Public sector pensions are dangerously underfunded. Official reports put the total unfunded liability for plans across the country at around $1.5 trillion, though estimates using methodologies based on sounder actuarial principles estimate the unfunded liability to be closer to $3.8 trillion.
The causes of this crisis are myriad, though the two largest are a failure to contribute the full actuarially determined contribution and using assumed rates of return that are unrealistically high.
One source of public plans’ woes, though far from the largest contributor to the current crisis, is the fees paid by plans for active investment, particularly when investing in hedge funds and other alternatives, finds a new research brief from the Center for Retirement Research:
In recent years, public plans have increasingly scrutinized the fees they pay to external asset managers to gauge whether the fees are justified…
Even though most plans outperform their blended benchmark, the data show a correlation between higher fees and worse relative performance. And, looking at expense ratios across the various asset classes, it is clear that alternatives charge much higher fees than traditional asset classes such as public equities and fixed income. Finally, plans that underperformed their blended benchmark from 2011-2016 reported higher expense ratios than plans that outperformed their benchmark, particularly within alternative asset classes.
These initial findings suggest that investment fees – in particular, outsized fees on alternatives – may play a meaningful role in plan underperformance. Future research on the impact of fees would benefit from a longer timeframe that incorporates a full market cycle – which will be increasingly possible as the trend toward improved fee disclosure continues.
The brief found that plans that overperformed their benchmarks had expense ratios (investment fees divided by total assets) of 34 basis points (0.34%), while those that underperformed their benchmarks paid 44 basis points (0.44%).
Actively managed investments are problematic for two main reasons. First, basic economic theory tells us you can’t beat the market in the long-run. Second, in the case of public sector pensions, there are often issues related to the transparency of the fees paid to these funds, which has led many plans to divest from alternatives.
For a more in-depth explanation on the role of investment returns in public pension financing, read this helpful guide from Reason Foundation’s Anthony Randazzo.