The 'Pathological' Behavior of US Pension Funds?
Ouch. Finance professor Timothy Riddiough says some of the people running America’s 6,000 state and local public pension plans are exhibiting “pathological investment behaviors.”
No, really. Pathological. (At least, he says, from the perspective of classical financial economics perspective.)
These pension fund managers invest in the same assets, then hope to beat the market, he says. They take foolish bets to try to get out of their funding crisis, like gamblers hoping to win back their losses. They engage in “delusional benchmarking, giving themselves A’s and B’s for C and D work.”
Oh, and they are pouring somewhere nearing 10% of their members’ money into private real estate ventures that have a dismal track record and which they won’t be able to exit easily if they need to.
Like I said: Ouch.
Riddiough is a finance professor at the University of Wisconsin and an expert in real-estate investment trusts. He holds the department chair in urban land and real estate economics. And his comments matter not only for his expertise but because they come in an extraordinary and detailed takedown of public pension funds, especially their fondness for “private equity real estate” funds.
The National Association of State Retirement Administrators, the organization that represents the managers, disagreed.“Public pension funds are long-term investors and invest in diversified portfolios that are intended to maximize investment returns within an acceptable level of risk,” the organization said in a statement. “As a group, public pension funds invest around 7% of their assets in real estate. As part of their required due diligence, public pension funds continually review their asset allocations and risk profiles to ensure they are optimizing risk and investment return.”
It added: “Although the report author accuses public pension fund managers of a ‘herd mentality,’ in fact, many public pension funds do not invest in real estate at all, and among those that do, there is a wide range in the percentage of their portfolio that is invested in real estate. Moreover, the author’s attempts to link growing pension underfunding to increased allocations to real estate are purely speculative: public pension funds have been diversifying their portfolios for many years after investing predominantly in just two asset classes: public equities and bonds. Such diversification is prudent and part of a sound investment and risk management strategy.”
In a nutshell, Riddiough cites detailed industry data showing that these private funds have underperformed publicly traded real-estate investment trusts, the kind anybody can buy on the stock market or through a money manager like Vanguard, by a country mile.
He also cites data showing there is no evidence any individual managers have any particular, persistent skill worth paying for.
Since reliable records began back in the late 1970s, these private REITs overall have trailed the ones available through the stock market by an average of more than 5 percentage points a year, according to industry data. Someone who had put their money in public REITs back then would today “be nearly 7-times better off” than someone who backed the private funds, he says.
Seven times better off.
Yet public pension funds keep buying them, year after year. State and local pension funds may now account for about half of all the money in these private equity real-estate funds. We’re talking tens, even hundreds, of billions of dollars.
These comments come just as Boston College’s Center for Retirement Research warns that public pension funds have just booked an absolutely terrible fiscal year (which is typically measured from July 1 to June 30). That, it adds, is even despite the massive stock market rebound in the spring, and the soaring prices for bonds.
Average returns during the fiscal year: 1.75%, or barely a quarter of targets.
Err…they could have made more than four times as much, or 8.1%, in Vanguard’s Balanced Index Fund (VBINX) over the same time. They managed to underperform the basic global stock index (ACWI), which gained more than 2% and which they could have owned through a single exchange-traded fund, like this ACWI. And they were way, way behind things like long-term U.S. Treasury bonds (VUSTX) and TIPS (VIPSX) which earned you better than 20%.
The pension funds’ target returns for the year averaged about 7.2%, Boston College calculates. Oops.
Pew Charitable Trust recently estimated that the total funding shortfall just for the 50 plans run at state level came to $1.3 trillion, meaning that’s how much more they owe in payouts than they have in assets. Oh, and that was in 2018, so we’re out of date.
The good news? Any Joe or Joanna Public can invest in real estate easily, without having to have any access to exclusive, overpriced, illiquid private equity real-estate funds. I’m not trying to bang any drum for Vanguard, but their Real Estate Index Fund (VNQ) and International Real Estate Index Fund (VNQI) are among the easy options you can buy and forget about.
The first thought that crossed my mind after reading article was who is professor Timothy Riddiough?
I never heard of him and to be honest, after reading this article, I'm not very impressed.
Let me sum it up for you. US public pension funds are run by a bunch of delusional sociopaths who keep allocating to private real estate and they would have been better off just investing in public REITs and public markets in general.
I'm not kidding. They engage in “delusional benchmarking, giving themselves A’s and B’s for C and D work.”
What is he talking about? Delusional benchmarking? There is a passive portfolio typically made up of public stock and bond indexes and they try to add value over this reference portfolio (benchmark portfolio) over the long run.
And if they're good, like large Canadian public pensions, they'll add anywhere between 70 to 150 basis points a year (on average) over their passive benchmark. And over the years, it adds up to a lot of moolah.
For example, here is the latest asset mix for CPP Investments as at June 30th:Here is a 10-year review of how assets grew and net returns:
Notice how CPP Investments has outperformed over the years since it initiated in active strategy program in 2006, investing more in private equity, infrastructure, real estate and private debt:
And it's not just in Private Markets, CPP Investments does sophisticated internal strategies in Public Markets too.
The end result is they've delivered significant dollar value-added (DVA) since inception of their active strategy (2006) over their minimum required return and over their Reference Portfolio:
We are talking about billions of dollars -- $94 billion over minimum required return and $53 billion over the Reference Portfolio made up of 85% global equities since the introduction of active management back in 2006.
Now, CPP Investments is Canada's largest and most sophisticated pension fund. Along with OTPP and HOOPP, they are considered to be the best pensions in the world.
No US public pension comes close to these pensions but I'm using this as an example of how well governed pensions add significant value over passive public market benchmarks over a long period.
This finance professor castigates US public pensions for investing in private real estate and makes outrageous claims without understanding that pensions have a fiduciary responsibility to diversify across public and private markets and take advantage of their long investment horizon to add value over public market benchmarks over the long run!!
And stating that public REITs have outperformed private REITs during the greatest bull market in history is data mining at its worst!
There's a ton of "beta" in public REITs so I would expect them to outperform during bull markets in stocks, and severely underpeform during a bear market.
Remember, pensions are trying to deliver the highest risk-adjusted returns, and they will typically underperform their benchmark portfolio during a roaring bull market.
But they make that performance up and more during bear markets and that's not explained at all in this article or by this professor.
Two years ago, I wrote a comment criticizing some other guy who kept saying pensions cannot beat a 60-40 portfolio. All these finance professors need to take the time to read it here, and get insights from Leo de Bever and others, people who actually know what they're talking about.
Leo de Bever and two finance professors wrote a paper for Norway's giant pension, A review of real estate and infrastructure investments by the Norwegian Government Pension Fund Global (GPFG).
You can read it here. Leo was arguing for more allocation into unlisted real estate and infrastructure but in the end, the two finance professors disagreed and said that Norway is better off in listed REITs.
I'm not going to get into too much detail here but Leo de Bever was right, there's too much beta in listed real estate and especially listed infrastructure, and it is appropriate to look at things over a longer time frame (read pages 140 on management compensation systems).
Are US public pensions perfect? Of course not, as Clive Lipshitz and Ingo Walter argue in their seminal paper, they can learn a lot from Canadian pensions.
But if you ask Clive, the number one problem at US public pensions is flawed plan design, there is no shared risk model to ensure these plans remain fully funded though thick and thin.
And what happens when US public pensions keep getting underfunded? Well, they hit a pension brick wall, like New Jersey, and end up taxing their taxpayers to top up these chronically underfunded pensions.
Again, it has nothing to do with investing in private real estate, everything to do with faulty pension design.
So, please ignore professor Timothy Riddiough and his ridiculous claims of pathological behavior at US public pension funds. He truly has no clue of what he's talking about and is dangerous in what he's proposing instead (indexing and more public REITs).
If I had a choice of investing with Blackstone's Jon Gray over the years or some public REIT, my money would definitely be with Blackstone even if the fees are higher.
And there are plenty of other private real estate funds which have delivered outstanding returns for US public pensions, net of fees.
Below, an older clip where Blackstone's Jon Gray, then head of Real Estate now president and chief operating officer a, talks about how they add value over a long period of time. I also embedded another interview from a couple of years ago.
Listen to the king of real estate and ignore this finance professor from Wisconsin.