Active versus Passive Investment Management of State Pension Plans: Implications for Personal Finance

By Walden, Michael L. | Journal of Financial Counseling and Planning, July 1, 2015 | Go to article overview

Active versus Passive Investment Management of State Pension Plans: Implications for Personal Finance


Walden, Michael L., Journal of Financial Counseling and Planning


Introduction

Pension plans for state and local public employees are a key part of the nation's retirement system. In 2011 these plans covered 19 million active and retired workers and had a total asset value of $3 trillion (U.S. Census Bureau, 2012, 2013). While many private pension plans have shifted from defined benefit to defined contribution systems in recent years, state pension plans have overwhelmingly remained as defined benefit plans (Snell, 2009). Such plans-which specify the pension amount received based on the worker's salary and years of service-place the risk for meeting the liabilities on the state as opposed to the worker.

Recent studies suggest state pension plans may face a crisis in fulfilling their promises to enrollees. Plans typically discount future liabilities (payments to retirees) using an 8% discount rate (Congressional Budget Office, 2011). In the current environment of very low interest rates on lowrisk investments, critics argue the 8% rate is much higher than a generally accepted low-risk discount rate, thereby masking future payment problems state pension plans will face (Munnell, Aubry, Belbase, and Hurwitz, 2013). To make the payments to retirees, critics say the plans will require additional contributions from state funds. Such contributions could be significant, totaling $163 billion in present value terms for the next 30 years (Novy-Marx & Rauh, 2014).

This looming underfunding of state pension plans has prompted some state pension directors to attempt to increase their investment returns by allocating more funds to potentially higher return -yet riskier- investment categories (Walsh, March 2010). This idea raises some fundamental questions about state pension funds. State pension plans hire professional investment firms to actively manage the pension funds. The funds pay substantial fees to the firms for their services (Hooke &Walters, 2013). Could state pension funds earn the same-or superior-rates of return by following a passive investment management strategy using low-cost mutual funds? And if so, how would a shift from an active investment strategy to a passive investment strategy for state pension funds help the plans address their potential future payment shortfalls?

Using data measuring the investment performance of state pension funds over the 2003-2012 decade, this paper provides answers for these two important questions. Since the relative performance of active and passive investment strategies is also an issue for individual investors, the paper's analysis has implications for financial planners and counselors in their efforts to educate individuals about investment principles (Finke, Huston, and Winchester, 2011; Grinstead, Mauldin, Sabia, Koonce, and Palmer, 2011; Prawitz & Cohart, 2014; Robb & Woodyard, 2011).

The paper is divided into several sections. The next section reviews the longstanding debate between active and passive investment management strategies and summarizes the empirical research addressing the debate. Following is a section discussing the state pension fund data collected for the analysis as well as the three alternative passive management investment strategies used in the comparisons. The fourth section presents the empirical results from comparing actual state pension fund investment returns to the returns from alternative passive management portfolios. The fifth section uses the results from the active versus passive management comparison to estimate what a shift to a passive investment management strategy using low-fee mutual funds could mean for ameliorating potential future state pension payment shortfalls. The final section offers conclusions.

Active Versus Passive Investment Management

The debate over the relative merits and performances of active investment management and passive investment management strategies has occupied both investors and academics for decades. Active investment managers use their skill and knowledge to attempt to choose and alter the investment portfolio toward a goal of outperforming an investment market index. …

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