Arthur Frankenstein didn’t got down to create a monster. He had the very best scientific intentions. He hoped to create a residing being from, properly, physique components. As Mary Shelley’s story performs out, we study that Frankenstein’s experiment ended badly.
A a lot much less grisly experiment started in 1911 in Massachusetts. That’s the place the primary statewide pension fund in america got here into being. It proved to be a way more profitable experiment however not with out its personal unexpected penalties.
In the present day, all 50 states preserve a minimum of one statewide pension plan. All however 5 have a number of statewide plans. After which there are all town and county plans. Jurisdictions with a number of pension plans are the topic of this put up.
Diversification is a cardinal precept of prudent pension fund administration. The precept is written into fiduciary legislation all over the place. Public plan trustees have been scrupulous of their efforts to diversify investments. They invariably set up an asset allocation plan for diversifying amongst asset lessons. They rent a number of funding managers. They use index funds. Their returns hew to broad market indexes. For instance, my research point out that, on common, giant public fund returns have an R2 of 98% with these of the market. Public pension funds are diversified to the nth diploma.
Diversification Gone Haywire
Right here is the place issues start to get sticky. Giant public funds use a median of greater than 150 asset managers.(1) A principle of environment friendly portfolio administration is that the investor doesn’t use lively managers for diversification, which could be carried out far more cheaply with index funds. Hiring scads of managers is expensive. I estimate that public pension funds, with their 35% common allocation to expensive various investments and 20% or much less in index funds, incur funding bills of 100 to 150 bps per yr. They usually underperform market indexes by a like quantity. Trustees are getting their diversification, sure — however with woeful inefficiency.(2)
The Monster We Constructed
Issues worsen when there are a number of pension funds in a single jurisdiction. This leads to redundancy amounting to de facto consolidation of all the person funds, for that’s its bottom-line impression on taxpayers. Think about a taxpayer in Los Angeles. Their taxation is influenced by the efficiency of three metropolis pension funds, one county fund, and three statewide funds. The consolidated fund incorporates greater than 1000 actively managed portfolios with numerous particular person positions. One portfolio’s losers offset one other’s winners; funding bets by the a whole bunch cancel each other out. The result’s an unholy index fund, patched collectively with out intention and giving rise to a monster of inefficient diversification.
There are $5 trillion of public outlined profit belongings in america. I estimate public plans waste $50 billion a yr via inefficient diversification. The waste provides to the already monumental burden of funding public pension plans, which finally falls upon the taxpayers.
What’s the resolution? A number of states, corresponding to Minnesota, have a state board of funding. Though Minnesota has a number of statewide pension plans, their belongings are pooled for the aim of funding. This can be a step in the fitting course. However, as famous, particular person pension funds are usually inefficiently diversified, so there isn’t any assurance that merely pooling plan belongings will obtain the specified consequence. And state boards of funding usually miss native funds.
A surer various is to index public pension belongings in actual fact. Jumbo-size, government-run pension funds working in a political goldfish bowl lack comparative benefits as traders. Passive investing at subsequent to no value transforms the sport into one by which public funds could be constant winners.
Key Takeaways
Public pension plans might use index funds or appear to observe market benchmarks, however in actuality, they:
- Nonetheless make use of a whole bunch of lively managers
- Tackle costly various investments
- Find yourself with mixture portfolios that mirror the market however at a lot larger value
(1) See Aubry, J-P and Okay. Wandrei. 2020. “Inner vs. Exterior Administration for State and Native Pension Plans.” Middle for Retirement Analysis, Boston Faculty.
(2) See Ennis, R.M. 2025. “The Demise of Different Investments.” The Journal of Portfolio Administration (forthcoming). https://papers.ssrn.com/sol3/papers.cfm?abstract_id=5163511.