Indefensible Decisions by Pension Fund Managers

Pension consultants don’t always select investments that are appropriate for plan participants.

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Trustees of pension plans have a fiduciary obligation to act in the best interest of plan participants. This makes perfect sense. Those participants have no say in how their retirement savings is invested. They rely totally on the expertise and good faith of the plan trustees.

In many instances, that trust is misplaced. A significant portion of pension plan assets are invested using consultants. These consultants often recommend investments in actively managed mutual funds where the fund manager attempts to beat a designated benchmark. If these consultants followed the data, which demonstrate that most active fund managers fail to beat their designated benchmark over almost all time periods measured, they would advise their clients to invest in a globally diversified portfolio of low management fee index funds, in an appropriate asset allocation. Here’s the rub: If they did that, they would be out of a job.

Some responsible pension plan trustees have taken matters into their own hands. On June 19, the investment committee of the massive California Public Employees' Retirement System announced that it had voted to replace the stand-alone actively managed funds in its $1.64 billion defined-contribution plan with passive options.

While this is a welcome development from a widely admired and much-followed plan, many other plan trustees have not only refused to follow suit, but have increased their investments in far-riskier alternative funds, consisting primarily of hedge funds. According to the research firm Preqin, public pension funds in the U.S. plan to further increase allocations to hedge funds in 2013. A survey by Deutsche Bank concluded that the amount of this increase in 2013 will be 11 percent, which will bring the total investment in hedge funds to an unimaginable $2.5 trillion.

A disturbing article by Sheelah Kolhatkar in the July 11 issue of Bloomberg Businessweek shows why this news should be alarming to participants in those plans. The title of the article is telling: “Hedge Funds Are for Suckers.” Kolhatkar correctly notes the demise and poor return performance of some of the big hitters in the hedge fund world, but the bad news didn’t stop there. Over eight of the past 10 years, a simple S&P 500 index outperformed the HFRX Global Hedge Fund Index. This underperformance has continued year-to-date. There have been a number of insider trading convictions of hedge fund managers. One of the largest and most successful hedge funds, SAC Capital Advisors, is facing intense scrutiny from various government agencies over as yet unproven allegations of insider trading.

Not everyone is a loser in this process. The consultants “earn” fat fees and hedge funds charge obscene fees, while often generating “negative alpha” (less than benchmark returns). The plan trustees earn the perks typically associated with handing out lucrative business.

If I am describing your plan, you don’t have to stand by and endure the mismanagement of your retirement funds. Ask your plan administrator to provide you with inception-to-date data comparing the returns of your plan to a benchmark index of comparable risk. If your plan is underperforming, start asking pointed questions like: Could you explain why our plan would not likely achieve higher returns if you fired all the active fund managers and replaced all of them with low management fee stock and bond index funds?

Sy Syms, the well-known clothier, had this as his company’s slogan: "An educated consumer is our best customer." You need to be an educated participant in your pension plan. Otherwise, you risk the transfer of your hard-earned money to consultants and hedge fund operators whose pockets are already overflowing.

Dan Solin is the director of investor advocacy for the BAM Alliance and a wealth adviser with Buckingham Asset Management. He is a New York Times best-selling author of the Smartest series of books. His latest book, 7 Steps to Save Your Financial Life Now, was published on Dec. 31, 2012.

The views of the author are his alone and may not represent the views of his affiliated firms. Any data, information and content on this blog is for information purposes only and should not be construed as an offer of advisory services.