July 5, 2013

Wall Street Fees Bleeding Pension Funds, Report Says

Study of state investment systems shows indexing could erase $80 billion in unfunded pension liabilities

States struggling with unfunded pension liabilities could come up with tens of billions fairly quickly by simply cutting Wall Street out of their fat pension management contracts.

That is the oft-stated conclusion of a new study by the Maryland Public Policy Institute which, though filled with unflattering statistical comparisons between actively managed portfolios and passively managed index funds, reads at times like a personal feud with Wall Street professionals.

The paper’s authors, affiliated with the free-enterprise-oriented state policy nonprofit and also the Maryland Tax Education Foundation, bemoan their state’s “opportunity cost” of $2 billion to $3 billion as a result of Maryland pension system’s 10-year underperformance despite their previous written reports and public testimony.

“The response of the system to these facts has been to 'shoot the messenger' rather than to acknowledge the problem, admit a mistake and institute reforms," write report authors Jeff Hooke and John J. Walters. "The response of the governor and Legislature has been to do nothing. This ‘head in the sand’ tactic is mirrored by Maryland’s underperforming peers despite the huge dollars involved.”

The authors analyze 46 of the 50 states, excluding four states whose data lacked comparability. They found that, net of fees, the top 10 states paying the highest pension management fees to Wall Street (averaging 0.6%%) had five-year returns (ending June 30, 2012) of 0.34%, compared with a 2.38% return for the 10 states paying the lowest fees (averaging 0.22%) over the same time period.

“State pension funds should consider indexing,” the report advises. “Indexing fees cost a state pension fund about 3 basis points yearly on invested capital vs. 39 basis points for active management fees (or 92% less).”

That difference could save the surveyed 46 funds $6 billion in fees annually while delivering similar or superior returns. Comparing 5-year median pension performance to a benchmark that mimics the asset allocation of state pension funds, the authors find a 0.69% annualized return advantage to the index fund.

“Although 0.69% doesn’t sound like much, on a $30 billion portfolio, it represents $207 million per year, or over $2 billion for ten years, when compounding is used,” the authors write.

They add that were states to expand the small proportion of their pensions that are passively managed to 80% or 90% of their portfolios, “the annual savings, at a seven percent liability discount rate, reduces unfunded pension liability by $80 billion,” thereby improving results for both taxpayers and public sector employees.

The paper’s authors argue that state pension systems routinely fall for a Wall Street “sales pitch” that says fund professionals can outperform the market with their investment savvy. Yet they cite S&P Dow Jones data to show that over the five years ended December 31, 69% of domestic equity funds failed to beat the S&P benchmark while fully 13 out of 14 bond benchmarks beat actively managed fixed-income funds.

They decry what they view as a lack of accountability on the part of state pension system managers, who fall for the “sales pitch,” add to costs by monitoring performance with the help of outside “Wall Street-type” investment consultants, yet take no action in response to underperformance.

Maryland, for example, has seen little money manager turnover. “In fiscal 2009,” the authors write,” “the market crash caused the system to lose billions. None of the high-priced money managers saw the crash coming, yet they kept their system contracts. This non-accountability is not specific to Maryland, but endemic to the public pension fund sector.”

Hooke and Walters’ solution — noting the classic investment exposé “Where are the Customers’ Yachts?” — is to fire Wall Street, which they argue should not be politically difficult to accomplish:

“Fee cuts will impact principally the incomes of public stock and bond money managers, hedge fund managers, and private equity fund managers, who are concentrated in just a few states.”

The authors are vocal in their encouragement of a transition to indexing, going through details of the process:

“Indexing is easy for states to implement, as index firms respond to state requests for proposals (RFPs) just like active managers. A state can liquidate most of its active manager portfolios within a few months, and provide the cash to index firms, which can then invest the money in the underlying securities of an index within a few weeks.”

The authors also reserve some choice words for Wall Street trends such as alternative investments, which they call “old wine in a new bottle,” and private equity funds, whose portfolio valuations by independent CPAs they describe as “less than rigorous.”

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