The $7.8 Billion State Retirement System Rip-off

Daniel Solin

A recently published study by Jeff Hooke and Michael Tasselmyer of the Maryland Public Policy Institute took a look at the $37.6 billion Maryland State Retirement and Pension system. Their findings weren't pretty, but they are elucidating for both individual and institutional investors.

It wasn't all bad news. As usual, those advising the pension funds did spectacularly well. They reaped a whopping $221 million in fees for the fiscal year ending June 30, 2011. The hard working employees who are depending on the decent returns from plan assets fared poorly. According to the study, Maryland's returns trailed those of nearby states with June 30 fiscal years by about 1 percent each year. That might not seem significant until you convert this underperformance to dollars. It cost the plan $3 billion over the last 10 years.

The study correctly noted the current investment practice of most public pension systems. It is probably no different than the way you invest your personal assets. They go to a Wall Street firm that tells them they can "beat the markets", primarily by stock picking. They justify their hefty fees by claiming this expertise which, if it existed, would be very valuable.

The problem is there is precious little evidence that this expertise does exist. The study noted that during calendar year 2011, 84 percent of actively managed U.S. equity funds underperformed their benchmarks. It cited two other studies with similar results.

The authors looked at retirement plans in all 50 states. Total assets were a staggering $2 trillion. Total fees spent on Wall Street fees were $7.8 billion.

The conclusion and recommendation of the authors of this study will be familiar to readers of my books and blogs. Here it is: Buy index funds. That's it. By simply purchasing a globally diversified portfolio of low management fee stock and bond index funds in a suitable asset allocation (typically 60 percent stocks and 40 percent bonds for large pension plans), plan administrators could save the bulk of the outlandish fees they are paying for stock picking advice that often yields returns that underperform the index.

A more comprehensive study of the performance of state pension plans supports the conclusion of Hooke and Tasselmyer. This analysis looked at the performance of all state pensions plans for which there was publicly available data. Here's what they found: Over the 10-year and 23-year periods studied, all of the plans would have had higher returns with an index-based portfolio, with the stock portion tilted towards small and value stocks.

As Hooke and Tasselmyer correctly noted: "There is substantial evidence that Wall Street managers are unable to beat passive equity index funds that cost much less in fees."

It is unfortunate that participants in these state pension plans can do little to change the cozy system that rewards Wall Street at their expense. You are not similarly constrained when it comes to managing your own money. Fire your stock picking broker or adviser. Buy index funds. It's an easy fix.

Dan Solin is a senior vice president of Index Funds Advisors. He is the New York Times bestselling author of The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, The Smartest Retirement Book You'll Ever Read, and The Smartest Portfolio You'll Ever Own. His new book, The Smartest Money Book You'll Ever Read, was published on December 27, 2011.

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