The Many Shades Of Public Pension Mismanagement

[Originally published by Market Urbanism]


1. My two Forbes articles this week were about how Miami’s liberalized culture and economy have made it an international banking center; and how reducing medallion requirements for taxis would level their playing field with Uber.

2. About a month ago, I asked readers whether they thought cities would be smarter to invest their pension funds using “in-house,” government-hired money managers, or outside private ones. I haven’t been able to address the issue, but last night rediscovered in my notes the story that sparked the question.

On April 8, the New York Times ran a report about how, in the last 10 years, New York City’s five pension funds—for police, fire, teachers, board of education, and general employees—missed out on an estimated $2.5 billion in returns because of high fees and poor investments by their Wall Street advisors. The Times cited a press release by city comptroller Scott Stringer, who had ordered an analysis of the $160 billion fund. Here’s a quote from Stringer’s release:

Wall Street managers of private asset classes such as private equity, hedge funds and real estate fell $2.6 billion short of target benchmarks after fees. Over the same period, managers of public asset classes exceeded the benchmark slightly. However, those managers gobbled up more than 95 percent of the value added—over $2 billion—leaving almost no extra return for the Funds…The poor performance of private asset classes ($2.6 billion below benchmark), combined with the marginally better performance in public markets, has cost the City pension funds nearly $2.5 billion in lost value over the past ten years.

The story didn’t get much press, because of its complicated nature, but there was some commentary from Bloomberg media. This is fitting given that during his NYC mayoralty, Michael Bloomberg tried to bring the city’s pension fund investing more in-house, to no avail.

A. Bloomberg View’s Matt Levine estimated that the expense ratio the city spent for firms to manage its public assets was .2%, which doesn’t much exceed the .17% expense ratio of the Vanguard 500 Index Fund’s small-investor shares. That said, he still thought the city had gotten a (somewhat) raw deal, since large investors can usually hire managers at discount.

B. Bloomberg View’s Barry Ritholtz gave a cautioned endorsement for in-house management of the city’s fund, as an antidote to the $2.5 billion loss.

C. He linked to a 2013 Bloomberg Business report that described how this would work. The report noted that New York City is “the only one of the 11 biggest U.S. public-worker pensions that refuses to manage any assets internally.” Doing so would be cheaper, since publicly-hired money managers usually earn 6-figure salaries, not the exorbitant 8-figure salaries common on Wall Street. But this cheaper route can also mean lower returns:

The California Public Employees’ Retirement System, the largest U.S. pension, manages almost two-thirds of its assets, including 83 percent of stocks and 91 percent of bonds. Chief Investment Officer Joseph Dear received $522,540 in compensation in 2011. Yet its 6.1 percent average annual return for the 10 years ending June 30, 2012 is 1.1 percentage point less than that of the Pennsylvania Public School Employees’ Retirement System. The Pennsylvania fund manages only 26 percent of assets internally and paid Chief Investment Officer Alan Van Noord $269,302 in 2011. New Jersey’s $75.3 billion pension manages 73 percent of its assets in-house, the most among the 11 biggest U.S. public funds. The system returned 6.4 percent for the 10-year period ending June 30, 2012.

These low returns don’t surprise me. In fact, I have a hard time believing that public management of pensions is desirable, for the reasons I described last month. In-house managers earn salaries that are abnormally low for their profession, and that are fixed. They also work for debt-prone corporations (aka cities and states) who have no need to profit immediately, or even in the long term. This sounds like a poor set of incentives for producing high returns. Public managers may also be overruled by a broader political climate of “social divestment,” in which governments steer their funds away from politically-incorrect companies, even if that means lower returns.

Of course, what goes unstated is that respective tales of public and private mismanagement of government pensions make an even stronger case for converting employees to 401(k)s. The main argument for doing so is that it would shift pensions from defined-benefit to defined-contribution, thus absolving taxpayers from the need to fully fund them. But it would also finally allow workers more investment autonomy. Rather than having all their savings tied up in one large fund, to be managed at their government’s discretion, employees can decide for themselves what to do with their money.