The Great American Pension Rip-Off

Unless you work for a city or state government, you probably don't have a traditional pension -- also known as a "defined benefit plan." The number of employers offering these plans has decreased sharply, and now, by some estimates, only 29 percent of workers in the United States have access to them. In contrast, 83 percent of state and local government employees have access to a defined benefit plan.

If you are one of these lucky few, consider yourself fortunate. Most defined benefit plans provide for an automatic payout in retirement based on a formula that typically includes the size of your salary and how long you worked for your employer.

No employee contribution is required, and employees are not permitted to take early withdrawals before a specified retirement age.

Participants are not involved with the management of the funds in a defined benefit plan. Instead, the fund is typically managed by "professionals" who are selected by the plan's trustees.

In theory, these plans should be a significant benefit to participants. And because some of these participants are members of police and fire departments, who put their lives on the line every day to protect the rest of us, we should take pride in knowing they will have a secure retirement.

Unfortunately, there is a massive gap between theory and practice in the way that the funds in pension plans are managed. Many plans are "underfunded," meaning the money required to cover current and future retirement benefits is not "readily available." Bloomberg has compiled a list of the most underfunded state pension plans, which you can find here. It's not a pretty picture.

This underfunding is caused largely by the underperformance of the plan's investments. An extensive study of the returns earned by state retirement plans over various time periods found that only one state managed to outperform a comparable passively managed index portfolio. And that single outperforming state, Oregon, did so by only a very modest margin.

The solution to this problem is disarmingly simple: Pension plans should fire their expensive consultants, who are engaged in the zero-sum game of trying to pick "winning" fund managers, and switch to low-cost passive investing. There are a number of reasons, however, why that is not likely to occur. Here are three:

Unwillingness to Accept the Data

A recent report commissioned by the United Kingdom's Department for Communities and Local Government reviewed how pension plans in England could be made more efficient. It found that local plans could save as much as $394 million annually by converting to passive investments over active ones. The report also observed higher turnover costs with active management investments because the fund managers traded more frequently in an effort to "beat the market."

The conclusion in this report was unequivocal. Relying on international studies, including from the United States, the report found that "any additional performance generated by active investment managers (relative to passively invested benchmark indices) is, on average, insufficient to overcome the additional costs of active management."

Fraud and Mismanagement

Being awarded a contract to manage a major pension plan can be very lucrative. Unfortunately, when there is money to be made, it can bring out the worst in "investment professionals." The amount of mismanagement and outright fraud involving pension plans is shocking and depressing. It includes "dark pools," "pay to play" arrangements, shady "placement agents" and sometimes outright bribes. Here's a recent example:

On June 20, the SEC announced that it had fined an advisory firm $300,000 for pay-to play violations. The advisory firm, which neither denied nor admitted wrongdoing, allegedly made political contributions to public officials who had influence over pension funds that do business with the firm.

For a helpful review of fraud and mismanagement involving pension plans, see this article by Rex Holsapple.

Ego and Cognitive Dissonance

Holding a position as trustee of a large public pension plan is definitely an ego boost. You wield a lot of power and are well compensated for your time. You are wined and dined by advisors and consultants who desperately want your business. When you select active management investments, you are assured an endless round of expensive dinners and meetings where you debate the merits of fund managers who succeeded or failed. The process of adding and dropping fund managers is never-ending.

It's tough to give this up. Going "passive" eliminates the thrill of the chase. The number of meetings can be reduced dramatically.

It's regrettable that the plundering of public pension plans continues unabated. At some point, better educated participants are no longer going to take it, and will hold trustees accountable for their conduct.

2014-04-01-Hiresfrontbookcover.jpgDan Solin is the director of investor advocacy for the BAM ALLIANCE and a wealth advisor with Buckingham. He is a New York Times best-selling author of the Smartest series of books. His latest book is The Smartest Sales Book You'll Ever Read.

The views of the author are his alone and may not represent the views of his affiliated firms. Any data, information and content on this blog is for information purposes only and should not be construed as an offer of advisory services.