A New Study Compares the Investment Expenses Paid by Large Public Pension Funds

“A new study, [Public Pension Management and Asset Investment Review Commission],… compares the investment expenses paid by large public pension funds. Although such comparisons are difficult because of vast reporting discrepancies, the study still raises important questions about investment expenses of these funds—including some in Illinois…

“Among 84 funds with assets over $10 billion… by far the most expensive on the list was Illinois’ largest fund, the Teachers’ Retirement System (TRS), at 1.58%, or $778.6 million…

“[T]he State Universities Retirement System (SURS), ranked 42nd with an expense ratio of 0.34% and expenses of $63.3 million, and the Illinois State Employees’ Retirement System (Illinois SERS), ranked 67th at 0.17% with expenses of $28.9 million. The average expense ratio for the 84 funds was 0.37%.

“Caution should be used in interpreting this information. As noted in the Pennsylvania report, it is difficult to precisely compare investment expenses among public funds because they are not reported consistently. This is particularly true for expenses related to so-called alternative investments that are not publicly traded, such as real estate, private equity and hedge funds.

“Illinois TRS’ ranking is partly attributable to a reporting change in FY2016 that more than doubled investment expenses, according to a spokesperson. Before FY2016, TRS subtracted real estate investment expenses from real estate income and showed only net real estate income in its Comprehensive Annual Financial Reports (CAFRs); the fund subsequently reported real estate expenses and income separately. Although the change made TRS’ investment expenses appear higher, it did not have any financial impact, the spokesperson said. Without the additional expenses related to real estate and other alternative investments, TRS’ investment expenses in FY2017 would have been $349.6 million instead of $778.6 million and its expense ratio would have been 0.70% instead of 1.58%...

“Besides reporting differences, funds’ investment expenses can vary due to the mix of investments. Over the past decade, public pension funds across the country have increasingly turned to higher-fee alternative investments to meet their investment return targets, but the use of alternative investments varies widely. In FY2017 TRS had 40.3% of its portfolio in alternative investments, 35.5% in stocks and 21.5% in bonds; for the 81 funds with assets over $10 billion that report allocations, the average mix was 26.2% alternative investments, 48.9% stocks and 22.4% bonds, according to Public Plans Data. (These numbers don’t sum to 100% because of a small percentage of assets in cash and other investments.)

“Investment expenses also depend on whether a fund’s investment approach emphasizes high-fee active management or low-fee indexing. As explained in the Pennsylvania study, active investing involves managing a portfolio to outperform the returns of a given market index, while index or passive investing involves investing in a set of securities to replicate the performance of a market index. TRS uses indexing for 33.5% of its stock portfolio. Illinois SERS, whose assets are managed by the Illinois State Board of Investment, has 65.9% of its total portfolio in index-type investments. In 2016 the Board of Investment revised its investment strategy to focus on indexing and reduce its exposure to hedge funds…

“Of course, even high investment expense is justified if it results in a higher return. However, the study concluded after subtracting fees and adjusting for the risk of various asset classes that low-cost investments usually outperform most managers.

“The Illinois General Assembly should consider requiring a similar study of its public pension funds. While the recent change in reporting by TRS is a step in the right direction, the public would benefit from uniform, comprehensive reporting of fees across all systems. Moreover, a systematic examination of asset allocation, investment approach and manager selection would help ensure that investment expenses are warranted.

“Although investment costs are important, neither increasing investment returns nor reducing investment costs will solve Illinois’ pension problems. At the end of FY2018, the State’s five retirement systems—including TRS, SURS, Illinois SERS and the Judges’ and General Assembly Retirement Systems—had a total unfunded liability of $133.5 billion and only 40.2% of the estimated assets needed to pay future benefits.

“Illinois is expected to spend $7.1 billion, or 18.2% of its general operating expenses, on pension contributions in FY2019. Even so, statutorily required State contributions are not expected to be sufficient to keep the unfunded liability from growing until FY2029.  

Under Illinois law, the State’s FY2020 contribution to TRS is $4.8 billion. The fund’s actuaries estimate that full funding would be 63.7% higher at $7.9 billion” (Public Pension Management and Asset Investment Review Commission). These excerpts are from the Civic Federation, January 11, 2019.