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Thursday, Aug. 31, 2017 12:08 am

State cuts funding for teacher pensions

Pension fund resists move to passive investments

Warren Buffett bets on the S&P 500.
PHOTO Lionel Hahn/TNS
The head of the state pension system for teachers warns that a $531 million reduction in expected state contributions to the pension plan this year will cost taxpayers $1.6 billion in the future.

“Cutting the state’s contribution only increases our concern that TRS will eventually become insolvent,” said Dick Ingram, executive director of Teachers Retirement System in a written statement. “For every dollar that the state cuts from the TRS contribution now, they will have to spend $3 down the road to replace that revenue because of the interest costs.”

The changes approved by the General Assembly will reduce the state’s contribution from $4.56 billion to slightly more than $4 billion during the current fiscal year, more than $2.8 billion less than what the TRS says it needs to fully fund the pension system this year. TRS says that unfunded liabilities total $71 billion.

The TRS board of trustees approved the lower payment last Wednesday to comply with state law. At the same meeting, trustees allocated $525 million to five investment firms that collectively already managed $865 million in TRS assets. The bets on private money managers came amid growing skepticism among financial experts nationwide that actively managed portfolios can outperform index funds or passive investments.

David Urbanek, TRS spokesman, said that board has rejected arguments that index funds, which have low fees and track benchmarks such as the Standard and Poor’s 500 or Dow Jones Industrial Average, are a better bet than money managers who are paid to outperform the market. About 30 percent of TRS’s portfolio consists of passive investments, Urbanek said, and history has shown that paying fees to external money managers is wise.

“The best proof of that is, our annual rate of return over the last 30 years is 8.1 percent,” Urbanek said.

But the S&P 500 went up by an annual average of nearly 9.5 percent between 1987 and 2017, assuming dividends were reinvested. It wasn’t a fluke. According to Business Insider, the S&P 500 had an annual average return of 10.77 percent between 1926 and 1956, and an average yearly return of 9.63 percent between 1956 and 1986. The S&P 500 has also outperformed TRS investments in the short term, rising 4.84 percent during fiscal year 2016 – 2.6 percent if dividends weren’t reinvested – when TRS investments had a return of .01 percent, after more than $300 million in fees were paid to money managers.

Numbers like those are fueling arguments that pension funds should drop money managers who get paid regardless of investment performance in favor of index funds. The typical deal has money managers collecting 2 percent of funds invested, regardless of performance, plus an additional 20 percent of any dividends realized. Pennsylvania last spring shifted $2.4 billion from actively managed funds to index funds, which charge a lower upfront fee than money managers and allow pension funds to keep all dividends.

The trend has also taken hold in Illinois. Last year, the Illinois State Board of Investment, which manages a $20 billion pension fund for state employees, judges and legislators, trimmed the number of money managers from 81 to 17, adding $1 billion to passively managed funds so that so that 44 percent of assets were invested in passive funds. Previously, slightly more than 28 percent was passively managed. The investment board’s portfolio realized average annual returns of 5 percent over the past decade and 8.2 percent since 1970. The S&P 500 has gone up by an annual average of 7 percent over the past decade and by more than 10.8 percent per year since 1970.

TRS spends more than the national average on fees, according to a study by the Pew Charitable Trust released last spring that surveyed 73 pension funds in all 50 states. The study found that the average pension fund that reported fees paid .34 percent of its portfolio in fees; TRS gave .54 percent of its portfolio to external money managers, according to the study, half what the Illinois Board of Investment paid.

Given that S&P 500 returns have, since Calvin Coolidge was president, consistently beaten average annual returns by pension funds in Illinois and other states, why not fire all the money managers, put every nickel into S&P index funds and exercise patience?

Urbanek says that TRS, which has money invested in real estate, private equity, bonds and hedge funds, believes in diversification. “We’re looking at the long, long term,” he says. “In that environment, you have to look at a diversified portfolio.”

But no less an investment sage than Warren Buffett argues that stock index funds are superior to actively managed funds that carry hefty fees. And he’s put his money where his mouth is. Despite a reputation as perhaps the most astute investor in U.S. history – his company Berkshire Hathaway has outperformed the S&P 500 by twofold since 1965 -- Buffett nearly 10 years ago bet $500,000 that no professional fund manager could beat the S&P 500 over the span of a decade. Ted Seides, a hedge fund manager, accepted the wager.

The bet isn’t over until December, but Buffett declared victory in February, at which point the S&P had realized a gain of 85.4 percent; Seides chose five hedge funds that collectively gained 22.4 percent. Furthermore, fees would have consumed approximately 60 percent of the gains realized in the five hedge funds, Buffett wrote in his annual letter to Berkshire Hathaway shareholders.

Conceding that he’d lost, Seides, in a May column published by Forbes, wrote that history wasn’t likely to repeat itself. Hedge funds usually outperform index funds in bear markets, he noted, and so Buffett benefited by virtue of a bull market.

“My guess is that doubling down on a bet with Warren Buffett for the next 10 years would hold greater-than-even odds of victory,” Seides wrote.

But Buffett gloated in his letter to Berkshire Hathaway shareholders. It’s likely that at least one money manager out of 1,000 will be right and have investments rise for nine consecutive years, he wrote, but that would also be true if 1,000 monkeys picked investments. The difference, he wrote, is that the lucky monkey wouldn’t have people standing in line to invest money.

“When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients,” Buffett wrote. “Both large and small investors should stick with low-cost index funds.”  

Contact Bruce Rushton at brushton@illinoistimes.com.

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