Flawed Investing is Depleting Pension Assets

Highly paid consultants and active fund managers aren’t helping retirees to get better returns.

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The management of pension fund assets is big business. Every broker, hedge fund manager, private equity fund manager, and mutual fund manager wants a piece of this mega-trillion dollar action. High priced consultants stand ready to advise pension administrators which fund managers to include and exclude in their portfolios.

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Government employees, both active and retired, depend on the ability of pension plans to generate sufficient returns to fund their retirement. With all the resources available to them, you would think this wouldn’t be a problem. You would be wrong.

One study looked at the selection and termination of investment management firms by plan sponsors including public and corporate pension plans, unions, foundations, and endowments. It examined 8,755 hiring decisions by approximately 3,700 plan sponsors over a 10-year period from 1994 to 2003. The managers hired were responsible for an aggregate of $737 billion in assets, while the fired managers handled $117 billion. Clearly, the plan sponsors had their pick of the finest fund managers available.

One of the criteria used to select these managers was their past performance. Three years before hiring they beat their benchmarks by an impressive 2.91 percent per year. For the three years post-hiring, these investment stars underperformed their benchmark by an average of 0.47 percent per year.

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The hiring and firing cycle continued. Underperformers were fired. But here’s the twist. After being fired, the excess returns of the fired managers on average were better than their replacements. The lesson is clear: Past performance is not predictive of future performance. Here’s a simpler way to put big bucks in the pockets of pension plan beneficiaries:

  • Fire all plan consultants who try to pick funds that will beat the markets.
  • Eliminate all actively managed funds (where the fund manager attempts to beat a designated benchmark), hedge funds, and private equity funds from pension plan portfolios.
  • Limit investments to a globally diversified portfolio with an allocation of approximately 60 percent stocks and REITS and 40 percent bonds, using only passively managed funds from firms like Dimensional Fund Advisors and Vanguard.
  • The Florida Retirement System is an excellent example of the significant impact these changes could make. According to a recent article in the St. Petersburg Times, Florida pays 148 employees who supervise about 190 private fund managers and a bevy of consultants, researchers, auditors, and lawyers. But what would happen if this huge infrastructure was dismantled and the Florida plan switched to a 100 percent index-based portfolio, which, presumably, could be run by a couple of internal staffers?

    A study by Index Funds Advisors looked at the decade ending December 31, 2010, during which the Florida Retirement System’s assets had grown to $124.2 billion, with an annualized net return of 4.6 percent. [Full disclosure: I am a senior vice president of Index Funds Advisors]. The analysis compared these returns to simulated and annually rebalanced portfolios of index or passively managed funds from Dimensional Fund Advisors, Vanguard, and a set of industry benchmarks which had approximately the same amount of risk as those in the Florida plan. Index funds are low cost investments that track fixed rules or various benchmarks, regardless of market conditions.

    The study assumed a beginning value of $79.2 billion, based on the annualized net returns of the plan assets over the past ten years. The simulated index portfolios had an ending value of about $165 billion using Dimensional’s passively managed funds and about $142 billion using Vanguard’s funds. The net difference to plan participants could have been $40 billion with the Dimensional portfolio and $17.8 billion with the Vanguard portfolio.

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    When the study compared the returns of the Florida plan to 26 years of simulated index data generated by Index Funds Advisors from January, 1985 to December, 2010, the results were more staggering. Plan beneficiaries could have missed out on as much as $50 billion. You can see the sources of this data and disclaimers here.

    The ramifications of this study, which has been expanded to almost all 50 states, are profound. It appears the fees paid to active consultants and active fund managers significantly detracted from returns that might have been achieved with low-cost passive consultants and managers who follow consistent rules, regardless of market conditions.

    Dan Solin is a senior vice president of Index Funds Advisors. He is the author of the New York Times best sellers The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, and The Smartest Retirement Book You'll Ever Read. His new book, The Smartest Portfolio You'll Ever Own, will be released in September, 2011.