Finance

How Public Pensions Can Start Healing Themselves

A series of questions and answers can help.

Be careful.

Photographer: Ken James/Bloomberg

Our discussion last week about representatives of the League of California Cities urging CalPERS, the state’s huge pension fund for public employees, to juice up investment returns generated a lot of interesting feedback.

It is clear that public-pension funds need some help. Rather than offer specific investment recommendations, I am going to make some suggestions to help them think about what they should be considering when reviewing their own portfolios.

It is important for managers and public representatives to understand what they know, what they don’t know, and what they can’t possibly know. Some of the biggest mistakes in asset management come from not knowing the answers to those deceptively simple questions.

What do we know?: Begin with that simple question of what any pension fund, consultant, or investment committee member knows. I’ll limit it to five issues that can be answered with a high degree of confidence.

What’s in the portfolio? This should be a simple question, especially when it comes to publicly traded equities and fixed income. You can find out exactly what those holdings are. However, the increase in alternative investments such as private equity, hedge funds and venture capital during the past few decades means that parts of the portfolio are opaque. Being aware of exactly what is in the portfolio is a key to answering many of our other inquiries.

What are our future liabilities? This usually can be answered with some confidence: you know how many people participate in your pension, their average ages and typical career lengths. A fair estimate should allow the calculation of future yearly obligations. The caveat is the further out we look, the greater the possibility of unforeseen events that might affect your projections.

What are our funding contributions? How much of our current obligations are funded? And what does the present funding level look like relative to future needs? Note that this is a political decision made by state or city legislators, who typically want to get re-elected and are averse to raising taxes. All that is really known with a high degree of confidence is the present funding levels.

What are our costs? Part of this can be known with great specificity — namely, contractual management fees and published costs of mutual funds and exchange-traded funds. Some costs, such as trading fee and salaries, can be estimated with a reasonable degree of confidence. But some items — namely, performance fees — can only be known retrospectively, based upon how well a manager performs.

How much risk are we assuming? There is a range of risks that a fund portfolio can have relative to the safest investment (aka risk-free) U.S. Treasuries. Do we understand what our risk profile is and how much more or less risk we might be taking?

What is unknown? The next set of questions pension funds should be considering is the unknowns: we can break this down into three broad categories of what might happen in the future:

Future market action: We don’t know about future profits, how individual stocks or regions will perform, or about inflation and interest rates. Basically, anything that could occur in capital markets and the economy in the future is an unknown.

Political action: Pensions are funded via direct contributions by cities and states. We know many pension funds are underfunded; we have also seen resistance from municipalities to allocate enough money to cover pension obligations. Although some states have specific rules about minimum funding of pensions, not all do. There is a variable political component to this.

Performance (and fees): The performance of active managers cannot be known in advance. Yes, there are hopes and wishful thinking, but it is not the same as actual returns. And, for pensions that have sizable investments in alternatives, the performance portion of the fees are similarly unknown. 

Last, many people seem to operate under a set of false beliefs that manifest themselves in the form of costly investment decisions. This is a challenge for both the future beneficiaries of any pension and the state that is obligated to fund them. Not coincidentally, lots of these costly errors are the result of doing business with individuals or firms with a vested interest in selling a product to the fund, or consulting on such products.

I believe pension funds should make the effort to have simpler, less expensive investments. Outperformance is hard to achieve, while holding down costs is something more attainable. But in the meantime, understanding what pensions do and don’t know is a great first step.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

    To contact the author of this story:
    Barry Ritholtz at britholtz3@bloomberg.net

    To contact the editor responsible for this story:
    James Greiff at jgreiff@bloomberg.net

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