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Trust Funds of the World: Unite! December 29, 2008

Posted by federalist in Economic Policy, Finance, Pensions.

State and local government pension funds contain several trillion dollars in assets.  I have previously highlighted the significant hazards of public defined-benefit pensions, but I neglected to note a particularly terrifying one: Many of these funds are overseen by novices.

Some time ago the WSJ reported on Stanford’s “Committee on Fund Governance” forum report:

Some recommendations are so elementary they seem hardly worth stating. One suggests trustees educate themselves about their duties. “A fund should identify and disclose its leadership structure,” reads another. Many funds profess to follow these and other principles. Yet Mr. Clapman says his group found “a very large percentage [of funds] are not doing one or more of” the report’s recommendations.

There is no reason for every trust to get involved in investment management when the only thing that varies between funds is how much they owe and when.  They’re all trying to do the same thing — and all for public benefit — so there should be huge economies of scale to merging their funds.  A number of UK endowments realized this and joined a cooperative called OXIP (Oxford Investment Partners).  Vanguard is a cooperative investment company in the US that offers similar outsourcing of investment management.

But outsourcing investment management does not go far enough.  Any ongoing exposure by taxpayers to pension obligations is dangerous and unjustifiable. Taxpayers, shareholders, creditors, and employees have no business carrying the risk that pensions will be underfunded or mismanaged, or that investments will not perform as projected.

Defined-benefit pensions should buy annuities to cover their liabilities. For a small fee this transfers the risks of longevity, investment performance, and investment management to third an insurance company which is formed and regulated precisely to handle those risks.  (As an added bonus, buying annuities from an insurance company makes it nearly impossible to obscure the present value of pension benefits being promised.)

The status quo is outrageous: The same government officials who offer pension benefits to government employees get to pick the models that predict how long pensioners will live and how well investments will perform.  These perennially optimistic projections make the pension obligations look cheap, but some taxpayer money is still taken and put in a trust fund to invest against those obligations.  Of course, these funds are under government control, which means they are constantly threatened with political abuse.  Meanwhile, the trustees are not investment experts, so they have to pay for a staff, which has to pay for consultants, which recommend funds of funds, which invest in individual funds.  Every party in this investment management chain collects fees, but none of them guarantees anything.  So when the trust fund comes up short the taxpayers have to cough up yet more money to cover pensions promised long ago, and nobody is held to account for the failure of the trust to meet its obligations.

If governments were not allowed to run their own pension fund scam, they could still offer defined-benefit pensions: They would just have to provide them by purchasing (up front) annuities from insurance companies.



1. federalist - December 30, 2008

Pension Tsunami is an extensive clearinghouse for coverage of pension fund perils.

2. Rob Yale - December 31, 2008

Federalist — This reminds me of the clever plan by Charles E. F. Millard the director of Pension Benefit Guaranty Corporation who wanted to increase returns and decrease risk. According to The New York Times (http://www.nytimes.com/2008/08/22/business/22norris.html?fta=y) Millard wanted to diversify his portfolio from Treasuries into more stocks.

He said, “If sixth-graders in America took finance, I could say to you that, ‘As every sixth-grader knows, diversification mitigates risk, and this policy is substantially more diversified, and that is why it has a lower standard deviation.’”

Which makes sense in normal times; however, if many companies pension plans are failing (which is when the PBGC is really tested) it’s unlikely that the stock market will be going up. It’s amazing what pension fund managers will let themselves believe (and hurt their actual performance) in order to raise their theoretical future returns.

3. federalist - January 13, 2009

David Swensen explains:

You can divide institutional investors into two camps: those who can hire high-quality, active-management investors and those who can’t. If you are going to invest in alternatives, you should be all in, and do it the way Yale does it — with 20 to 25 investment professionals who devote their careers to looking for investment opportunities. Or you belong at the other end, with a portfolio exclusively in index funds with low fees. If you’re not going to put together a team that can make high-quality decisions, your best alternative is passive investing.

Regarding funds of funds and consultants:

Fund of funds are a cancer on the institutional-investor world. They facilitate the flow of ignorant capital. If an investor can’t make an intelligent decision about picking managers, how can he make an intelligent decision about picking a fund-of-funds manager who will be selecting hedge funds? There’s also more fees on top of existing fees. And the best managers don’t want fund-of-fund money because it is unreliable. You need to be in the top 10% of hedge funds to succeed. In a fund of funds, you will likely be excluded from the best managers.

Consultants make money by giving advice to as many people as possible. But you outperform by finding inefficiencies most of the market has not yet uncovered. So consultants ultimately end up doing a disservice to investors.

4. federalist - January 14, 2009


State pension funds lost an estimated $865.1 billion in the past year, according to the Center for Retirement Research at Boston College. Most are expected to meet long-term obligations but likely will need additional public and employee contributions.

Assets in 109 state funds plunged 37% in the 14 months that ended Dec. 16, according to data released in January by the Boston College center. The funds, which have about 20.4 million members, now have about $1.46 trillion, down from $2.3 trillion in 2006.

Prior to the recent losses, the plans were on average 86%-funded, said J.P. Aubry, an economic research associate at the Boston College center.

5. federalist - March 4, 2009
6. federalist - April 6, 2009

Whoa: Commonwealth Foundation reports:

Pennsylvania maintains over 3,000 public pension plans at the state, city and municipal levels, the most of any state and approximately 25% of all such plans in America. Over 2,200 of these plans are of the often financially and politically problematic “defined-benefit” genre. According to the Pennsylvania Public Employee Retirement Commission (PERC), over 67 percent of these plans have fewer than 10 members.

7. federalist - March 7, 2010

Well, what do you know? Banks’ Latest Pitch: Pension Hedging. At least the private sector has realized it’s better to pay reinsurers to assume longevity risks of their defined-benefit plans. (Clarification: The private sector overseas, where a company can’t easily dump its pension liabilities on the government.)

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