Across North America, states and provinces should consolidate thousands of smaller public pension plans, which often are run inefficiently because of insufficient resources for effective investment management.
Such consolidation could improve investment outcomes and reduce costs. At small plans, even highly capable trustees lack the resources necessary to oversee effective and cost-effective investment management.
“We know that public pension funds benefit from economies of scale provided by larger size,” Keith Brainard, research director of the National Association of State Retirement Administrators, said in an interview. “Larger funds tend to have lower costs and generally are able to afford the resources, internal and external, needed to make sound investment decisions.”
There is some movement toward consolidation. Last year, Indiana consolidated the administration of seven state retirement funds — including the Indiana Public Employees' Retirement Fund and the Teachers' Retirement Fund — to place the investment management of a combined $26.2 billion under a single board of trustees, executive director and chief investment officer.
Two major entities, the state of Pennsylvania and the province of Ontario, are at least considering such moves, although the proposals are in the initial stage and haven't been embraced yet by legislators. The proposals call for consolidating thousands of public systems to achieve advantages of economies of scale in investment management and enhanced fiduciary oversight resources.
Pennsylvania has more than 3,200 local government pension plans, vastly more than any other state, and accounts for more than 25% of public pension plans in the U.S., signaling consolidation is in order and long overdue.
Jack Wagner, Pennsylvania auditor general, called for combining the plans, possibly in a new entity. The combined assets of just the 2,600 plans receiving state contributions that he examined in a study released in September would total more than $10 billion. That scale could provide more resources for more effective oversight than available now for those plans, whose assets average only $3.1 million each. Many plans have fewer than 100 active members.
The Pennsylvania Municipal Retirement System, which already oversees 950 plans with combined assets of $1.6 billion, could host the other local government plans in the state, but those plans would have to give up control of their assets and assumed rate of return, which helps determine contributions. That could be a deterrent as PMRS lowered its rate to 5.5%, effective Jan. 1.
Ontario's idea was put forth in a budget proposal earlier this year and a study released in October. It is more ambitious than the Pennsylvania proposal in size, according to a report commissioned by Dwight Duncan, deputy premier of Ontario and minister of finance, and prepared by William Morneau, executive chair of Morneau Shepell Ltd., a human resources consulting and outsourcing services company.
The report recommends creation of a pooled fund that could start with $100 billion in pension and other public investment funds. The pooled fund would consolidate assets of some 100 public sector funds in Ontario including investment funds like those of the University of Toronto with some C$5.3 billion (US$5.35 billion) in total endowment, pension and working capital assets.
“Implementation of such a framework would reduce duplication and costs, broaden access to additional asset classes and enhance risk management practices,” the report stated.
Keith Ambachtsheer, president of KPA Advisory Services and director, Rotman International Centre for Pension Management, Rotman School of Management, University of Toronto, calls Mr. Morneau's recommendations “spot on.”
Echoing the Ontario report, the Pennsylvania report said consolidation would “provide for greater investment returns.” And that is the bottom line.
Last year, New York City Mayor Michael Bloomberg and John C. Liu, city comptroller who oversees the New York City Retirement Systems, recommended unifying the boards of the five separate funds, whose assets total a combined $122 billion. Mr. Liu called the systems “unwieldy, inefficient and heavily politicized.”
The proposal, which never moved forward, might have gone further than the Ontario idea, under which the pension and other investment funds in the province would still keep their boards and have fiduciary responsibility for asset allocation.
A Massachusetts law is a step in the right direction, providing for transferring to the Massachusetts Pension Reserves Investment Trust board control of assets of local government retirement funds whose funded ratio and investment rate of return fall below specified minimums.
The Ontario report also looks at the U.K., where the Treasury and the London Pensions Fund Authority are evaluating the potential of creating a new investment entity that would manage £30 billion ($48.3 billion) in assets pooled from some 35 pension funds.
Other entities sponsoring public pension and other investment funds should examine the possibility of consolidation in the face of underperformance and relatively small amounts of assets. States with the largest numbers of public-sector defined benefit plans after Pennsylvania are Illinois with 451; Florida, 302; Minnesota, 137; and Michigan, with 132, according to Mr. Wagner's report.
The pressure of severe pension plan deficits and state and municipal financial budget distress is a primary catalyst for considering plan consolidation and should force policymakers to come to terms with obsolete, scattered systems of investment management.
“The most important reason for consolidation is to reduce cost of administration and ... improve investment returns,” Mr. Wagner said in an interview. These consolidations would save “easily in the tens of millions, if not hundreds of millions, of dollars” for taxpayers, while improving the retirement system finances. As Mr. Wagner noted, “The major funding source (for pension plans) comes through investments.”
But even a large plan cannot achieve scale advantages without well-structured governance, an independent board, and management with well-defined objectives, focused on implementing, monitoring and measuring them.
Meanwhile, the executive and legislative branches of Pennsylvania and Ontario should embrace the consolidation proposals to improve their public fund management, increase returns and reduce costs, and provide an example for other scattered systems.
Without consolidation, systems of scattered funds in many cases are not sustainable in the long run. n
This article originally appeared in the December 10, 2012 print issue as, "A bigger fund is better".