Do Public Pensions Need a Shift in Investment Strategies?

A report, which says their investments have underperformed since the 2008 financial crisis and are costly, suggests officials should switch to purely passive investing.

Public employee pension funds, endowment funds and other nonprofit institutional investors in the U.S. have underperformed properly constructed, passively investable benchmarks by a wide margin since the global financial crisis of 2008, contends Richard Ennis, an early pioneer of quant investing and co-founder of U.S. investment consultancy EnnisKnupp, in a research paper.

A composite of 46 large public funds underperformed a passively investable benchmark by 155 basis points (bps) per year for the 12 years ended June 30, 2020. The composite underperformed the benchmark in 11 years out of 12, according to his findings.

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With public defined benefit (DB) pension plans’ holdings of $4.5 trillion (according to public plans data from the Center for Retirement Research [CRR] at Boston College), Ennis figures that underperformance of 155 bps per year costs stakeholders nearly $70 billion a year.

Ennis notes that a number of public pension fund officials might disagree with his findings and point out that their funds have outperformed their benchmarks or at least matched them. However, Ennis refers to public pensions’ benchmarks as “reporting benchmarks”—i.e., performance benchmarks of the funds’ own devising that they employ in their annual reports. He argues that his comparisons of returns of the reporting benchmarks of 24 of the largest U.S. public funds over the decade ended June 30, 2020, with the returns of “properly constructed,” passively investable benchmarks tailored for each of those funds found evidence of a sizable downward bias in the returns of custom benchmarks.

Ennis says the “extreme diversification” of public pension funds makes them more costly, “with poor prospects for keeping up with a passively investable benchmark over time.” Citing data from the CRR and Greenwich Associates, Ennis says large public funds use an average of 182 investment managers, commingled funds and partnerships; they index about 22% of their assets; and their typical allocation to alternative investments is approximately 28% of assets.

In the paper, Ennis makes some similar points about endowments’ investing. He notes that both public pensions and small endowments underperform by the amount of their cost. The solution, he says, is for fund trustees to invest purely passively at next-to-no-cost.

The paper, “How to Improve Institutional Fund Performance,” is available for download here.

Not Everyone Agrees

In a statement to PLANSPONSOR, Hank H. Kim, executive director and counsel of the National Conference on Public Employee Retirement Systems (NCPERS) in Washington, D.C. said: “Blessed with 20-20 hindsight, another analyst has come up with the idea that passive investing is better than active investing for public pension plans.

“Anyone can look back and detect patterns. Looking ahead is the perennial challenge for investors. Foresight is inevitably imperfect, and this is why professional investors arm themselves with as much information as possible, and then diversify and take steps to guard against downside risk.

“Index investing has a place in portfolios; Ennis himself has noted this, calculating that 22% of assets in large public plans are indexed. But in managing public pension assets for the long-term, professional investing and the flexibility to choose investments within carefully established guidelines have been a proven formula for decades. Matching the markets this year or next isn’t the goal of public pension funds; the goal is to keep the funds of contributors and employers growing prudently over the long haul.

“The ability to seize opportunities is lost in passive investing; so is the ability to exit an investment nimbly when markets are in turmoil. There is also growing body of academic literature to show that index investing contributes to the overvaluation of assets. A National Bureau of Economic Research study has shown that passive flows into the S&P 500 over the last two decades disproportionately increased the prices of its largest members.

“The late Vanguard CEO Jack Bogle, known as the father of the index fund, warned shortly before his death in 2019 that index funds, while a triumph for retail investors, could also yield broader and detrimental consequences. ‘If historical trends continue, a handful of giant institutional investors will one day hold voting control of virtually every large U.S. corporation. Public policy cannot ignore this growing dominance, and consider its impact on the financial markets, corporate governance, and regulation. These will be major issues in the coming era,’ Bogle wrote in the Wall Street Journal.

“It is naïve, simplistic, and potentially dangerous to suggest that a wholesale shift to index investing is in the best interests of public pension funds or indeed the U.S. economy as a whole.”

Any opinions stated in the study or in the statement to PLANSPONSOR do not necessarily reflect the stance of Institutional Shareholder Services Inc. (ISS) or its affiliates.

Can Employees of Tax-Exempts in Puerto Rico Participate in 403(b)s?

Experts from Groom Law Group and CAPTRUST answer questions concerning retirement plan administration and regulations.

We are a national 501(c)(3) tax-exempt organization who recently started employing individuals who live and work in Puerto Rico. Since citizens of Puerto Rico are also U.S. citizens, can they participate in our 403(b) plan?”

Charles Filips, Kimberly Boberg, David Levine and David Powell, with Groom Law Group, and Michael A. Webb, senior financial adviser at CAPTRUST, answer:

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This is a very good question. Unfortunately, there is no straightforward answer. An employee benefit plan covering Puerto Rico bona fide resident employees or individuals who primarily render their services in Puerto Rico must be qualified under Puerto Rico Code Section 1081.01.  However, there is no direct Puerto Rico counterpart to Code Section 403(b). As a result, allowing the participation of Puerto Rico resident employees in a 403(b) plan that is not qualified in Puerto Rico would cause negative tax consequences under Puerto Rico tax law for both the plan sponsor and the Puerto Rico participants as plan contributions would be treated as Puerto Rico taxable wages. 

In theory, a 403(b) plan could cover Puerto Rico resident employees only if such plan’s framework meets the Puerto Rico qualification requirements under Puerto Rico Code Section 1081.01 as a defined contribution profit sharing plan or a stock bonus plan and secures a favorable determination letter from the Puerto Rico Treasury Department. The 403(b) plan, in form and operation, must meet the Puerto Rico Code Section 1081.01 requirements regarding Puerto Rico resident employees. To be qualified under the Puerto Rico Code, the plan must comply with these requirements, among others:

  1. The plan must be funded through annuities or a trust (custodial accounts are not funding vehicles allowed under the PR Code).
  2. For the plan to offer elective deferrals under a cash or deferred arrangement, the plan must be part of a defined contribution profit sharing plan or a stock bonus plan.
  3. Plans qualified under the Puerto Rico Code are subject to all the provisions of Title I of the Employee Retirement Income Security Act (ERISA).
  4. Plans qualified under the Puerto Rico Code must comply annually with the nondiscrimination tests of the Puerto Rico Code.
  5. Puerto Rico income tax must be withheld on distributions from the plan to Puerto Rico resident participants and reporting to the Puerto Rico Treasury Department and the Puerto Rico resident participants must be made upon distributions.
  6. The plan must contain the Puerto Rico Section 1081.01 requirements for Puerto Rico resident employees.

 

Compliance by a U.S. 403(b) plan with Puerto Rico tax qualification requirements is not practical (though some U.S. 401(a) plans are dual-qualified).  Consequently, as an alternative, 501(c)(3) tax-exempt organizations normally set up a separate plan qualified for tax purposes only in Puerto Rico for its employees who are bona fide residents of Puerto Rico.

Plan sponsors are encouraged to consult with Puerto Rico counsel before making a decision to grant retirement benefits to their Puerto Rico resident employee. Factors such as tax, administrative and compliance matters shall be considered.

 

NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.

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