How Volatility Hits Pension Plans

by: Felix Salmon

Nanea Kalani of Honolulu Civil Beat has obtained non-public performance numbers for the Hawaii Employees’ Retirement System, and they’re not pretty at all: in the three months to September 30, the fund managed to lose $1.4 billion, or 11.2% of its value.

Hawaii ERS quarter ended Sept 30

What we’re seeing here is the brutal effect of volatility on portfolio performance. Let’s say you start with $1,000. If your portfolio falls by 5% and then rises by 5% — or, for that matter, if it rises by 5% and then falls by 5% — you end up with $997.50 — just a quarter of a percentage point away from where you started. But if it falls and rises (or rises and falls) by 20%, then you end up with just $960, down 4% on your initial investment.

There’s two different lessons to be drawn from the way that Hawaii is investing its money. Firstly, going for active rather than passive investment doesn’t work very well. The policy benchmark — what the fund would have returned if it was passively invested rather than actively managed — has consistently outperformed actual performance.

(Click to enlarge)

Secondly, Hawaii hasn’t chosen its managers very well: it’s also consistently underperforming the median public pension fund. If you’re relatively small (about $10 billion, in this case), it’s hard to outperform. As the Pension Consulting Alliance note puts it, “Relative underperformance can largely be attributed to the Plan’s equity (domestic and international) managers’ combined performance trailing their respective benchmarks”.

But there’s a deeper problem here, I think — and that’s related to the fact that the fund is being asked to return an “assumed actuarial rate” of return of 8% per year — in an environment of high volatility and extremely low interest rates. The right thing to do is to say “sorry, I can’t do that” — but that’s a great way to get fired. So instead, fund managers move further and further out the risk curve, in an attempt to hit their target returns. With predictable consequences.

Sometimes, the strategy works. In fact, the strategy is always going to work some of the time. The note proudly says that “the Plan outperformed the policy benchmark and the Median Plan in three of the last five 12-month periods”. But this is the problem with volatility: if you overshoot on the way up and you overshoot on the way down, you end up underperforming overall.

I’m not particularly picking on Hawaii, here, I’m just using it as an example. Most public pension plans have very similar problems. They take on more risk than they should, just because they’re being asked to hit unrealistic return targets. And the losers, of course, are all of us.