Some state retirees and outside observers are flagging warning signs about Maryland’s $67 billion pension fund, including $800 million in yearly management fees and alarms raised by a bond rating agency about risky investments. They’re questioning an investment strategy that leans on private equity, real estate and hedge funds — so-called alternative investments that are supposed to juice returns — but have instead led to subpar performance compared to other states.

Maryland doesn’t need Wall Street magic for its pension fund, retirees argue, just a simple, low-overhead strategy that’s proven to work for the 420,000 Maryland retirees dependent on the fund.

“After I kept seeing this ... glossing over of what the numbers actually said, and having seen outside experts question the price we were paying for all of this advice and partnership, I started digging deeper,” said Peta Richkus, a state retiree and former secretary of Maryland’s Department of General Services who is a beneficiary of the fund.

The professional investment staff that help guide the fund have defended their approach, saying that private equity in particular has been an effective way to increase returns — even as they shift away from other alternative investments and poorer-performing overseas stocks.

Private equity has generated over $5 billion in added value to the fund over the past decade when compared to investment in the stock market, even after paying investment fees, said the State Retirement Agency’s Executive Director Martin Noven, making it “an investment strategy I’ll stand behind every single day.”

Noven and Chief Investment Officer Andrew Palmer defended the investment strategy in an interview, but declined to provide on-the-record answers to specific questions about management fees and overall plan performance compared to other investing strategies.

According to data collected by Pensions and Investments, as of 2023, Maryland’s 7% return over the previous decade ranks 49 out of 83 public pension plans around the country. Maryland’s pension system ranks near the middle of states for assets in the fund compared to the number of payments the fund is obligated to make to retirees and other recipients, according to an analysis by Equable Institute, a public pension research and education group.

But retirees like Richkus and others concerned about the fund’s management — such as Jeff Hooke, an adjunct professor at Johns Hopkins University’s Carey Business School — say that the state should instead pursue a simpler investment strategy rooted in publicly available stocks and bonds. That would cut management fees to a fraction of what they are now, while generating stronger returns.

“Maryland has tried to juice the returns on the pension fund with private equity and private real estate, but it just hasn’t worked out,” said Hooke, who has long been an opponent of the use of private equity in Maryland’s pension fund. “These are huge fees, meaning hard-earned cash is going from Maryland union members to guys with penthouses in Manhattan and homes in Palm Beach.”

Sky high fees, but fund still losing to stock market

Maryland’s pension system didn’t always rely on private equity and other alternative investments. Instead, in the early 2000s the fund was primarily made up of bonds and publicly traded stocks, not so different from how most private investors allocate their 401(k) and other retirement funds.

But after the Great Recession in 2008, when the value of the stock market fell precipitously, the state decided to increase alternative investments controlled by the fund as a way to boost returns.

As of June 30, 2023, alternative investments comprise 43.2% of the fund’s total asset allocation. Public equity comprises only 30.2%.

“We invest in private equity for the outsized returns the asset class has generated for our members and beneficiaries,” Palmer, the chief investment officer, said in a statement. The private equity performance by Maryland’s pension fund had far outperformed that of other states, he noted.

Private equity funds — which buy and sell private businesses — comprise more than one-fifth of the pension plan’s total assets. In the decade-plus since the switch to more alternative investments, the private equity component of that plan has performed well.

• Private equity has generated over 16% returns after paying management fees.
• But hedge funds, real estate and other alternative investments have performed poorly, generating a fraction of private equity’s returns.
• Investments in publicly traded companies, which comprise almost one-third of assets, have generated returns of 8.4% over the past decade. That’s strong, but not nearly as strong as the double-digit returns the U.S. stock market has generated because Maryland chose to invest in international stocks.

It’s this exact kind of hit and miss investment approach, say Richkus and Hooke, that indicates why the state should stop pursuing so many alternative investments in the first place. They argue that the most prudent investment strategy is a simple, passive investment strategy in publicly available equities and bonds — 60% stock, 40% bonds.

And for at least for the last decade, a 60:40 index fund has outperformed Maryland’s pension fund, returning 8.1%. That stock and bond index fund also came with a fraction of the management fees, and would have brought in billions in additional returns over the past decade.

“The pension staff may believe that these complex structures work, but a 60:40 index beats all of them,” said Hooke.

Maryland, other states pursuing private equity investment strategy

Even with the high fees involved, public pension funds across the country have shifted more and more of their assets over the past decade to private equity and other forms of alternative investments, according to Eileen Appelbaum, the co-director of the Center for Economic and Policy Research in Washington, D.C. Now, she said, there are only “a handful” of states that rely mostly on public equities.

One of those states is Nevada. The fund has generated returns of 8.9% over the past decade, while operating on a low-overhead investment strategy rooted primarily in a public stocks and bond index.

In making private equity investments, funds are also accepting the reality that private equity funds are notorious for buying and gutting struggling companies and industries in a bid to maximize profits, such as nursing homes and newspapers.

The staff at the Maryland State Retirement Agency don’t see the fund’s use of private equity that way.

Staff said that private equity has helped boost Maryland’s returns while reducing the volatility inherent in public markets, and they trust the numbers the private equity firms post. Staff added that because the fund is required to pay out billions in benefits every year, large public market fluctuations could hamper the fund’s ability to pay out benefits — a consideration private investors don’t have to deal with. And the high returns justify any risk, according to staff.

Red flags about risky investments

Bond agencies, which play a critical role in assigning the state’s credit rating, have also been raising concerns about the risky asset allocation within the fund. In the latest round of 2023 rating reports, Maryland won another AAA rating, but Moody’s put Maryland on a “negative outlook,” in part because of concerns about risky investments within the pension fund.

By one metric tracked by Moody’s, Maryland has the second-highest probability of large-scale investment losses of any pension system in the country. The agency wrote that Maryland “still faces elevated risk stemming from its plans’ reliance on volatile investments to meet its return targets.”

Richkus’ biggest concern is the possible impact on other state retirees like the thousands of rank-and-file state workers, teachers, and law enforcement officers, who stand to lose out significantly if the state were to consider cutting pension benefits in the wake of fund losses.

“If something goes wrong with the fund, those people will be the ones to suffer,” she said. “And I’m also concerned the fallout would have a huge impact on the state’s image and reputation, and on Maryland’s bond rating.”

Peder Schaefer is a Baltimore-based freelance journalist.