Public pension funds are among the largest concentration of financial assets in the United States. They cover 26 million active- and retired government employees, and in the second quarter of 2019 comprised more than $4.5 trillion in assets (increasing in 2020 to more than $5 trillion). These funds provide the retirement benefits of municipal, county, state and federal government employees including police, firefighters, teachers, maintenance workers and many others.
Another large pool of assets, about $600 billion, comprises the endowment funds of U.S. universities including Harvard, Yale, Stanford and numerous others.
Both pension funds and endowment funds are staffed by investment professionals who engage institutional investment consultants to help them plan strategy and hire external investment managers. All of these participants are highly qualified and very well paid.
Evaluation of performance
Richard M. Ennis, a prominent institutional investment consultant who was previously CEO of the respected consulting firm EnnisKnupp and edited the prestigious Financial Analysts Journal , has carefully studied the investment performance of these funds.
Ennis’s results are startling. His latest article on the subject, which caps and summarizes the findings of a series of previous articles, finds that, in Ennis’s words: “Public employee pension funds, endowment funds and other nonprofit institutional investors in the U.S. have a serious performance problem. They have underperformed properly-constructed, passively-investable benchmarks by a wide margin since the Global Financial Crisis (GFC) of 2008 some 13 years ago.”
Ennis concludes, addressing the performance of public pension funds specifically: “The bottom line on public fund performance is that underperformance of 152 bps [1.52%] per year on $4.5 trillion in assets [for the 12 years ending June 30, 2020] translates to an outright waste of stakeholder value of $68 billion annually, a figure I find astonishing.”
To put it another way, this waste costs the average U.S. taxpayer, who pays to fund public pensions, around $500 a year (the result of dividing the 1.52% times $4.5 trillion cost to taxpayers by the 141 million U.S. taxpayers in 2019).
This underperformance is almost exactly equal to the amount of the fees charged by the investment professionals hired to advise and invest the pension funds. In every other respect the performance of the funds is indistinguishable from that of a combination of two- or three passively managed, ultra-low-cost stock and bond index funds.
If these funds had been invested in low-cost index funds, their performance would have been much better, and the fees charged would have cost the average taxpayer only about $3 a year instead of $500.
Ennis found that endowment funds, even of the top elite universities, performed, incredibly, even worse. They paid fees averaging 1.8% a year, underperforming a combination of low-cost index funds by a similar amount.
The explanation: Principal-agent theory
Economics often has an explanation for real world phenomena that may seem senseless, but are unsurprising if it is assumed that people are rational and self-interested. In this case the explanation lies in what is called principal-agent theory.
It would seem irrational for administrators of pension funds to pay 150 times greater fees than they would have had to pay for index funds, when the result is no better. But as I explained in my book “The Big Investment Lie”: “A branch of classical economics explains why perfectly rational, self-interested institutional investors would “fall victim” to these irrationalities… [That] branch of economics is called principal–agent theory. The principal–agent problem occurs whenever the “agent” in charge of managing an asset is not the same as the “principal” who owns it…”
You might assume that the principal and the agent are on the same team and therefore have the same interests. But economic assumptions — and reality — are colder than that. People have different incentives even if they’re on the same team.
The agent, who deals with managing the asset on a daily basis, has more information than the principal does. Therefore, the agent is in a position to manipulate that information so as to be seen in the best light by the principal. This is often done by complicating the information so that it is difficult for the principal to evaluate the agent’s effectiveness.
This is exactly what occurs in the professional investment management field. The agents — the pension fund administrators, the consultants who help plan investment strategy and hire the investment managers, and the managers themselves — speak in an impenetrable mathematical-sounding jargon. They create “custom benchmarks” to be evaluated on — except that the artificial performance benchmarks they concoct are much easier to beat than more conventional market indexes such as the Russell 3000
or the S&P 500
Who are the principals and who are the agents, and what is the solution?
In the case of public pension funds, the principal-agent problem is at its worst because it can be difficult to identify the principal, and the chain between principal and agents is long and complex.
These funds are overseen by a board of trustees, who hire the funds’ staff. The trustees might be regarded as principals because they are officially responsible for its performance. But they themselves are also agents, because they don’t have “skin in the game” as a principal would. If the fund underperforms it doesn’t cost them personally — unless, perhaps, they are sued for the underperformance.
Ultimately, the principal is the taxpayer who funds these pension plans. It is the taxpayer who must foot the bill for the funds’ underperformance.
It is likely that nothing will be done unless taxpayers rise up and protest, or even sue pension fund trustees. Such lawsuits are not unknown. In at least one case a donor to a university endowment fund has lodged a suit alleging that the fund’s underperformance was due to not investing in low-cost passive index funds.
Ennis, however, passes the buck to the trustees. He says: “Trustees of these funds should put an end to the waste of precious resources and invest passively at next to no cost.” Yet as the ultimate principals, taxpayers may have to lead the charge.