Are Pension Fund Managers Really Earning Their Fees?

It's hard to conceive of what today's mammoth stock markets would look like without the active participation of pension funds. They currently hold more than $1 trillion in equities, or 25% of the total value of U.S. stocks. Moreover, about 80% of such holdings belong to defined-benefit pension plans, which allow corporate sponsors to profit directly from superior investment returns by reducing pension contributions or even recapturing surplus assets.

Given such incentives and the huge amounts of cash involved, one would think that pension funds would do fairly well in the investment sweepstakes--particularly since a host of banks, insurance companies, and investment counselors compete vigorously for the job of managing such funds. But the surprising truth, according to a new study by economists Josef Lakonishok, Andrei Shleifer, and Robert W. Vishny in the latest Brookings Papers on Economic Activity, is that money managers lagged significantly behind the stock market itself during the lush bull market of the 1980s.

Drawing on data covering 769 all-equity pension funds with more than $120 billion in assets, the researchers found that on average the funds' annualized returns over each three-year interval (the typical period money managers claim they need to prove their expertise) lagged behind the Standard & Poor's 500-stock index by 1 percentage point and by 2.1 percentage points when the funds' returns are weighted by size. Average one-year returns produced even greater underperformance. And that's not counting management fees or lower returns on cash holdings.

The study also found that the funds would have performed just as well or in some cases even better if their stock portfolios at the start of a year had been frozen for 6- or 12-month periods. In other words, active trading over these intervals didn't seem to pay off.

To be sure, funds with high equity turnover rates over a three-year period did do significantly better than funds with lower activity. And the top 25% over a three-year period did outperform the lower 75% by an appreciable margin in the following three-year period. But these skilled managers still fell short of the returns posted by the s&p 500 by an average 1.5 percentage points a year.

The puzzle, in light of these results and the fact that management fees subtract an additional half a percentage point or so from fund returns, is that money managers have survived and flourished in recent years. Why haven't more funds dismissed their advisers and turned to passive investment strategies such as index funds? The answer, the researchers suggest, may be more sociological than economic.

Since corporate treasurers and their staffs are generally responsible for hiring money managers, monitoring performance, and switching to new managers when returns lag, the study notes that they would lose power if they turned to passive investment strategies. At the same time, using outside managers allows treasurers to deflect the blame if returns lag. For their part, money managers addto the aura of significant activity by "schmoozing"--constantly reporting on investment strategies and providing other forms of hand-holding.

Notwithstanding these blandishments, the researchers conclude that most equity pension fund managers subtract rather than add value to fund performance. And they predict that economic considerations will ultimately prevail and bring about important changes in the money-management industry. The big question, they say, is "how fast?"