It will shock few Illinoisans that public pension funds across the U.S. are underfunded, undermanaged and underperforming. And yet year after year these funds, with $4.5 trillion in assets and covering 14.7 million workers and 11.2 million retirees, show themselves outpacing self-selected benchmarked goals for investment returns.
Pension expert Richard Ennis took a closer look at 24 such funds, including two big ones in Illinois. In a recent issue of the Journal of Portfolio Management, he wrote that they underperformed passive investing indexes by an average 1.4 percentage points, despite reporting a 0.3-point positive margin against benchmarks. Only one of the funds beat indexing over the 10-year period.
“This sharp disconnect raises questions about the usefulness of the funds’ performance reporting, as well as their heavy reliance on expensive active management,” he concluded. “Altogether, the results paint an unflattering portrait of the stewardship of public pension funds in the United States.”
Ennis, 78, is a retired chairman of industry consultant EnnisKnupp (acquired in 2010 by Hewitt Associates, now part of Aon) and a former editor of Financial Analysts Journal. He argues that funds set benchmarks too low and then overpay managers once performance is made to appear better than it is. He estimates that management fees average 1.3% of assets–roughly equaling the fund underperformance he measured.
Among the two dozen funds he surveyed, the $66 billion Teachers’ Retirement System of Illinois was the fourth-worst performing, reporting an annualized return (8.3%) that was 3.23 percentage points lower than an indexed return. The gap was a negative 1.24 points, just above the median, for the $24 billion State Employees Retirement System of Illinois. For the State Universities Retirement System, which Ennis examined at Crain’s request, the shortfall was 1.9 points.
While benchmark revisions are sometimes prompted by changes in asset allocations, Ennis wrote that they are often revised to “more closely match the execution of the investment program,” adding: “We talk about hugging the benchmark in portfolio management. Here is a different twist on that theme, with the benchmarks hugging the portfolio.”
Ennis had more to say in this email exchange with Crain’s.
What prompted you to do this now?
Curiosity. My research revealed that public pension funds overwhelmingly underperform passive investment benchmarks indicating a fair economic return. At the same time, it seemed to me that most were reporting favorably relative to their custom benchmarks. So I decided to investigate. This paper is the result.
Did the 10-year study period account for an adequate number of down markets by asset class to give active managers an opportunity to test their ability to select individual securities and structure portfolios?
Could you elaborate?
I don’t like the question. By that I mean, the question itself reflects the spin mentality that investment managers put on presenting poor performance results: “Our style (category of investment) was out of favor. Just you wait.” Proper performance measurement takes into consideration manager style or approach, and my work has done so. Accepted practice is to give active managers a reasonable amount of time to perform. And the 10 years covered here is enough. It began with a major bear market, followed by an extended bull market.
You write that divining the true cost of management expenses is opaque.
CEM Benchmarking, a respected independent arbiter of institutional fund benchmarking, reported that U.S. public pension funds underreport their costs by more than half. Look at the most recent CalSTRS annual report. Reported investment expenses are about 11 basis points (0.11%). South Carolina, which does an excellent job of capturing costs, reports costs of 137 basis points (1.37%). Expense reporting by the funds is largely useless. Most underreport, and the reporting they do is nearly indecipherable.
How would you rate the quality of the public pension fund boards overseeing the process?
In terms of diligence, loyalty and having all the best intentions, I would rate most boards very highly. That said, most individual members of the board are in way over their heads in terms of trying to supervise extraordinarily complex investment programs such as these. They have virtually no alternative to accepting the recommendations of staff. The boards are best served when they include one or more finance or economics professors as elected members, or non-governmental investments professionals serving as board members.
Are there any peculiarities of the Illinois funds?
Not that I’m aware of.
If you had a magic wand, what would you do to improve public pension fund reporting?
I would bring about the type of reform initiated in the private sector in the wake of the Studebaker debacle. ERISA (passed in 1974) established minimum funding requirements for corporate plans. The accountants (Financial Accounting Standards Board) required that liabilities be reported at their market value. The reform played out over decades and in piecemeal fashion, but these are the two pillars that set apart public and private plan funding: assured funding and liability valuation.
How do your findings differ from other studies done on this issue?
No one else has looked at the issue with public pension funds. In unpublished research, I find the same benchmark bias exists among large endowments funds. Just last week, (the Wall Street Journal’s) Jason Zweig discusses a similar phenomenon among mutual funds in his Intelligent Investor column.
The Illinois Teachers’ Retirement System has a sizeable allocation in alternative investments and private equity. Is that also true of the State Universities Retirement System?
TRS has a longer history with alts than does SURS, and their allocation there has been greater.
Has it paid off for TRS?
I have not analyzed TRS performance in detail. At the total fund level, my analysis indicates that TRS’ active management record is among the worst of the approximately 50 large funds in my dataset. This holds for the 10 years covered in this paper and the longer 13-year period in my research. The excess return of -3.23% for TRS means that it underperformed passive investment by that margin annually for 10 years. I doubt that the fund keeps many of its investment managers on that long with those kinds of numbers.
I gave the Illinois State Board of Investment, which manages fund assets, a chance to comment on your findings. I never heard back. Does that surprise you?
You can bet they are all aware of the papers I’ve been publishing for the last two years. Lying low does not surprise me.