The Return Illusion
November 10, 2016
“The asset allocation changes have performed as expected. In the seven fiscal years since the Great Recession of 2008, PSERS earned a net of fee return of 9.16 percent with significantly less risk, while materially outperforming a global 60/40 portfolio return of 7.85%.”
PSERS Chief Investment Officer James Grossman, Jr. from PSERS Press Release October 7, 2016
In the recent press release announcing results of the Pennsylvania School Employees Retirement System (PSERS) pension fund’s 2016 fiscal year, CIO James Grossman, Jr. suggested that asset allocation changes which diversified the fund away from exposure to the equity markets and into “non-correlated” asset classes had been a success, producing a lower-volatility portfolio which nonetheless exceeded the returns which would have accrued to a standard 60% equity/40% fixed income portfolio. This sounds as though the PSERS’ portfolio has been adeptly steered through some turbulent times, but unfortunately the PSERS fund remains a drastically underfunded plan which will continue to demand ramped-up contributions from the state and school districts.
An annual 9.16% return sounds great on paper, but, to borrow a sports analogy, what really matters is how you do on the field. On a historical basis, the PSERS’ fund has made little progress in improving its net asset value (NAV) during the current bull market. On June 30, 2009, the pension had an NAV of $ 42.995 billion, while at the end of June 2016, it reported an NAV of $50.2 billion—a measly 17% increase during a seven-year span in which the US equity indices tripled and interest rates fell (raising bond prices). Part of the problem is that the fund is cash-flow negative, paying out more in benefits and investment fees than it earns in interest, dividends, and other current income and receives in contributions combined. A dearth of cash-flow means that the fund is selling investments from its portfolio every year to make ends meet, and this weighs heavily on its NAV.
Faced with the persistent demand for cash, the PSERS fund would have been better served to place greater focus on increasing current income from its investments as well as reducing its investment fees and expenses. We compared the actual results of the PSERS fund with a 60/40 portfolio. The results are striking; the passive index portfolio would have ended June 2016 with $59.1 billion, a full $ 8.9 billion more than PSERS’s actual NAV.
Since the press release does not provide details on what Grossman specifically means by a global 60/40 portfolio, we chose a plain-vanilla index fund portfolio of 40% US equities/40% investment-grade bonds/20% international equities. Each year, the dividends received from the funds were used to pay out benefits in excess of the contributions provided by PSERS employees and employers and any additional monies were reinvested according to the 40/40/20 ratio. If, as in most years, the dividends were not sufficient to meet the required distributions to PSERS beneficiaries, shares were sold in the same 40/40/20 ratio to raise the cash.
One major advantage of the passive portfolio is the greater cash flow received—driven by the higher current yield and the lack of external investment fees in the index funds. The PSERS fund averaged $489 million annually in investment fees over the last seven years. This led to a consistently larger asset-drawdown for the PSERS fund than would have been experienced in the index portfolio.
While past results are no guarantor of future performance, a passive income portfolio would make sense for a pension fund like PSERS which finds itself with a consistent cash-flow mismatch between inflows and distributions. We would welcome the opportunity to discuss this approach with any concerned parties.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
Securities offered through LPL Financial, member FINRA/SIPC. Investment advice offered through Great Valley Advisor Group, a Registered Investment Advisor. Great Valley Advisor Group and Doylestown Wealth Management, Inc. are separate entities from LPL Financial.