A Pension Plan Decision You Should Follow

According to an article in Morningstar, the Illinois State pension plan has fired all active managers and will make no further effort to "beat the market."

The Illinois State Board of Investment terminated its relationship with T. Rowe Price, Fidelity, Invest and four other fund families. As a consequence, $2.8 billion of assets in the $4 billion fund will now be managed passively by Vanguard and Northern Trust.

Outside management fees will be reduced from more than $10 million to $1 million.

I have one question for the Board: What took you so long?

Pension plans typically underperform

On July 18, 2013, I wrote a blog for U.S. News. I discussed the sorry state of pension plan management. Most plans pay hefty fees to "consultants" who advise them which actively managed funds to buy and sell. These consultants usually ignore the data demonstrating most of these funds will underperform a comparable index fund over almost all time periods measured.

If the consultants advised their pension plan clients to invest in low cost index funds, they would be out of a job.

An exhaustive analysis of the performance of state pension plans found all of the plans studied underperformed a passively managed, index based portfolio.

On the surface, this data is surprising. Given the huge amount of their assets, pension plans can afford to hire the most qualified portfolio managers, with the most impressive track records. They can also retain the best (and most expensive!) consultants to help them select funds to include in their portfolios and to do ongoing due diligence on the performance of these funds.

Their large size also gives them leverage to negotiate lower fees than those available to the general public.

Despite these advantages, their track record is dismal.

The odds are daunting

The reason for the underperformance of pension plans is not surprising once you understand the data. According to an analysis provided by Dimensional Fund Advisors, for the 15-year period ending December 31, 2015, only 17 percent of stock mutual funds and 7 percent of bond mutual funds survived and beat their index.

Even if the consultants were successful in overcoming these daunting odds of picking a "winning fund", the possibility of that fund continuing to outperform is not good. Dimensional found that, of the 541 "winning" stock funds for the period 2001-2010, only 37 percent of them continued to "win" for the period 2011-2015. Fixed income funds had a better track record of outperformance. Of the 7 percent that were "winners", 51 percent continued to outperform.

A primary reason for the underperformance of most mutual funds is high costs and excessive turnover. Both are hallmarks of actively managed funds.

The takeaway for investors

You don't have the resources of large pension plans. Even if you did, judging by their track record, you would be better off in index funds.

You do have something they don't: Your investment decisions aren't influenced by politics and cronyism. You can invest based on a dispassionate review of the data. Once you understand the hype about active management is part of a well-oiled scheme to enrich consultants, brokers, and others who tell you they can reliably "beat the market", your path to retirement with dignity will become much more clear.

Isn't it time to follow the lead of the Illinois Pension Plan and reject active management in all its forms, including hedge funds and other alternative investments?

The views of the author are his alone. He is not affiliated with any broker, fund manager or advisory firm.

Any data, information and content on this blog is for information purposes only and should not be construed as an offer of advisory services.