An Easy Way to Reduce State Debt

According to a recent Bloomberg article, America’s biggest state pension systems earned less than half of what they needed to keep up with promises made to millions of graying civil workers.  This means states will either need to put more money into their plans or cut benefits to retirees.

Bloomberg compiled data from the most recent annual reports of state pension funds with more than $20 billion in assets as of June 30, 2010. These funds held a combination of equity and fixed income investments, hedge funds, venture capital funds, specialty funds and cash. They paid tens of billions of dollars in management fees, consulting fees, performance fees and trading costs.

You would think these funds performed well, given all the sophistication and expertise that billions of dollars can buy. Yet, for the 25 pension funds in the survey, the median 10-year return was a measly 3.15 percent ending in June 2011. That’s a disgrace. Although the median pension did show a positive return for the period, it significantly underperformed a simple portfolio of index funds.

This poor performance and the billions spent on fees could have been easily averted if state trustees listened to John Bogle years ago. The trustees should have just taken the return of the markets, as John Bogle said, rather than foolishly thinking they were the anointed ones who would beat the markets.

I have been writing about a simple Core-4 portfolio for several years. This portfolio covers the world in just a few low-cost index funds (ETFs can also be used). The Core-4 combines an equity allocation using a US total stock market index fund, a total international index fund, a real estate index fund (REITS) and a total investment grade U.S. bond market index fund.

The table below lists a Core-4 portfolio using Vanguard investor class shares. It is based on a 60 percent stock and 40 percent bond allocation. The portfolio is rebalanced each December, meaning the four funds are reset back to their original 60 percent stock and 40 percent bond mix.

Fund Name Mutual Fund Symbol Mutual Fund Expense Allocation in a 60-40 Core-4 10 Years annualized  ending June 30
Vanguard Total Bond Market VBMFX 0.22% 40% 5.4%
Vanguard US Total Stock Market VTSMX 0.17% 36% 3.7%
Vanguard Total International Stock VGTSX 0.26% 18% 7.0%
Vanguard REIT Index VGSIX 0.26% 6% 10.6%
60-40 Core-4 Portfolio Return Rebalanced Annually

6.0%

Any individual investor could have bought into this portfolio in June 2001. Pension funds could have also bought in, although at a much lower fee. Had this been done, the 6.0 percent return would have blown away the 3.15 percent return achieved in the state plans — and at a cost of about one-twentieth what the states actually doled out to an army of high-paid experts.

With state budgets as tight as they are, and state governors cutting teachers from classrooms, I have an idea that helps. Rather than cutting teachers, cut the fat in the Department of Treasury that manages pension assets. Fire the high-paid hedge fund managers and investment consultants and convert all state pension plans to 100 percent low-cost index funds. Then, rehire teachers with the cost savings.

John Bogle has been preaching low-cost indexing for more than 35 years. He knew then what so many high-level state trustees know today but won’t admit: big state pension plans have great difficulty beating the markets after fees and expenses because they are not skilled at doing so. Save the states a few billion dollars a year in fees and expenses by converting to all index funds, and save a few thousand teachers along the way.