Arthur Frankenstein did not set out to create a monster. He had the best scientific intentions. He hoped to create a living being from, well, body parts. As Mary Shelley’s story plays out, we learn that Frankenstein’s experiment ended badly.
A much less grisly experiment began in 1911 in Massachusetts. That’s where the first statewide pension fund in the United States came into being. It proved to be a much more successful experiment but not without its own unforeseen consequences.
Today, all 50 states maintain at least one statewide pension plan. All but five have multiple statewide plans. And then there are all the city and county plans. Jurisdictions with multiple pension plans are the subject of this post.
Diversification is a cardinal principle of prudent pension fund management. The principle is written into fiduciary law everywhere. Public plan trustees have been scrupulous in their efforts to diversify investments. They invariably establish an asset allocation plan for diversifying among asset classes. They hire multiple investment managers. They use index funds. Their returns hew to broad market indexes. For example, my studies indicate that, on average, large public fund returns have an R2 of 98% with those of the market. Public pension funds are diversified to the nth degree.
Diversification Gone Haywire
Here is where things begin to get sticky. Large public funds use an average of more than 150 asset managers.[1] A precept of efficient portfolio management is that the investor does not use active managers for diversification, which can be carried out much more cheaply with index funds. Hiring scads of managers is costly. I estimate that public pension funds, with their 35% average allocation to pricey alternative investments and 20% or less in index funds, incur investment expenses of 100 to 150 bps per year. And they underperform market indexes by a like amount. Trustees are getting their diversification, yes — but with woeful inefficiency.[2]
The Monster We Built
Things get worse when there are multiple pension funds in a single jurisdiction. This results in redundancy amounting to de facto consolidation of all the individual funds, for that is its bottom-line impact on taxpayers. Consider a taxpayer in Los Angeles. Their taxation is influenced by the performance of three city pension funds, one county fund, and three statewide funds. The consolidated fund incorporates more than 1000 actively managed portfolios with countless individual positions. One portfolio’s losers offset another’s winners; investment bets by the hundreds cancel one another out. The result is an unholy index fund, patched together without intention and giving rise to a monster of inefficient diversification.
There are $5 trillion of public defined benefit assets in the United States. I estimate public plans waste $50 billion a year through inefficient diversification. The waste adds to the already enormous burden of funding public pension plans, which ultimately falls upon the taxpayers.
What is the solution? A few states, such as Minnesota, have a state board of investment. Although Minnesota has several statewide pension plans, their assets are pooled for the purpose of investment. This is a step in the right direction. But, as noted, individual pension funds tend to be inefficiently diversified, so there is no assurance that simply pooling plan assets will achieve the desired result. And state boards of investment typically leave out local funds.
A surer alternative is to index public pension assets in fact. Jumbo-size, government-run pension funds operating in a political goldfish bowl lack comparative advantages as investors. Passive investing at next to no cost transforms the game into one in which public funds can be consistent winners.
Key Takeaways
Public pension plans may use index funds or seem to follow market benchmarks, but in reality, they:
Still employ hundreds of active managers
Take on expensive alternative investments
End up with aggregate portfolios that mirror the market but at much higher cost
[1] See Aubry, J-P and K. Wandrei. 2020. “Internal vs. External Management for State and Local Pension Plans.” Center for Retirement Research, Boston College.
[2] See Ennis, R.M. 2025. “The Demise of Alternative Investments.” The Journal of Portfolio Management (forthcoming). https://papers.ssrn.com/sol3/papers.cfm?abstract_id=5163511.
