While so-called pension reform is the subject of much debate, there should be one public-pension issue upon which everybody can agree: the costs of managing pension assets. Unfortunately, this was absent from Gov. Corbett's recent proposal.
The goal of an asset manager is to maximize portfolio returns. The components of maximizing returns are twofold: fees and performance. The record is clear that passively managed, broad-based index funds have substantially lower fees than actively managed funds, and asset managers rarely beat the market over the long run. Therefore, shifting from higher-cost, lower-performing, actively managed investments to lower-cost, higher-performing, passively managed index funds will save governments in Pennsylvania and around the country billions of taxpayer dollars.
After a thorough review of our county's public-pension fund's performance and fees over many years, our pension board recently voted to move 90 percent of our pension-fund assets to a portfolio offered by Vanguard, a Valley Forge-based, investor-owned firm with hundreds of employees in our county. It is important to note that the county's reformed procurement process requires companies to disclose any financial or political dealings they may have had with county officials. Vanguard had none.
This shift will reduce the fund's management-fee expenses by more than two-thirds, a savings of more than $1 million annually.
The switch also enables the county to eliminate one consulting firm and more than a dozen asset managers. The combination of lower management fees and lower personnel costs gives the passively managed funds at least a full percentage-point advantage on alternative investments. Plus, from a performance perspective, the S&P index had beaten our actively managed fund's annual performance in eight of the last 10 years. The combination of reduced costs and higher returns is the proverbial win-win for county residents, employees, and retirees.
Governments have an obligation to be careful stewards of the public's money. If higher-fee, actively managed investments do not consistently outperform the market, we should not entrust public funds to them.
Two Pennsylvania funds - the State Employees' Retirement System (SERS) and the Public School Employees' Retirement System (PSERS) - are substantially invested in higher-cost investment vehicles such as private equity, venture capital, real estate, and hedge funds. In fact, the two funds each pay about 1 percent (or a total of about $770 million) in manager fees, a rate seven times higher than Montgomery County will be paying for its diversified Vanguard mutual fund lineup and 20 times higher than those funds would pay if the commonwealth simply invested in an S&P 500 Index fund.
The PSERS fund earned about 12 percent on its investments in 2012, compared with the S&P 500 return of 16 percent. For that year alone the pension fund would have been better off by about $1.25 billion if it was solely invested in the S&P. Even if the actively managed funds had matched the returns of the passive funds, the savings in fees would still have been hundreds of millions of dollars.
Of course, there will still be ups and downs in the market. And, as we've recently seen, down times can be very painful. But, over the long haul, the overall market has an impressive record that almost no managers can beat. The S&P 500 has average annual returns of about 9.85 percent since its inception in 1926.
Real pension reform with lower fees and higher performance - that is the approach we've taken in Montgomery County and I strongly suggest that Pennsylvania follow suit.
E-mail Josh Shapiro
at email@example.com, or follow him on Twitter at @Josh_Shapiro.