[ by Melanie Gretchen ] Wall Street money managers are cashing in on record fees from state pension funds, which have been paying for poor results over the past 10 years, according to a recent study from 2 Maryland think tanks.  The Maryland Public Policy Institute, and the Maryland Tax Education Foundation, reviewed the annual financial data of major statewide retirement systems from 50 states.  Exacerbating state pension funds' investment problems were the think tanks' findings that fees of $7.8 million – an  increase of 15% over 3 years – have resulted in a consistent failure of money managers to hit target returns or outperform passive equity index funds, which charge lower fees. Majority Report. Over the last 10 years, annual returns for large public funds hit an average of 5.9% versus expected target returns of 7% to 8%, according to the report:

"The vast majority of public pension systems in the United States contract with Wall Street firms to select the publicly traded stocks and bonds that comprise the bulk of the systems' investment portfolios.  The firms' typical 'sales pitch' is that they can 'outperform' a given section of the stock or bond market;  therefore, the system should pay them a fee for their stock - or bond - picking prowess."

Maryland, the primary focus of the report, was also the primary loser.  That state spent more on fees (relative to its net access) than most other states, toward returns about 1% less than other state systems each year.  What the shortfall amounts to: about $3 billion in lost income over the last 10 years, the report said. The Math. U.S. public pensions earned a median of 1.15% over the year ended 6/30/12, according to a separate recent study by Wilshire Associates demonstrates.  With the average Wall Street fee ratio of 0.41% paid by state pension systems, almost half of those returns were consumed by the fees. A Solution. Rather than looking to Wall Street for heightened returns – and poorer profits – states could benefit from switching their investments from actively managed funds to more cost-effective passive equity index funds, the study says.  While they strive to achieve the same rate of return as a market index, like the S&P 500 or the Dow Jones Industrial Average, they have fewer transaction costs and are less expensive to manage than traditional mutual funds:

"Many states index a small portion of their portfolios to public indexes.  Extending this practice to 80 or 90% of their portfolios would provide annual savings in excess of $6 billion."

Nevertheless, "states seem to dismiss years of evidence, and most still believe they can find managers who will beat the market," says Jeff Hooke, one of the study's authors.

"In the corporate world, if you screw up, you admit a mistake, fire the fund manager and move on. States usually don't do that. To fire a money manager would be to admit that you picked the wrong guy." -- Mr. Hooke.

Keith Brainard, Research Director of the National Association of State Retirement Administrators, whose members are the directors of the largest statewide public retirement systems, said states can be more aggressive in their investment strategy toward increased returns.

"If public pension funds are to be truly diversified, they cannot invest solely in passive indexed accounts.  Take a look at the large university endowments and foundations, managed by many of the most capable people in the investment management business. You'll find a very small portion of their assets invested in passive accounts." -- Mr. Brainard.

For further details, go to [CNBC, 8/10/12].