Photo above by LendingMemo with Flickr Creative Commons License.
By Len Lazarick
Persistent critics of the investment performance of Maryland’s $45 billion pension fund for state teachers and employees are again slamming the fund for failing to match the performance of other state pension systems, even though its 14.4% return was nearly twice as high as the fund’s target.
In a report, Jeffrey Hooke and John Walters of the Maryland Public Policy Institute say the failure to match the 17.3% return on investment made by over half the public state pension funds cost the state over $1 billion. As they have in the past, they also complained about the high fees paid to outside managers of some of the funds used by the State Retirement and Pension System, which covers 244,000 active and retired state employees and teachers and their beneficiaries.
Wilshire Trust Universe Comparison Service for state pension plans, median fund investment performance for year ending June 30, 2014.
“As the table shows, the underperformance trend is not only continuing but worsening as the percentage divide widens,” said Hooke and Walters. “Part of problem may be due to the fund’s large exposure to alternative investments, such as hedge funds and private equity funds, that have tended to perform worse in recent years than traditional investments such as publicly traded stocks and bonds.”
A spokesman for the State Retirement Agency, Michael Golden, said the institute’s report was “flawed,” “not supported by facts,” and mischaracterized the agency’s investment performance.
“These returns have resulted in greater progress toward full funding of the system that was projected last year,” Golden said. The five-year return on investment was 11.68%, while the target for the fund is 7.7%.
Long-running dispute
Hooke and the Maryland Public Policy Institute have a long-running dispute with officials of the State Retirement Agency and the board headed by State Treasurer Nancy Kopp over how the funds are managed and how much outside investment managers are paid.
Hooke favors using index funds in which money is put into a basket of stocks or bonds that match broad categories of investments, such a U.S. stocks, international stocks, real estate or corporate bonds.
“Like most states, the Maryland state pension fund indexes only a small part of its total investment portfolio, preferring to ‘roll the dice’ on active money managers (of public bonds and stocks) and alternative investment managers,” Hooke and Walters say. Eliminating active managers, selling alternative investments, and adopting indexing both improve performance and “save the state huge amounts in money management fees.”
Golden admitted that Maryland’s investment performance is “unimpressive” compared to other state funds.
“However, the reason for this ranking is not due to active management and fees,” Golden said. “After the financial crises of 2008-2009, the board determined that the fund had too much exposure to public equities, which historically has been one of the riskiest, most volatile asset classes, and wanted a more balanced and diversified portfolio.”
Because of this, assets have gradually been taken out of public equities and put into other asset classes.
About 35% of pension fund in stock market
Maryland currently invests about 35% of its portfolio in the stock market, but that is a smaller portion than other states hold.
“During a time period when public equities generate unusually high rates of return, as they have for the last five years, the fund can be expected to underperform peers who have higher allocations to public equities,” Golden said. “The reverse should be true when public equities experience negative returns.”
Hooke disagreed. “Sadly, the fund does not seem to know that hedge funds and private equity funds have returns that correlate well with public equities — one problem for why the hedge funds and private equity funds do not beat public equities are the fees, which are a drag of 2-4% of annual returns.”
Golden also disputed Hooke’s assertion that “taxpayers make up the difference between sub-par returns and median returns by paying more money into the pension fund.”
CORRECTION, 9/26/2014 10:30 a.m.: Annual payments into the pension fund are based on employee salaries and the number of participants, as well as long-term liabilities and return on investment.
State and local taxpayers, who foot part of teacher pensions, will put $1.9 billion into the pension fund in fiscal 2015.
1. As everyone with more than a passing familiarity with public finance knows, the comparison between a long-term assumed rate of return and a single year return is meaningless. Golden’s first sentence is a red herring and is written only to confuse people. It is completely irrelevant whether a fund beats its long-term assumed rate of return in a given year. What IS relevant is whether it beats THAT YEAR’S benchmarks. And by benchmarks, I mean real-world benchmarks, not phony “custom” benchmarks. THAT is why MPPI can criticize SRPS even though it exceeded its assumed rate of return this year.
2. Without knowing the components of SRPS’s hypothetical “all-passive portfolio,” it is not possible to know whether the comparison between active and passive management Golden proposes is meaningful.
3. Golden claims the reason Maryland underperforms its peers is because the board realized AFTER the financial crisis that it had too much exposure to public equity. So AFTER it suffered losses, it changed its asset allocation to underweight public equity, and thus has missed out on five years of recovery in public equity. Does this sound like a good management strategy to you?
4. Not to mention that many alternative asset classes which are supposed to provide non-correlated returns don’t in fact do so. When the next market downturn occurs, I will be watching to see if these alternative asset classes perform as well as we’re told they will. I suspect they will not.
Blaming poor returns on “the recession” shows that the Retirement board is not getting independent advice. A recession happens about every seven years, and when there is a recession, most assets decline with equities (equities themselves decline 35%). It’s poor (non-existent) risk management and It needs to be built into the assumptions.
“Golden also disputed Hooke’s assertion that “taxpayers make up the difference
between sub-par returns and median returns by paying more money into the
pension fund.”
There are only three ways pension liabilities (benefits to employees) get funded: employee contributions, taxpayer (employer) contributions, or asset returns. If they are not funded, benefits eventually get cut.
If asset returns are sub-par, either contributions have to go up or benefits get cut. It’s not an assertion, it’s the laws of math.
But the truth is, I do not expect “spokeman” to be familiar with math. Part of the same group of cronies in Annapolis who thought it was a good idea to cut $700 million from pension funding so we could spend money, instead of cutting spending and funding pensions.
Hey, maybe the stock market will bail us out!
Those who in the past have claimed that our assumed rate of return of 7.7% was too high, now criticize us for having earned 14.4% in the most recent fiscal year. The latest report published by The Maryland Public Policy Institute makes several mischaracterizations about the Maryland State Retirement and Pension System that warrant clarification.
The report begins by describing Maryland’s investment performance for the year ending June 30, 2014 as sub-par. Over this time period, the fund earned a return of +14.37% net of fees, exceeding the actuarial assumed rate of return of 7.70%. These returns have resulted in greater progress toward full funding of the System than was projected last year. In fact, returns have been strong for the five years ending June 30, 2014, generating a net annualized return of 11.68% versus the actuarial target return of 7.75%.
The report also incorrectly attributes the fund’s peer ranking to the level of
management fees paid to active managers. The correct way to assess whether
active management is adding value is to compare the returns earned by the fund
in fiscal 2014 to returns earned by the fund had it been an all-passive portfolio. By doing this we see that for the year ending June 30, 2014, the fund’s 14.37% return outperformed the returns for an all-passive alternative at 14.16% by 21 basis points.
This equates to roughly $90 million in value generated by active management. Active management has added value over a longer time period as well. For the five years ended June 30, 2014 the fund has exceeded its policy benchmark by 90 basis points on an annualized basis, resulting in roughly $1.9 billion in value creation.
It is inappropriate and misleading to refer to management fees as “high-priced advice” without including a comparison against an all-passive alternative.
While much of the report is flawed and not supported by facts, it does correctly
highlight that the fund’s peer group ranking is unimpressive. However, the reason for this ranking is not due to active management and fees. After the financial crises of 2008-2009, the Board determined that the fund had too much exposure to public equities, which historically has been one of the riskiest, most volatile asset classes, and wanted a more balanced and diversified portfolio. As a result, assets have gradually been re-allocated away from public equities and into other asset classes.
While the current long-term target allocation to public equities is significant at 35%, it represents an underweight to this asset class relative to the peer group. During a time period when public equities generate unusually high rates of return, as they
have for the last five years, the fund can be expected to underperform peers who have higher allocations to public equities. However, the reverse should be true when public equities experience negative returns. Over a full market cycle, the fund’s positioning should provide a more diversified return stream, which should provide less volatility and greater reliability over the long term, for our members and the taxpayers of the state.
While MPPI’s thesis that the fund’s return of 14.4% for fiscal 2014 is now costing
taxpayers $1.16 billion is provocative, it is also myopic and perhaps even a bit misleading. Fiscal 2016 employer contributions to the fund are projected to increase by $129 million over fiscal 2015 employer contributions. To suggest that this increase of $129 million is due entirely to investment returns is deceptive. A recent study by the System’s actuary revealed that the increase of $129 million (not $1.16 billion) to the employer contribution is not as a result of the System’s strong investment returns. Indeed, the System’s actuary listed the funds 14.37% investment return as the leading cause for reducing the increase to the taxpayer funded employer contribution.
Those who in the past have claimed that our assumed rate of return of 7.7% was too high, now criticize us for having earned 14.4% in the most recent fiscal year.
The latest report published by The Maryland Public Policy Institute makes several
mischaracterizations about the Maryland State Retirement and Pension System that warrant clarification. The report begins by describing Maryland’s investment performance for the year ending June 30, 2014 as sub-par. Over this time period, the fund earned a return of +14.37% net of fees, exceeding the actuarial assumed rate of return of 7.70%.
These returns have resulted in greater progress toward full funding of the System than was projected last year. In fact, returns have been strong for the five years ending June 30, 2014, generating a net annualized return of 11.68% versus the actuarial target return of 7.75%.
The report also incorrectly attributes the fund’s peer ranking to the level of management fees paid to active managers. The correct way to assess whether
active management is adding value is to compare the returns earned by the fund
in fiscal 2014 to returns earned by the fund had it been an all-passive portfolio. By doing this we see that for the year ending June 30, 2014, the fund’s 14.37% return outperformed the returns for an all-passive alternative at 14.16% by 21 basis points. This equates to roughly $90 million in value generated by active management.
Active management has added value over a longer time period as well. For the five years ended June 30, 2014 the fund has exceeded its policy benchmark by 90 basis points on an annualized basis, resulting in roughly $1.9 billion in value creation. It is inappropriate and misleading to refer to management fees as “high-priced advice” without including a comparison against an all-passive alternative.
While much of the report is flawed and not supported by facts, it does correctly
highlight that the fund’s peer group ranking is unimpressive. However, the reason for this ranking is not due to active management and fees. After the financial crises of 2008-2009, the Board determined that the fund had too much exposure to public equities, which historically has been one of the riskiest, most volatile asset classes, and wanted a more balanced and diversified portfolio.
As a result, assets have gradually been re-allocated away from public equities and into other asset classes. While the current long-term target allocation to public equities is significant at 35%, it represents an underweight to this asset class relative to the peer group. During a time period when public equities generate unusually high rates of return, as they have for the last five years, the fund can be expected to underperform peers who have higher allocations to public equities. However, the reverse should be true when public equities experience negative returns. Over a full market cycle, the fund’s positioning should provide a more diversified return stream, which should provide less volatility and greater reliability over the long term, for our members and the taxpayers of the state.
While MPPI’s thesis that the fund’s return of 14.4% for fiscal 2014 is now costing
taxpayers $2.91 billion is provocative, it is also myopic and perhaps even a bit misleading. Fiscal 2016 employer contributions to the fund are projected to increase by $129 million over fiscal 2015 employer contributions. To suggest that this increase of $129 million is due entirely to investment returns is deceptive. A recent study by the System’s actuary revealed that the increase of $129 million (not $2.91 billion) to the employer contribution is not as a result of the System’s strong investment returns. Indeed, the System’s actuary listed the funds 14.37% investment return as the leading cause for reducing the increase to the taxpayer funded employer contribution.
The Hooke/Walters report says the state paid almost $300 million for investment advisory fees, a sum which dwarfs all other administrative expenses of the pension plan, according to the CAFR. It certainly is an attractive option to slash these fees; they do seem unreasonable.
The state should fire the pension fund managers saving the fee paid to them and invest everything in the Index 500. Returns for the index 500 have averaged 25%, 20% and 16% for 1, 3, and 5 years respectively. Using the value of the fund, that equates to a lot money!