Pennsylvania’s new governor, Josh Shapiro, hopes to end state pension funds’ reliance on external managers who often charge high fees and place funds in opaque “alternative investment” vehicles. As the Philadelphia Inquirer reported in late January, Shapiro told reporters: “We need to get rid of these risky investments. We need to move away from relying on Wall Street money managers.” If Shapiro is successful, Pennsylvania’s State Employees’ Retirement System (SERS) and Public School Employees’ Retirement System (PSERS) may achieve better returns with less risk, which is good for both public employees and taxpayers.

Reforms are needed because both systems are severely unfunded. As of June 30, 2022, PSERS had $71 billion of assets against an actuarially accrued liability of $115 billion. This latter value refers to the amount actuaries estimate is needed today to pay future benefits. This leaves the system with a funding shortfall of $44 billion and a funded ratio (assets divided by accrued liabilities) of just 62%. Pension systems should have a funded ratio of 100%, meaning that employers have set aside enough money to make all future payments.

SERS’ numbers are somewhat better, but that is partially because its last reporting date was December 31, 2021 before the bear market of 2022 set in. At that time, SERS had $40 billion of assets to pay $53 billion of liabilities, leaving a $13 billion shortfall and a funded ratio of 77%. But in six months, by June 30, 2022, SERS had lost $5 billion of its assets.

Pennsylvania’s state pension systems need to find $60 billion to reach full funding. One way to start closing this funding gap is to manage assets more efficiently, and this is an approach Governor Shapiro would like to bring over from Montgomery County, where he previously chaired the Board of County Commissioners. There, Shapiro spearheaded an effort to move county retirement assets into low-cost passive investment vehicles, such as index funds.

As The New York Times reported at the time, Shapiro became convinced that index funds were a good choice for public pension funds after meeting in 2012 with John C. Bogle, the founder of Vanguard, a leading provider of index funds. Mr. Bogle persuaded Shapiro and the County’s Chief Financial Officer that “no one is smart enough to beat the market over a sustained period of time.”

This advice appears to be working. Compared to Pennsylvania’s state pension systems, the Montgomery County Employees’ Retirement Fund is in better shape, most recently reporting a funded ratio of 84%.

If Shapiro is able to influence the state pension system boards to follow his county’s lead, large cost savings are possible. According to a PSERS presentation, the system paid $1.7 billion in 2021 to outside managers overseeing its $25 billion portfolio of alternative investments, including private equity, private credit and private real estate holdings (it is worth noting that most of these fees took the form of “carried interest,” a portion of investment gains collected by fund managers. Had 2021 been a down year, investment fees would have well below the 7% of assets PSERS incurred.)

Aside from Montgomery County, Pennsylvania can also look to other states that have successfully lowered investment fees incurred by their pension systems. In North Carolina, State Treasurer Dale Folwell began efforts to reduce fees and transfer assets from alternative products to index funds shortly after taking office in 2017. His department recently reported investment costs of $556 million on $111 billion of total retirement assets under state management, yielding an anuual rate of only 0.5%. The Teachers’ and State Employees’ Retirement System of North Carolina, the Tarheel State’s largest public employee pension system, recently reported a funded ratio of 95%. The Public Employees’ Retirement System of Nevada has also been making similar investment cost-cutting moves.

While it may appear that investing in complex, opaque, and trendy instruments is the smart call, market-beating performance usually proves to be fleeting. Keeping pension fund assets in poorly understood, high-fee vehicles is often a bad deal for public employees and taxpayers alike. Governor Shapiro is wise to call attention to this issue.