Pennsylvania Pension Fund Initiates Shift to Lower-Cost Investment Strategy

Pennsylvania’s $72 billion pension fund for public school employees has taken a major step toward reducing investment management fees. On Dec. 18, the board of the Public School Employees’ Retirement System (PSERS) approved an update to its investment policies that includes a plan to eliminate $6 billion in hedge fund holdings and reallocate the proceeds to lower-cost investments over time.

Implemented as an update to the plan’s target asset allocation, the change will affect about 8% of the system’s portfolio and could reduce annual investment fees by more than $100 million. Cutting such fees keeps more money in the pension system to fund retirement benefits instead of covering external management costs.

The investment fee and transparency practices of Pennsylvania’s two major public employee pension systems have drawn attention in the state for several years. In 2017, lawmakers created the Public Pension Management and Asset Investment Review Commission as part of the comprehensive Act 5 pension reform legislation in part to examine such practices for PSERS and the separate Pennsylvania State Employees’ Retirement System (SERS).

More recently, the FBI and federal prosecutors, along with the Securities and Exchange Commission, began investigating PSERS’ financial records to determine whether plan officials exaggerated investment fund earnings and accepted gifts or money from outside investment advisers and consultants. PSERS has stated that it is fully committed to cooperating with both inquiries, which are ongoing. On Nov. 18, the PSERS board announced that the plan’s executive director and chief investment officer would retire during the first half of 2022.

With the board’s endorsement of the new strategy—which also has the effect of slightly increasing the risk profile of the system—administrators are now expected to implement the changes over the coming months and years. The vote represents the most concrete action to date to implement the fee-saving recommendations made in 2018 by the Act 5 investment commission. Lawmakers instructed that panel to identify $3 billion in potential investment fee savings across both plans over 30 years and suggest improvements to transparency and risk reporting practices.

Research demonstrating that Pennsylvania’s investment fees were among the highest in the nation helped inform the savings target and the broader commission mandate. In the most recent financial report from PSERS, for example, the plan reports a total of $584 million in investment fees—an amount that exceeds 0.8% of assets, which is more than twice the national average.

The expert panel met throughout 2018 and released a final report in December that year identifying nearly $10 billion in potential fee savings—far exceeding the legislative mandate—and making recommendations to strengthen investment transparency practices and conduct annual stress tests that assess plan performance under a range of economic conditions. Researchers from The Pew Charitable Trusts provided technical assistance on stress testing during the commission process, and on the creation of the commission as part of Act 5. The most recent effort could save $3 billion; additional fee reduction initiatives are underway at SERS and PSERS.

The move to significantly alter the investment strategy was initiated at the October meeting of the PSERS board by Richard Vague, Pennsylvania’s secretary of banking and securities. Former state treasurer Joe Torsella, vice chair of the 2018 investment commission, also supported the strategy. Plan investment staff then proposed the specific asset allocation changes for the board’s approval at the December meeting.

The board targeted its fee reduction effort on the absolute return asset class, which includes investments in several hedge fund strategies that are designed to diversify the overall portfolio by generating positive returns with low volatility and low correlation to public equities and bonds. These investments accounted for less than 10% of the portfolio but generated nearly one-third of all fees paid in 2021, according to asset class level fee data that has been published in PSERS annual reports since 2015.

Pew’s core investment transparency recommendations focus in part on reporting this information to inform investment strategies. Both the investment commission and the PSERS board have reviewed and analyzed additional information on fee structures for other asset classes, including private equity performance fees. Incorporating these fees into regular plan reporting is an additional step that would provide a more complete picture of fees paid and further align the system’s procedures with Pew recommendations.

An update on implementation of Pew’s recommendations and a discussion of the transparency issues facing state retirement systems will be included in a forthcoming brief. For that research, analysts examined transparency practices across the 50 states, compiling data on asset allocation, performance, and fees from the 73 largest state-sponsored pension funds, including both of those in Pennsylvania.

Greg Mennis is the director and Lennox Kohn is an associate with The Pew Charitable Trusts’ public sector retirement systems project.