State pension funds are paying record fees to Wall Street money managers, while getting less-than-impressive results in return, says a recent study from two Maryland think tanks.
The Maryland Public Policy Institute and the Maryland Tax Education Foundation reviewed the annual financial data of major statewide retirement systems from 50 states.
According to the findings, state public pension funds spent over $7.8 billion in fees last year alone - a 15-percent increase over three years - despite the consistent failure of money managers to hit target returns or outperform passive equity index funds, which charge lower fees.
"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," says the study. "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."
Over the last 10 years, annual returns for large public funds averaged 5.9 percent versus expected target returns of 7 to 8 percent, according to the report.
Maryland, which was the primary focus of the study, lagged others by about 1 percent each year, despite spending more on Wall Street fees, relative to its net assets, than most other state systems.
"This shortfall is significant and translates into about $3 billion in lost income over the last 10 years," says the report.
As the European debt crisis and a global economic slowdown put equities under pressure, this year's returns look even worse. A separate recent study by Wilshire Associates shows that U.S. public pensions earned a median of 1.15 percent over the year ended June 30.
With the average Wall Street fee ratio of 0.41 percent paid by state pension systems, nearly half of those returns were eaten by the fees.
Poor returns have prompted many state pension systems to turn to "alternative investments" - like private equities, real estate, hedge funds, and distressed debt - which tend to be less liquid and more volatile than conventional stocks and bonds.
In fact, some of the best performing state pension funds were able to achieve strong 10-year returns mostly because of above-average allocations to alternative investments, according to a separate study by investment advisory firm Cliffwater.
The top best performing state pension funds over the 10-year period are: Missouri State Employees' Retirement System with 7.1 percent annualized return, South Dakota Retirement System with 7 percent, and Oklahoma Teachers' Retirement System with 6.9 percent, according to Cliffwater.
The study from the Maryland think tanks says states would be much better off by switching from actively managed funds to more cost-effective passive equity index funds.
Equity index funds aim to achieve the same rate of return as a market index, like the S&P 500 (^GSPC) or the Dow Jones Industrial Average (Dow Jones Global Indexes: .dji). These funds have fewer transaction costs and are less expensive to manage than traditional mutual funds.
"There is substantial evidence that Wall Street managers are unable to beat equity index funds that cost much less in fees," notes the report.
It points to S&P Dow Jones Indices data showing that 84 percent of actively managed U.S. equity funds failed to meet their benchmarks last year. For actively managed bond funds the underperformance is similar.
"Many states index a small portion of their portfolios to public indexes. Extending this practice to 80 or 90 percent of their portfolios would provide annual savings in excess of $6 billion," says the report. (Related: Top States for Business)
"But states seem to dismiss years of evidence, and most still believe they can find managers who will beat the market," says Jeff Hooke, one of the study's authors.
Boards of trustees for these funds are dazzled by Wall Street's marketing, Hooke told CNBC. "It's a formidable machine."
According to Hooke, states rarely switch money managers, as they are reluctant to admit mistakes.
"In the corporate world, if you screw up, you admit a mistake, fire the fund manager and move on. States usually don't do that. To fire a money manager would be to admit that you picked the wrong guy," says Hooke.
But Keith Brainard, Research Director of the National Association of State Retirement Administrators, whose members are the directors of the largest statewide public retirement systems, says: "There are asset managers that do add value; the premise that a pension fund would be better off in passive, low-cost securities only is simplistic and uninformed."
"If public pension funds are to be truly diversified, they cannot invest solely in passive indexed accounts," Brainard told CNBC. "Take a look at the large university endowments and foundations, managed by many of the most capable people in the investment management business. You'll find a very small portion of their assets invested in passive accounts," Brainard said.
Many have criticized state pension funds for setting unrealistic targets.
Because pension funds use the expected return targets to justify lower current contributions needed keep them solvent, they have been reluctant to lower projected returns.
It would require the already financially strapped states to either cut employee benefits or raise taxpayer contributions to the state pension fund, says Hooke. "Raising taxpayer contributions means either raising taxes, or cutting government spending for other uses like education or roads."
Politicians being politicians, "they choose to kick the can down the road," he says.
Let me comment on this article by highlighting some truths and then going over some gross distortions. First, it's no secret that active management has been an abysmal failure at most state pensions. Billions in fees were doled out to beat equity and bond indexes and the results for the most part are gross underperformance. The truth is states are better off indexing this money.
Second, while some states allocating to alternatives have fared well over the long-run, most have not. With all due respect to that Cliffwater study (as if they are an objective source!), the harsh truth is most institutional investors have been burned by hedge funds and the same can be said of private equity funds where 2 & 20 in fees is being scrutinized.
Third, unrealistic investment assumptions and the financial crisis are partly to blame as to why so many state plans are grossly underfunded. The main reason, however, is that during the last decade most states took pension holidays and raised benefits without paying for them (see 7 truths about public employee pensions).
Fourth, shoving more money into hedge funds, private equity, real estate, infrastructure and other alternatives will not solve America's pension funding crisis. Hard political decisions need to be made and all stakeholders, including unions, need to make compromises.
Fifth, we need more studies which scrutinize fees being paid out to all external managers at public pension funds. What ultimately counts is IRRs net of all fees and F/X costs for each and every investment portfolio. The main reason why US public pension funds lag their Canadian, Danish and Dutch peers is that their governance model is deeply flawed. US funds can learn a lot from Canadian funds which are increasingly internalizing most investment activity.
Finally, let me repeat something which we all know but rarely scrutinize: Beta is cheap but true alpha is worth paying for. In 2012, you can swap into pretty much any equity and bond index at a fraction of the cost of what active managers, including hedge funds and PE funds, are charging you.
The fact that so many state plans are doling out billions in fees to Wall Street money managers that are grossly underperforming their targets is a true testament that US pensions continue getting pilfered and raped on fees. When will this stop is anyone's guess, but there needs to be a major overhaul of governance and politicians need to stick their nose out of public pension investment decisions.
Below, PBS NewsHour economics correspondent Paul Solman reports from Rhode Island on the struggles that states are facing over how to calculate investment returns for public pension funds to keep them fully funded. This report first appeared last June and is well worth watching.