Wall Street Fees And Investment Returns For 33 State Pension Funds by Jeff Hooke And John J. Walters, The Maryland Public Policy Institute
This study outlines fees and investment returns for state pension funds with fiscal years ending June 30, 2014. The study concludes that pension funds with the highest fees, as a percent of assets, recorded inferior investment returns, on average, versus those in states with the lowest fees. This conclusion contradicts the assumption that Wall Street advice helps clients achieve superior returns.
The study also shows that a passive index that mimics the investment allocation of the typical state pension fund outperformed the peer group median by 1.62 percent per year over a five-year period. On an initial $50 billion pension fund, this difference over five years is equivalent to $6.8 billion in foregone income.
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In this report, the Maryland Public Policy Institute updates calculations completed two years ago for the fiscal year ending June 30, 2012. The conclusions then are identical to those today—more fees equal lower returns. Neither state pension fund trustees, pension fund executives, nor investment management industry executives contested the findings of the earlier study, which were reasonably publicized.
Higher Fees Mean Lower Investment Returns
The top 10 states in terms of Wall Street fees had lower pension fund investment performance over the last five fiscal years than the bottom 10 states. See Table 1. Note that returns are expressed as “net of fees.”
Indexing Could Save Pension Funds Tens Of Billions
Instead of using the approach of active management, state pension funds should consider indexing. Indexing fees cost a state pension fund about three basis points yearly on invested capital versus 66 basis points for active management fees (or 1/30th the cost). For the five years ending June 30, 2014, we selected public security indexes that were good proxies for state pension fund asset allocations, just as we did two years ago. Indexing provided a much higher investment return. See Table 2, which shows a 1.62 percent annual premium for indexing, after deducting three basis points for fees.
If a fund had invested $50 billion in the replicating index on June 30, 2009, by June 30, 2014, five years later, it would have had $98.2 billion, assuming reinvestment of dividends. The same $50 billion investment in the median state fund portfolio would have been worth $91.4 billion, indicating a $6.8 billion shortfall.
By indexing most of their portfolios, we conclude the 33 state funds surveyed could save $5 billion in fees annually, while obtaining similar (or better) returns to those of active managers. Enacting this policy potentially reduces unfunded pension liabilities by $70 billion within two years.
Indexing is easy for states to implement, as index firms respond to state requests for proposals 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. Many large corporate pension funds and individuals already use indexing for equity portfolios, and equity indexing has perhaps a 15 percent market share of equity mutual funds for retail investors. To our knowledge, only one state, Nevada, is fully indexed.
The authors reviewed Wall Street money management fees of 33 states that disclosed appropriate public data and had a June 30 year-end. We compiled the states’ five-year annualized investment returns. The information was provided in the state pension funds’ Comprehensive Annual Financial Reports (CAFR). CAFRs are usually released five to six months after the fiscal year ends, so June 30 data are usually available the following January. Pension investment consultants, such as Wilshire Associates and Callan Associates, compile return data, but access to the individual state comparisons is limited to paying clients. The Wall Street fee data prepared by the authors is not commonly calculated in
a comparative way.
In this report, money management fees are expressed as a percentage of the fiscal year’s ending assets. For comparing five-year annualized investment returns, this analysis only used those pension funds with a fiscal year-end of June 30, 2014 (in order to facilitate an ‘apples to apples’ comparison). When states have different year-ends, it is not appropriate to make annualized investment return comparisons. The ‘start’ and ‘end’ dates are different for different portfolios. For those states that separate ‘state employee’ and ‘state teacher’ pension funds, we used the larger of the funds for comparison purposes.
Based on our work, we conclude that a number of states are not reporting fees properly. Misreporting may be a particular problem with private equity and hedge fund investments, where managers often deduct fees before sending cash returns. California’s Public Employees’ Retirement System admitted as much in June 2015, when it said tracking such fees was complex.
Active Management Described
The 33-state sample collectively spent $6 billion on such fees over their latest fiscal year. The vast majority of the state public pension systems contract with Wall Street firms to select publicly traded stocks and bonds, which comprise the bulk of the systems’ investment portfolios. Wall Street firms typically pitch their ability to outperform a given section of the stock or bond market, and declare that the system should pay them for a fee for their prowess in choosing a stock (or bond). To varying degrees, pension funds employees monitor the Wall Street firms, usually with assistance from other Wall Street-type companies (investment consultants).
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