(See UPDATE in Paragraph 5 below) Citing "a difficult second half of the year," the underfunded, $27 billion-asset Pennsylvania State Employees' Retirement System says its investments returned only 6.4% last year, below the system's annual target of 7.5%, according to a report by Chief Investment Officer Tom Brier. The less the funds earn, the more taxpayers may have to pay, under state formulas designed to bring pension assets closer to long-term pension obligations.
SERS fell short despite its history of spending hundreds of milions of dollars a year on fees paid to a range of private managers and strategies designed to boost returns while protecting investments from weak markets. SERS's stocks, bonds, real estate and hedge funds all posted returns below the fund target. Only one category, "alternative investments," posted higher returns than the 7.5% benchmark for 2014, thanks in part to soaring private equity valuations attributable to the strong U.S. stock market of the past few years. But even alternative investment returns sagged, posting a loss of 0.3%, during the fourth quarter of last year as stocks turned down.
By contrast with SERS, Montgomery County's $500 milllion pension system saw investments return 7.7% for 2014, beating its own 7.5% annual target, county finance director Uri Monson told me. Starting in mid-2013, Montco dumped SERS-style private investments and investment managers and bought indexed stock, bond, U.S. and foreign-investment funds from Malvern-based Vanguard Group, in hopes of cutting costs and boosting returns.
The Vanguard funds in Montco's portfolio returned 7.99%, with investments in a real estate stock (REITs) indexed portfolio leading total returns above the target. Indeed, Vanguard's indexed REIT investments returned 30% in 2014, according to Montco; SERS's "Real Assets" private fund managers returned just 6%.
(UPDATE: Why such a difference? SERS spokeswoman Pamela Hile tells me SERS's REITs actually returned 32% [corrected, from previously reported 38%, by SERS] -- beating Vanguard REIT index's 30% return -- but SERS now lumps in energy and commodities along with real estate -- and with the fall in the price of oil, that cut the combined (Real Estate + Energy + Commodities = Real Assets return) down to just 6% for the year.
(SERS ADDS: "To provide more context, SERS actually has two REIT portfolios – a U.S. (comparable to the Vanguard REIT index) and a global. The global portfolio returned 14.3% net of fees in 2014, for a combined overall [U.S. plus foreign REIT] performance of 17.1% net of fees for the year.")
(And how did Montco avoid being similarly caught by the falling price of oil? Did Montco invest the people's pension dollars in energy and commodities? "We did not," Monson told me.)
Montco commissioners' chairman Josh Shapiro says the Vanguard indexed funds, based on current allocations, have generally beaten the pension plan's actual privately-managed fund returns going back more than 10 years, and charged much lower fees to get those better results. Shapiro predicts his index-fund-based county pension system will spend less on investment management fees and earn higher profits in the future.
Montco still holds some funds in privately-managed accounts it hasn't yet terminated. The county has also invested some assets in alternative funds managed by SEI Corp., Oaks (the county's SEI investments returned 7.4% in 2014).
One-year comparisons have limited value; profits in a given year don't predict future years. Montco's own analysis shows that, in years when markets fell instead of rising, the old multi-manager investment program lost less money than indexed funds did. But markets have risen, and indexes outperformed the county's actual investments under the old program, in most years.
New Pennsylvania Gov. Tom Wolf in his recent budget address called for SERS and the teachers' pension system PSERS to reduce their reliance on high-fee private managers, and put more in indexed investments. Joe Torsella, a Democratic candidate for State Treasurer, has called for a similar shift to indexing. The governor and treasurer control several seats on the SERS and PSERS boards. But a majority are held by legislators and appointees who in the past supported the program of buying a wide range of investments from private managers.
Past Pennsylvania state treasurers including Barbara Hafer and Rob McCord, before his recent resignation in the face of federal corruption charges, have also defended the use of multiple private managers, and New Jersey in recent years has moved away from in-house management by state employees to hedge funds and private equity funds.
Why do states continue investing in multiple investment categories? Money managers who had or sought state pension business were in past years an important source of campaign donations for McCord and other past state treasurers, governors of both parties, and other Pennsylvania politicians.
Since 2010, federal law limits state and local governments from paying fees to investment managers who have donated to state and local campaigns; in the first civil case brought by the SEC since the ban, Wayne-based TL Ventures was forced to repay around $300,000 in fees it had collected from Pennsylvania and Philadelphia after the agency caught founder Robert Keith giving money to Philadelphia Mayor Michael Nutter and then-Gov. Tom Corbett.
But investment managers have continued to contribute to federal campaigns, including those associated with state and local politicians, such as the Republican Governors' Association, which collected fees from money managers who handled New Jersey state pensoin investments when the association was headed by New Jersey Gov. Chris Christie. Some legislators in New Jersey have moved to ban all political contributions by money managers doing business with the state; Philadelphia City Council has asked money managers hired by the city to disclose campaign contributions at all levels.