A report from the Maryland Tax Education Foundation and the Maryland Public Policy Institute finds that state pension funds spend a significant amount of money paying investors to manage their funds. States spent $7.8 billion on Wall Street in 2011. Funds’ recent poor performance casts these expenditures in a particularly bad light for taxpayers, and the Maryland researchers Jeff Hooke and Michael Tasselmyer suggest these funds are not well-spent.
Much less expensive investment strategies are available to investment funds, however, these investment strategies rely on index funds that typically seek to match the market’s performance rather than outpace it. However, as Governing the States and Localities explains:
Pension experts interviewed for this story, though, question the validity of the report, which compares investment firm fees with each plan’s net assets. Even with the higher fees, they say additional returns from investment managers outweigh the added cost in the long run, and tossing more money into equity index funds wouldn’t diversify portfolios.
“The suggestion that all public pensions should be shifted into index accounts is just not well informed,” said Keith Brainard, research director for the National Association of State Retirement Administrators.
The need to outperform the market comes from the way that states value their liabilities. Rather than valuing defined benefit pensions at the appropriate risk-free discount rate, states choose to assume higher rates of return, commonly 5 percent above the risk-free rate. When a low-risk investment strategy fails to meet these returns, state fund managers are incentivized to pursue riskier strategies with the hope of making the return needed to make the defined benefit obligations. This is demonstrated in state funds’ participation in recent IPOs.
The Maryland report states:
For many state pension funds, investment results over the last 10 years have failed to hit target returns of 7 to 8 percent annually. This has prompted Maryland’s System and other state systems to make large commitments to “alternative investments,” like leveraged buyout funds and hedge funds, with the hope of obtaining higher returns than conventional public stocks and bonds. In fiscal 2011, 25 percent of the Maryland System’s investment portfolio was in alternative investments, including private equity and real estate.
alternative investments are less liquid, less transparent, and more volatile than conventional public stocks and bonds. It is also questionable whether these investments provide higher returns than a similar risk-adjusted portfolio of public equities. Buyout fund promoters claim higher returns, for example, but many of their leveraged buyouts from the pre-crash period have yet to sell, and the state pension systems rely on the buyout funds’ in-house valuation of such investments to determine pension investment returns. The states exercise limited supervision over the buyout funds, and the examination of buyout fund portfo- lio values by fund auditors is typically inadequate.
With a risk-free discount rate for valuing guaranteed defined benefits, state fund managers would not be faced with the choice of either accepting higher risks or facing a reality of falling short on obligations. In determining what discount rate to choose, state policymakers should remember that the benefit level determines the cost of pension plans. Lowering the assumed rate of return does not change the cost of pensions, but merely means taxpayers will be paying for benefits as they are accrued, whereas a higher discount rate pushes these payments into the future.