Pennsylvania Gov. Tom Wolf's new budget proposes several steps he says will trim $10 billion from the $50 billion-plus shortfall between what the state has invested to pay hundreds of thousands of retired teachers and state workers, and the much larger sums it will have to pay them. (See also http://www.philly.com/philly/blogs/inq-phillydeals/295019951.html)
(The shortfall forces state Treasury and school district property tax "contributions" to the pension fund higher every year -- which is why ex-Gov. Tom Corbett called pensions "a tapeworm" -- and is a leading reason Pennsylvania has the third-worst Moody's credit rating of any state: only Illinois and New Jersey, which have also over-promised and under-funded pensions, rate worse.) I reviewed Wolf's pension plans here, and sent a copy to Wolf's office with a request for further comment. "Thanks, Joe. I don't have anything to add right now," Wolf spokesman Jeff Sheridan told me. So I asked around:
1) MONTCO'S VANGUARD WAY: Josh Shapiro, the ambitious head of Montgomery County's Democratic-dominated government, is cheered by Wolf's proposal to fire high-fee "Wall Street" (as Wolf calls them) investment managers and replace them by low-fee "passive" managers like the ones Shapiro and colleagues hired to run Montgomery County's pension fund in mid-2013.
How's that going? It's early to compare, but Montco financial officer Uri Monson back-ran reported returns for the six Vanguard index funds the county bought to replace its previous grab-bag of private managers, and found the Vanguard investment basket outperformed Montgomery County's actual earnings in seven of the nine years from 2004-07, including all seven years when stock prices rose.
Montco's old multi-manager, higher-fee strategy beat the Vanguard basket in the two years (2008 and 2011) when stock prices were flat or declined.
To Shapiro's mind, that plus Vanguard indices' data going back farther yield "30 years" of proof that cheap index funds beat the mix of higher-fee stock, bond, private-equity, real-estate, venture-capital, commodity and hedge funds Pennsylvania relies on.
Is it that simple? As I reminded Shapiro, Vanguard is warning clients that the next 10 and 20 years aren't likely to be as profitable, for U.S. stocks, as the last couple of decades. And, "past performance is no guarantee of future results." And, these pension annuity funds that have to pay pensioners every year have extra incentive to guard against valuation drops in bad years: Such declines force the fund to sell assets at a discount, spending down its principal, boosting its deficit, and making it tougher to recover lost assets.
And, how does Wolf intend to persuade, or force, SERS and PSERS (the state workers' and school employees' pension systems) to drop their hundeds of high-fee managers and turn more to indexes?
2) SERS: "We are working to gather details on the Governor’s plan, so I can’t speak to it specifically," SERS spokeswoman Pamela Hile told me. "What I can tell you is that last year, a little more than 0.5% of the total fund value went to management fees. This, in the view of the Board, does not represent an excessive amount." (As I have reported elsewhere, SERS and PSERS reported fees don't include the potentially lucrative "carried interest" profit percentages that private-equity managers pocket from clients' investments, among other payments.)
"Looking at the issue from a long-term perspective, over the past decade, SERS paid $2.4 billion in fees, while earning $19.7 billion net of fees and expenses AND paying out $23.2 billion in retirement benefits.
"Compare that performance to an industry standard 60% equity/40% bond index fund, SERS’ performance added $4.9 billion of value to the fund with 0.5% less volatility.
"To further illustrate this value, our alternative investment program, built with top-tier investment managers, outperformed the U.S. public market equities return by 5% net of all fees over the decade ended 2013... Over the past five years, we reduced fees 30%. We get good value for the fees we pay...
"In 2013, SERS earned $3.7 billion, after all investment management fees and expenses of $175 million were paid. From a basic dollar perspective, that’s like paying $175 over the year to net $3,700 in your pocket at the end of the year." It will be interesting to compare SERS vs Montgomery County returns, low-fee index vs. higher-fee active managers, for 2014 and later years.
Again, if Wolf and Shapiro are right, could the governor force SERS and PSERS to fire their managers and index their investments?
3) PSERS: "There are two Governor appointees and the Secretary of Education on our Board," notes PSERS spokeswoman Evelyn Tatkovski Williams. That's not enough votes for Wolf appointees to dominate the rest of the members, who represent the (currently Republican) state Senate and House, teacher and retiree groups. The Governor would need a new law to enable him to single-handedly change investment policy.
More generally, Williams said: "We are not aware of the details of the Governor’s proposal on investment management fees. We have not met with him," and won't comment on details of the proposal until they are available.
That said, the PSERS spokeswoman added that the higher fees PSERS pays, contrary to what Wolf or Shapiro claim, more than pay for themselves: "Our investment management fees are not excessive relative to the incremental value generated. PSERS paid $482 million in investment expenses for the fiscal year ended June 30, 2014. This amounts to 0.93% of our fund. (Again, some managers collect a lot more than PSERS reports).
"By spending those fees, we earned an additional $1.27 billion (net of fees) ABOVE the index return," Williams added in an email. "We would not have that additional $1.27 billion or 2.8% in additional investment performance if we did not use active managers.
"Looking longer term for the past 15 fiscal years (2000-2014), PSERS incurred $4.96 billion in investment management fees. In exchange for those fees, the Fund received the index returns plus an additional $16.42 billion in excess performance gross of the fees incurred. So, net of fees, PSERS generated $11.46 billion of incremental performance above the applicable index returns. At the total fund level for every 1 dollar that the fund spent in investment management fees, the fund earned the index return PLUS an additional 2 dollars net of fees over the past 15 years. PSERS has exceeded the passive index implementation of the asset allocation plan in 12 of the past 15 years, net of all fees.
"The real question is, should the Fund 'save' on management fees ($4.96 billion over 15 years) and give up on the returns/alpha generated in excess of the index performance ($16.42 billion over the same 15 years)? Who then is responsible for the lost performance (net of fees) of $11.46 billion?"
Still, Williams added, "PSERS is not opposed to indexing. PSERS’ philosophy is to use indexes in those asset classes where we do not believe we can find active managers who can beat the passive indexes on a net of fee basis. As of December 31, 2014, we had over 20% of the portfolio, or over $10 billion, in passive indexes managed internally by PSERS’ Investment staff.
"To the extent that any active manager is not performing up to our expectations, they will be terminated. An example is our U.S. equity allocation where 15 years ago we were primarily active in our implementation. Today, we almost entirely manage that allocation internally using passive indexes. PSERS uses passive management if we do not believe we can outperform the policy indexes net of all fees and cost. However, as noted above that has not been PSERS’ experience."
She also put it this way: Merely reducing management costs, which totalled $482 million for PSERS last year, "would have a marginal effect on the unfunded liability (which totalled) $35.1 billion" at June 30. If "saving on the management fees would mean giving up a large portion of the $1.27 billion in excess performance noted above," then "the unfunded liability is too large for any significant impact, even if there were no management fees at all."
In sum, "you get what you pay for."
PSERS would welcome the "extra infusion of cash" Wolf wants to raise by borrowing money, to help "begin to address the long-term underfunding of (PSERS) by the Commonwealth and School Employers," Williams concluded.
4) JANNEY ON PENSION BONDS: I asked Alan Schankel, managing director at Janney Montgomery Scott, if Wolf's proposal to boost PSERS funding by borrowing $3 billion is a good partial solution to the state's long failure to fully fund pensions.
"I am not a big fan of pension bonds," Schankel told me. "Issuing pension bonds retains and hardens the liability, just moving it to a different place on the balance sheet. Pension liabilities are a bit softer than bond obligations so the state loses some flexibility with bonds; they can defer a pension contribution for a year, for example, but not a debt service payment.
"It is true that the pension fund should get better returns from broad markets with the $3 billion (from Wolf's proposed bond sale) than the interest rate paid on pension bonds (he figures pension bond investors will demand roughly half the 7.5 percent rate that PSERS targets for yearly investment yield). That's the rationale for issuance (of pension bonds.)
"But if, theoretically, the state got the $3 billion, invested in the (stock) market and then the market crashed, they could be further behind. That is what happened to Puerto Rico which borrowed about $3 billion using pension bonds in 2008. Lousy timing." It's less risky (but also less potentially lucrative) to invest borrowed money "strategically," a little at a time.