Rebel pension results boost the case for index funds

Josh Shapiro, now the Pennsylvania Attorney General, moved Montgomery County's pensions to index funds a little over three years ago.

Why don't they just put it all in index funds? That's not enough to cure Pennsylvania's public worker pension finance troubles. But new data reinforce the suggestion: It could help.

The largest of the state's 3,000 state and local plans — such as the $40 billion Public School Employees' Retirement System, the $25 billion State Employees Retirement System, and the $5 billion Philadelphia system — face similar challenges:

Each has fewer public workers paying a chunk of their salaries to help fund their pensions, compared with the growing number of retirees.

Each has inherited multibillion-dollar deficits from elected officials who pledged relatively generous pensions — which have risen faster than a lot of private-sector pay schemes, pegged as they are to police- and teacher-union contract pay — but never set aside enough money to pay for them.

(Pennsylvania taxpayers pumped $2 billion directly into SERS last year — six times what state employees contributed from their paychecks — while Philadelphia puts one-seventh of its annual budget into yearly pension subsidies that payroll deductions and investment profits didn't cover.)

The three systems, overseen by boards that include elected officials, pay top dollar to hundreds of investment funds — hedge, buyout, real estate, venture, commodity, stock and bond, U.S. and foreign funds — in hopes of using their size and expert professional assistance to squeeze a little more profit out of the markets than you or I will probably achieve.

The major plans are so far behind their targets that it weighs on state and city credit ratings. For every $1 billion that Pennsylvania borrows to fund its highways, prisons, and other construction projects, it pays $7 million in extra interest a year, compared to more solvent states such as Delaware or Maryland, due in large part to fat pension liabilities, according to Moody's and Standard and Poor's. 

Ever so rarely, a pension plan's trustees rebel, fire the exotic managers and pump the people's money into automated stock and bond index funds, the kind of lower-fee, plain-vanilla investments that Vanguard Group founder John C. Bogle has been pitching for 40 years.

It's now a little over three years since suburban Philadelphia's Montgomery County, third-largest of Pennsylvania's 67 counties, fired its high-fee managers and gave 90 percent of its funds to Vanguard Group, which is based in neighboring Chester County, and the rest to hometown favorite SEI Investments, of Oaks, with orders to divide the pool among stock, bond, real estate, and U.S. and foreign investment index funds, at a fraction of the former cost.

At the time, Josh Shapiro, head of the Montgomery County commissioners, bragged that he was saving taxpayers a lot of money by firing wealthy stock pickers and buyout artists.

I pointed out that he had not yet saved the people a dime because cheap investments can turn out extra expensive, if they don't earn enough profits, net of fees, to outperform the exotic kind. 

But it's starting to look as if Shapiro, now Pennsylvania's elected attorney general, was right. After three years, a period when it starts to be a little bit intellectually respectable to compare investment returns, Montgomery County has outperformed its more-sophisticated rivals' plans.

For the three-year period 2014-16, SERS returned an average of 4.4 percent a year. Philadelphia returned an average of 1.5 percent a year. Montgomery County, with its index funds, returned 5.0 percent.

None of the funds achieved their long-term targets of around 7.5 percent a year. But Montco, with its index funds, did the least badly, outperforming the city and state funds weighed down by hedge funds and other low performers.

Philadelphia pension managers say they've seen the writing on the wall. Last year, they fired most of their hedge fund managers and shifted nearly half the total fund to indexed investments, especially to funds managed by Rhumbline, a Boston index-fund company that's as cheap as Vanguard. 

Pennsylvania has also moved more of its investments to index funds, which state employees manage even more cheaply than privately run index funds such as Vanguard or Rhumbline.

For calendar year 2016, as you might expect from the state's and city's increased use of indexed funds, results were a bit tighter: Philadelphia returned 6.7 percent, SERS returned 6.5 percent, and Montco returned just over 7.5 percent, making it the only one of the three to reach its long-term annual target.

For 2016, SERS trailed not just its yearly 7.5 percent target, but also the 7.3 percent "custom benchmark" its managers expected to achieve in last year's markets. 

SERS' real estate, in particular, performed poorly, compared with real estate indexes. Spokeswoman Pamela Hile blamed property revaluations, which SERS does every three years, for lower-than-expected reported gains. SERS' hedge funds and bonds outperformed their very-low fund-industry benchmarks, but still dragged down total returns for the year.

Three years makes for a "nearsighted" comparison, Hile warned me. SERS "has returned 8.6 percent net of fees over 30 years," and 7.7 percent — just above its long-term goal — in the last five years, she said. While one-third of SERS investments are indexed and more will be, a "diversified portfolio" still gives "the best value we can for our members over the long term."

The SERS and Montco numbers are subject to final revision. I'll check again later this spring, when New Jersey and Pennsylvania school employees' year-end pension investment returns are supposed to be ready, too, and we should have more detail on total fees paid and the relative performance of the individual money managers the firms hired.