ESG causes pension investment strategies to underperform passive funds

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Pension investment strategies have been coming up short for years as most states watch their unfunded liabilities grow. One study shows that actively managed public pensions have been underperforming passive index funds, which further demonstrates everything that’s wrong with most pension investment strategies.

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A new study looks at the best and worst-performing state pensions and their investment strategies compared to passive funds.

Pensions would do better if invested in passive funds

In a study published in August 2019, the Institute for Pension Fund Integrity reported that just five of the 52 pension funds it analyzed outperformed their 60/40 passive index investment portfolio. Only one state had both strong pension performance and was well funded.

The institute used the Vanguard Total Stock Market Index and the Vanguard Total Bond Market Index to build two passive index portfolios to compare state pensions to. One of the portfolios was 60% stocks and 40% bonds, while the other was 50% stocks and 50% bonds.

Now in a newer study, the Institute for Pension Fund Integrity looked at the investment strategies of the top and bottom performing funds compared to the passive portfolios it had created.

Differences between the best and worst pensions

Interestingly, asset allocation didn't differ drastically among the top and bottom performing funds, which means other aspects are causing problems for the worst funds. The IPFI said global and domestic equity was on average the biggest part of pensions' portfolios. The distribution of those assets among the top and bottom five funds was almost identical.

South Dakota consistently outperformed pensions in other states, both against the 60/40 passive fund strategy and in its funding ratio. According to the IPFI, the state's "commendable prioritization of benchmarks and fiduciary responsibilities exemplify the values of a successful pension."

The institute also found that states continue to struggle with underfunded and poorly performing public pensions.

Warning about ESG, proxy advisory firms for pension investment strategies

The IPFI also found an increase in the prevalence of ESG and other alternative pension investment strategies. The institute has argued that pension funds should not use ESG to select investments because their fiduciary duty is to maximize participants' returns. It also said that ESG, in general, underperformed passive investment strategies, which further explains why so many state pensions are struggling to perform.

The institute also looked at the use of proxy advisory firms and found that the use of their recommendations by public pension funds does not benefit returns. According to the study, of the five worst-performing state pensions, four were relying on services from proxy advisory firms. Additionally, South Dakota, which had the best-performing state pension, did not take assistance from such firms.

The IPFI calls on state pension funds to return to their fiduciary obligations by focusing entirely on the financial returns of their investments.

Details on the top and bottom pensions' investment strategies

The study found that South Dakota, Kansas, Delaware, Minnesota and Ohio were the best performing pension funds in 2019, while Wyoming, South Carolina, Indiana, Maryland and Pennsylvania were the worst funds. On average, 42% of the best pension funds' assets were allocated to global and domestic equity, while 41% of the worst funds were allocated to equity.

The IPFI also found no significant difference in allocations to private equity between the top and bottom funds at 8.4% for the best funds and 10% for the worst funds. The study found that the bottom five funds allocated 18% to fixed income assets, compared to the top five's 24.7% average allocation.

One other area of difference in allocations between the top and bottom five was alternative investments. The bottom five pension funds had an average of 16% of their portfolios allocated to alternative investments, while the top five had just 9.5% allocated to them on average. South Dakota and Minnesota, the two best performing pension funds, didn't allocate any of their portfolios to alternative investments.

Another significant difference was found in cash and equivalents. The bottom five funds had an average allocation of 2% to cash and equivalents, while the top five averaged a 7.3% allocation. South Dakota, the best performing fund, had 22.9% of its portfolio allocated to cash and equivalents. However, Kansas, the second-best performing fund, didn't have any cash or equivalents in its portfolio.

Funding ratios

Generally, the IPFI found that the five funds that performed the best against passive portfolios are better funded than the bottom five, which should come as no surprise. The top five funds have an average funding ratio of 78.7%, while the bottom five had an average ratio of 63.8%. However, Wyoming, which is the worst-performing pension, had a higher funding ratio than the average of the 10 funds compared.

The IPFI also said that the funds which performed the worst against the passive portfolio are not far from the mean in terms of funding ratios. It sees both consistencies and contradictions and a lack of "glaring and statistically significant patterns." As a result, the IPFI believes there are more variables to consider when comparing the performance of pension funds' investment strategies against set benchmarks.

How South Dakota outperformed all others

The IPFI doesn't believe those differences in allocations are significant enough to play a major role in why some pension funds' investment strategies work better than others. To better understand why some state pensions perform better, they looked at South Dakota, the best-performing state pension system against passive portfolios. The IPFI analyzed South Dakota's setting and using of benchmarks and the importance of fiduciary responsibilities among the pension fund's employees and guidelines.

The South Dakota Retirement System utilizes several benchmarks to ensure each asset type is performing well. Those benchmarks are comparable to the one the IPFI used to determine the ranking of each state's pension fund. The institute explained that breaking down the larger benchmark into asset-specific numbers reveals invaluable data to help the state make informed financial decisions.

The IPFI also had high praise for South Dakota's fiduciary responsibility. The institute found that the most well-funded state pensions are avoiding the pressure to implement an ESG investment strategy. South Dakota's laws prohibit the prioritization of ESG considerations over the maximization of long-term risk-adjusted returns.

The state also doesn't utilize any proxy advisory firms, unlike four of the five worst state pensions. The IPFI blasted the practice of using proxy advisory firms instead of conducting independent due diligence and research when it comes time to vote as shareholders on company proxy statements.