(August 3, 2012) — The rumbles of discontent are growing over the way the US public pension system compensates its money managers, according to a new study.
Some 50 state pension funds, collectively worth more than $2 trillion, paid $7.8 billion to asset managers in 2011, according to a report authored by two Maryland think tanks. In exchange for those fees, the report argues, public pension plans got very little in return, and would have been better off investing in passive equity index funds.
“The vast majority of public pension systems in the United States contract with Wall Street firms to select the publicly traded stocks and bonds that comprise the bulk of the systems’ investment portfolios,” write Jeff Hooke, chairman of the Maryland Tax Education Foundation, and Michael Tasselmyer, visiting fellow with the Maryland Public Policy Institute. “The firms’ typical ‘sales pitch’ is that they can ‘outperform’ a given section of the stock or bond market; therefore, the system should pay them a fee for their stock—or bond—picking prowess.” In truth, they claim, “there is substantial evidence that Wall Street managers are unable to beat passive equity index funds that cost much less in fees.”
Hooke and Tasselmyer point to data showing widespread benchmark underperformance to illustrate their point. According to S&P Dow Jones Indices, 84% of actively managed U.S. equity funds failed to meet their benchmarks in 2011. For actively managed fixed-income mutual funds relative to the 2010 Barclays Capital Aggregate U.S. Bond Index, the authors contend, the underperformance is similar.
Public pension systems would be better served, the report concludes, by indexing their investment portfolios. Not only would their capital be at less risk, the report stresses that the funds could save money by not paying “Wall Street management firms millions of dollars each year to deliver sub-par results.” Assert Hooke and Tasselmyer: “If public pension fund assets were indexed to relevant markets rather than actively managed, the public pension systems in Maryland and across the United States would save enormous amounts of money on fees, without undue harm to investment performance. In fact, many Wall Street managers ‘shadow’ their target indexes with 70% to 80% of their investments in the same stocks (or bonds) as those in the index.”
Although public pensions have not yet embraced passive investing, some prominent plans are trying to reform the way they remunerate their fund managers. The $6.5 billion Wyoming Retirement System is planning on introducing a performance fee bank, in which excess returns will be set aside for a period of time to incentivize managers to demonstrate sustained returns. Before the performance fee bank, the fund says, managers were paid a high fixed active fee, which ensured that the manager would be well rewarded even if returns were low. The performance bank aims to fix that situation, and the concept is already generating interest among the Wyoming Retirement System’s peers.
To read the report from the Maryland Public Policy Institute and the Maryland Tax Education Foundation, click here.