The years-in-the-making saga of Pennsylvania’s pension crisis (for a primer, click here) hit a new low as state Treasurer Joe Torsella revealed that a staggering $5.5 billion has been “wasted” on costly pension fund management fees. A Financial Times article last week detailed how the money was spent by the state on high-priced Wall Street advisors over the past decade, to little effect.
While the scale of the problem was larger than previously known – nearly five times higher than previous estimates – elected officials have long understood that the riskier investments and pricey fees paid to the funds’ investment managers were not paying dividends. Despite that knowledge, the 11-member board for the $29 billion State Employees Retirement System quietly approved another 10-year investment plan, developed by RVK Inc., that would continue to focus on the alternative investments that Torsella says has led to billions in waste.
“SERS already had one of the highest levels of investments in alternatives and just a few months ago decided they needed to invest in those funds further,” said Torsella spokesperson Michael Connolly. “These funds are often less transparent with much higher fees than what could be found on the open market.”
Many states have been drawn to “actively managed” alternative investments, which promise financial expertise that will help funds outperform the market – at least, for a price.
In total, Pennsylvania has spent $6.8 billion on similar private equity schemes over the past 10 years. However, Torsella maintains that the state retirement funds could have saved upwards of $5.5 billion and performed better with passively managed stock portfolios that simply tracked the major stock indexes like the Standard and Poor’s 500.
“The treasurer has long held the position that the pension funds that are as low-cost and low-risk as possible are the best option,” Connolly said. “SERS already had one of the highest levels of investments in alternatives in the nation.”
Every dollar is critical for SERS and the related Pennsylvania Public School Employees' Retirement System. Together, the funds are estimated to face unfunded liabilities in the range of $75 billion or more. Nevertheless, in April, the SERS board voted 7-4 to keep nearly 40 percent of the state employee pension investments tied up in the more costly actively managed alternative investment funds – which is still one of the highest rates in the nation.
Professor Donald Keim, a pension expert at the University of Pennsylvania, concurred with the treasurer's read on the latest investment plan.
"40 percent allocation seems really high," he said. "It doesn’t make sense. There’s simply too much evidence that actively-managed funds don’t provide sufficient additional return over and above the return on a passive fund with the same risk to offset the additional fees they charge."
So why invest more? The SERS board is comprised of elected officials, like Torsella himself, and appointees from Gov. Tom Wolf and General Assembly leadership, but sources familiar with its decision-making say that many members defer to SERS’ staff of financial advisors, who often hail from the financial sector. Others say board members like state Sen. Vincent Hughes have privately expressed concerns that passive management schemes could pass over investment opportunities in minority-owned firms.
Surprisingly, outside of the pension fund managers themselves, seemingly every political faction in Harrisburg professes support for controlling costly management fees.
Republican state Rep. Mike Tobash is leading a bipartisan pension reform committee in the state House that will produce a report recommending best practices to improve the pension funds later this year. He pointed to other efforts, such as the passage of House legislation that would require greater transparency from the state pension funds.
“There is a concern about the lack of lack of financial oversight in both pension boards. The commission intends to do a deep dive into those areas and produce savings for taxpayers,” Tobash said. “We are going to have a series of hearings on best practices for transparency, fees, and investment strategies...There is a House bill that deals with transparency and, along with the recommendations from the commission, we hope the Senate will pass it and the governor will sign it.”
Gov. Wolf said he also supports these legislative efforts, including a bill passed last year that requires the funds to cut $3 billion in management costs and reinvest the savings.
“From the minute the governor came into office, he made transitioning from active to passive investment a top priority,” said Wolf spokesperson JJ Abbott. “There will be a reduction in fees over time.”
However, it’s worth noting that three of Wolf’s SERS board appointees voted in favor of the recent investment plan – if they had voted according to the governor’s stated position on reducing fees, the board would have ended the costly use of investment managers for alternative investments instead of re-upping. Abbott said only that the appointees acted independently of the governor.
A spokesperson for SERS said only that the April plan provided “a prudent blueprint to continue to meet the long-term liquidity needs to pay benefits and covenants,” promising that the funds would hit their annual rate-of-return targets.
But, historically, SERS has sometimes missed its projected returns of 7.5 percent, at times by a wide margin. In 2015, the fund earned just 0.5 percent.
Torsella’s office maintains that there is no connection between management fees and fund performance.
“If they spent $6.8 billion in fees, sure that sounds like a lot. But, if it worked, why not spend $15 billion?” Connolly asked. “It’s because paying more doesn’t actually get you better performance.”