RCZ - April 27,2022
Pension Fund Pathologies
Professor Timothy Riddiough, who is Professor at the University of Wisconsin—Madison and member of the Outsourced Research Advisory Board, wrote an important paper: Pension Funds and Private Equity Real Estate: History, Performance, Pathologies, Risks”
Here are some important conclusions excerpted from this paper and my own experience advising over 100 retirement systems:
Investment strategies shifted to more opaque, private equity, especially in real estate, with increasing underfunding of pension fund liabilities. Unfortunately, these funds have not delivered the value add and opportunistic targeted returns. Both investment styles risk-adjusted underperformed by 3% per year.
Riskier private real estate investments hinder price discovery and hides true asset volatility. I have shown that property returns are smoothed due to appraisal-based valuations, thus underestimating volatility and risk. Furthermore, investors are not compensated for illiquidity risk.
These underfunded plans are assuming greater risk and achieving performance less than they would were they to leverage core funds.
Institutions favor gateway cities which are especially vulnerable to negative asset pricing shocks.
Pension plan sponsors exhibit “pathological behavior” according to Professor Riddiough. They suffer from herding, display loss aversion, fail to exploit valuable investment platforms, and seek our riskier investments—a call option—to mitigate the underfunding problem.
Plans focus too much on absolute return and not enough on risk-adjusted return. The overall process of institutional investing is flawed due to principal-agent problems that include the investment committees, the pension staff including the CIO, the pension consultants, and the managers who invest the capital. Manager research is especially flawed as it takes instruction from the capital placement and marketing departments.
In other words, institutional investors take the pension plan to the casino.
The likely victims are state and municipal taxpayers.