Pennsylvania Gov. Tom Wolf's plan to reduce pension fund costs is a credit positive for large passive asset managers such as BlackRock, Vanguard and State Street Global Advisors, said Moody's Investors Service.
"These firms will be the biggest beneficiaries of the strategic reallocation," Moody's said in a credit report on Monday. "Conversely, the shift is credit negative for active asset managers because this proposal is yet another sign of investors' increasing preference for lower-cost passive products."
Wolf's $30 billion budget proposal for fiscal 2016 to state lawmakers last week included a proposal to slash investment costs for Pennsylvania's two largest pension funds, the State Employees' Retirement System and the Public School Employees' Retirement System, by shifting more assets into low-cost index funds.
"Investment return data shows it makes sense to cut down on expenses to boost returns, so I think it is a sensible approach," said Tom Kozlik, a director at Janney Capital Markets in Philadelphia. "Every little bit helps."
Wolf essentially modeled his plan after Montgomery County, Pa. Two years ago the county, which borders northwest Philadelphia, voted to move 90% of its roughly $500 million pension-fund assets to passive manager Vanguard.
Passive investing emphasizes a diversified portfolio and minimizes fees. County officials say fees have dropped by more than two-thirds, saving the county more than $1.3 million annually. Basis points have dropped from 46 to 17, according to Josh Shapiro, chairman of the three-member Montgomery County Board of Commissioners and a member of the executive committee of Wolf's transition team.
"This is not only about fees but about returns," Shapiro said in an interview.
According to Shapiro, the diversified index fund portfolio Montgomery chose had annual average returns of 10.11% over 30 years, well above the assumption target of 7.5%.
Moves to curb investment fees are on the rise nationally. Last September, the California Public Employees' Retirement System exited all hedge fund investments to reduce the fund's portfolio complexity and risk and investment management costs.
"What people like CalPERS are doing is just the tip of the iceberg," Shapiro added. "We did the whole thing."
At the municipal level, New York City Comptroller Scott Stringer has undertaken a six-point overhaul of operations within the Bureau of Asset Management, which included a ban on placement agents across all investment classes of the city's five pension funds, valued at $161 billion.
"A driving force behind this movement is active managers' inability to consistently generate returns in excess of benchmark returns net of fees," said Moody's. "Reducing the amount of assets that go to pay investment management fees annually, all else being equal, has a positive effect on investment returns and higher returns in turn help narrow pension systems' funding shortfalls."
Kozlik warned that the strategy alone will not solve Pennsylvania's budget or unfunded pension liability woes.
Pennsylvania estimates its unfunded pension liability at $50 billion. Funding levels for SERS and PSERS were at 62.4% and 63.8%, respectively, as of June 30.
The governor has also proposed issuing $3 billion of pension obligation bonds.
"There are more significant issues for Pennsylvania to grapple with in order to reach structural balance and improve its credit standing," Kozlik said.
The three major bond rating agencies downgraded Pennsylvania last year, citing its pension liabilities. Moody's rates the commonwealth's general obligation bonds Aa3. Fitch Ratings and Standard & Poor's rate them AA-minus.
Pennsylvania's Office of the Budget said late Friday that it would borrow $500 million more from the state Treasury for its short term investment program account to meet payroll obligations, should the commonwealth need it. Budget officials cited "ongoing issues with Pennsylvania's structural finances and past budgetary practices."
With the added $500 million, the maximum amount of the current STIP is $2 billion. Wolf's predecessor, Tom Corbett, made a $1.5 billion internal loan agreement late in 2014.
