Chicago City Pensions are Broke

Posted by Jeff Carter
on November 18th, 2010

Why doesn’t this surprise me? Nice expose at the Chicago Tribune on city pensions. Click there and read the whole thing. We knew Illinois was broke. Now Chicago pensions are broke too.

Of course, crony capitalism was at play. Political favors were paid with union pension money. It sounded good on paper I am sure. The pension administrators gave money to “Private Equity” funds that invested the money. Of course, the private equity administrators were friends of Chicago government.

Instead of highlighting all the political corruption, the Trib does a good job of that, I want to highlight a broader point.

You can’t beat the market. From the Trib article,

“The perception out there is that private equity returns are better than returns in the public markets,” Kaplan said. “But the data that’s needed to make those determinations just aren’t there. The best available information suggests that they are about equal to stocks.”

“But the S&P is a stock index made up of 500 companies worth $10 billion to $200 billion. Against public market indexes that track smaller companies, the firm hasn’t done as well. The Russell 2000 Index, for example, has had annualized returns that are more than double SB’s returns.

One Chicago pension fund that steered clear of private equity and real estate seems to be weathering the financial crisis better than other city funds.

By sticking to a portfolio of basic stocks and bonds, the Metropolitan Water Reclamation District pension fund’s assets lost 14 percent of their value from 2005 to 2009, according to financial documents reviewed by the Tribune. Meanwhile, the teachers, municipal and laborers funds lost more than 20 percent, and the firefighters fund lost more than 33 percent.

“Our board is very conservative in its approach,” said Susan Boutin, executive director of the water district’s fund. “They feel they have a commitment to employees and retirees to not take on those kinds of risks.”

The water district also spends less on consultants, asset managers and administrative expenses as a percentage of total assets than the other city funds.

Other funds are paying huge fees even for investments that have failed to meet their expectations. For instance, over the last seven years, the teachers and municipal pension funds have invested $30 million in the Chicago-based private equity firm Hispania Capital Partners. So far, the investment is worth $4.2 million less than what was put into it.

That’s one of the worst performances found in the Tribune’s analysis. But every year, because of management fees, Hispania’s end of the deal grows. So far, it has received $2.3 million in fees.

SB Partners, a small private equity firm run by the former chief executive officer of Shorebank out of a single-family home in Holland, Mich., received $9.4 million from the municipal and laborers pension funds since 2000 while collecting more than $940,000 in fees.

It has invested in eight companies, including a string of Taco Bell franchises in Mississippi, Florida and Alabama; a water-heater leasing company in Wisconsin; and a single-location pharmacy in Denver.

At the end of 2009, SB had an annualized rate of return of about 4 percent, according to pension fund documents.”

Coincidentally, there is an article in the Wall Street Journal by Burton Malkiel. It talks about buy and hold investing. ”Low-cost index funds regularly outperform two-thirds of actively managed funds, and the one-third of actively managed funds that outperform changes from period to period. Even the very few professional investors who have beaten the market over long periods of time—Berkshire Hathaway’s Warren Buffett and Yale University’s David Swensen, for instance—are quick to advise that investors are likely to be much better off with simple low-cost index funds than with expensive actively managed funds.”

This is an important concept for the average investor. Toss your money into a passive mutual fund and dollar cost average. Over the long haul, you will make more money, and spend less money in fees. The markets of the past two years have proven that concept beyond a shadow of a doubt.

Certainly you should diversify. Buy the S+P, the Russell, and other countries indexes. But, buy passive no load indexes. When it comes time to retire, you will be glad you did.

If you want to seek higher returns, you have to assume more risk. Using futures and options can increase returns. Why is the cash equity market efficient when futures markets are not? The answer is margin and time. Futures markets respond to information and have volatile moves up and down depending on a lot of factors. But as the time of expiration draws near, futures markets get less volatile and approach the price of the cash market. Options follow the Black Scholes mathematical formula, but also move around a lot in response to news, speculation and time.

Other ways to seek higher returns are to invest in start up companies. You could also start one by yourself. But if you put money in a VC fund or a Private Equity fund, the returns are 100% determined by how savvy that manager is. They aren’t determined by the market.

University of Chicago Booth Graduate School of Business professor Eugene Fama first hypothesized the theory of efficient markets in 1962. He has been proven correct. Time to give him a Nobel Prize for Economics.

These are important lessons that everyone needs to know. No one can consistently beat the stock market. No one.

tip of the hat to Instapundit, thanks for the link!

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