A Pension Jackpot for Wall Street

Most consumers understand that when you pay an above-market premium, you shouldn't expect to get a below-average product. Why, then, is this principle often ignored when it comes to managing billions of dollars in public pension systems?

This is one of the most significant questions facing states and cities as they struggle to meet their contractual obligations to public employees. In recent years, public officials have shifted more of those workers' pension money into private equity, hedge funds, venture capital and other so-called "alternative investments." In all, the National Association of State Retirement Administrators reports that roughly a quarter of all pension funds are now in these "alternative investments" -- a tripling in just 12 years.

Those investments are managed by private financial firms, which charge special fees that pension systems do not pay when they invest in stock index funds and bonds. The idea is that paying those fees -- which can cost hundreds of millions of dollars a year -- will be worth it, because the alternative investments will supposedly deliver higher returns than low-fee stock index funds like the S&P 500.

Unfortunately, while these alternative investments have delivered a fee jackpot to Wall Street firms, they have often delivered poor returns, meaning the public is paying a premium for a subpar product.

In New Jersey, for example, the state's alternative investment portfolio has trailed the stock market in seven out of the last eight years, while costing taxpayers almost $400 million a year in fees. Had the state followed the advice of investors like Warren Buffett and instead invested its alternative portfolio in a low-fee S&P 500 index fund, New Jersey would have had more than $5 billion more in its pension fund. In all, as New Jersey plowed more pension money into alternatives, its pension returns have routinely trailed median returns for all public pension systems.

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