charge a very high price, almost one percent of the assets annually—that runs in the neighborhood of $750 million a year.”

A spokeswoman for the state pension plans, however, disagreed with McGinnis, claiming that that while the plan spent $482 million in fees last year, it earned an excess of $1.27 billion over its benchmark. Of course, one year is a meaningless sample size. The most recent annual report for the State Employee Retirement System we were able to find was as of 12/31/2013, and it shows a 10-year (the longest period shown) annualized return of 7.4% (see page 38) and a “custom benchmark” return of 8.3%. According to this New York Times article, the other pension fund had an even lower return of 6.9%. The fund’s chief investment officer James H. Grossman attributed the underperformance to a reduction in the allocation to equities from 70% to 40% at the worst possible time, the low point of 2009.

To buttress her argument, the spokeswoman could have pointed to a recent study from CEM benchmarking  which claims that active management as a whole has added 0.16% (net of fees) to pension fund returns. While this is a rather paltry number to start with, it gets worse, as the standard deviation on this 0.16% is 2.65%, implying that the 0.16% is truly a number that is statistically indistinguishable from zero. A small adjustment to a fund’s asset allocation could easily provide an additional 0.16% of expected return with just a small fraction of the 2.65% standard deviation.

Getting back to the New York Times article, it notes that pension funds have trailed behind individual investors in embracing index funds. While the percentage of mutual fund investments that are passively managed has increased to 30% from 13.8% in 2004 (based on Morningstar data), the corresponding percentage for public pension plan investments is 19.2%, according to Greenwich Associates. The author also cites Morningstar data showing that for the five years ending 12/31/2014, only 32% of active stock-fund managers beat their target market index. Of course, pension plan administrators will argue that they have access to far better managers compared to the general public. However, IFA’s own study of the performance of various state pension plans (Pension-Gate) belies this assertion. As the charts below show, the returns received have not properly compensated them for the risk taken.

In closing, we hope that the wisdom we have seen in Pennsylvania will quickly spread to the rest of the country. The problem of underfunded public pensions in the United States is something that is measured in trillions. This would be one step of the many required to address this problem.