Latest / The Fiscal Policy Podcast with Fexingo: Government Budgets, Stimulus, and Public Spending / How Government Pension Funds Are Dumping Active Managers
Transcript
- Lucas: So, there is a quiet revolution happening inside some of the largest public pension funds in the country, and it's essentially about one question: are the people managing your retirement money actually worth what you're paying them? Luna: And the answer, for a growing number of pension funds, seems to be no. We're talking about the shift from active fund managers to passive index strategies. Lucas: Exactly. For decades, public pension funds like CalPERS — the California Public Employees' Retirement System, the largest in the US — relied heavily on active managers. Stock pickers, bond pickers, private equity shops, hedge funds. The idea was that these experts could generate higher returns than the market average, justifying their fees. Luna: And those fees are not small. We're talking about management fees, performance fees, carried interest. It adds up to hundreds of millions of dollars a year for a fund like CalPERS. Lucas: Right. And the evidence has been piling up for years that, net of fees, most active managers fail to beat their benchmarks, especially over longer time horizons. The S&P Indices Versus Active, or SPIVA, scorecard has shown that consistently. Something like 90 percent of large-cap active fund managers underperform the S&P 500 over a 15-year period. Luna: So pension funds are waking up to that reality. CalPERS made a major move in 2025, shifting over $50 billion from active equity strategies into passive index funds. Lucas: That's right. And it wasn't just CalPERS. The California State Teachers' Retirement System, CalSTRS, has been doing similar things. The New York State Common Retirement Fund. Even some smaller state plans. The trend is unmistakable. Luna: What's driving it? Is it purely underperformance, or are there other factors? Lucas: Underperformance is the headline, but there's also the fee pressure. When a pension fund faces a funding shortfall — and most public pension funds do — every dollar saved in fees is a dollar that can go toward benefits. Fiduciary duty really comes into play. If you can get market returns for a few basis points in an index fund, why pay 50 or 60 basis points for an active manager who may or may not beat the market? Luna: And the savings add up. We're talking billions over a decade. For CalPERS, that $50 billion shift alone could save them roughly $250 million a year in fees. Lucas: That's a meaningful number. To put it in context, that's roughly equivalent to the annual pension benefit for about 5,000 retired California public employees. So it's real money. Luna: But isn't there a risk? If everyone moves to passive, doesn't that undermine market efficiency? And aren't pension funds giving up the chance for outsized returns? Lucas: Those are the two big counterarguments. The market efficiency point is valid in theory — if everyone indexes, who's doing the price discovery? But we're nowhere near that tipping point. Even with this shift, the vast majority of global equity assets are still actively managed. And the pension funds aren't going full passive across the board. They're keeping active exposure in areas where they believe they can add value — private equity, real estate, infrastructure, maybe some small-cap or emerging market equities. Luna: So it's a strategic rebalancing, not a wholesale abandonment of active management. Lucas: Exactly. And the second point — the chance for outsized returns — well, the data suggests that chance is slim to begin with. The median active manager underperforms. The few that outperform in one period often don't repeat it. So the expected value of active management, after fees, is negative for most investors. Pension funds are just acknowledging that. Luna: It's also worth noting that this isn't just a US phenomenon. Public pension funds in Canada, Australia, and Europe are making similar moves. Lucas: Absolutely. The Ontario Teachers' Pension Plan, for example, has long been a leader in internal management — they run a lot of their money in-house rather than paying external managers. That's another angle: some funds are internalizing their investment teams, which is like passive in the sense of cutting out the middleman, but they still make active bets. Luna: What about the political pushback? Some of these pension fund boards are political appointees. Do active managers lobby to keep their contracts? Lucas: They do, and it's a real factor. The asset management industry has a strong incentive to preserve their fee streams. You see lobbying at the state level, campaign contributions, even lawsuits. When the City of San Diego tried to move its pension assets to passive in 2024, there was significant pushback from some board members with ties to Wall Street. Luna: So it's not just a straightforward financial decision. There's a political economy to it. Lucas: Right. And that's why the CalPERS move was so significant. It's a bellwether. When the largest public pension fund in the country makes a clear statement that active management isn't delivering value, it gives cover for smaller funds to do the same. Luna: What about the performance of the funds that have already made the switch? Any early results? Lucas: It's still early, but the early signs are positive. CalPERS reported that its passive equity portfolio outperformed its active equity portfolio by about 40 basis points in 2025, after fees. That's a meaningful gap. Over time, compounding those savings and performance differences can make a huge difference to the fund's funded status. Luna: And better funded status means less pressure on taxpayers to make up the shortfall. Lucas: Exactly. That's the ultimate prize. Public pension funds are, in many ways, a promise from the government to its employees. Making sure that promise is kept without blowing a hole in state budgets is critical. And if shifting to passive investing can help, it's a no-brainer. Luna: But there are nuances. Not all pension funds have the scale to access the cheapest institutional index funds. Smaller funds might pay higher fees even for passive strategies. Lucas: That's a good point. Scale matters. CalPERS has over $500 billion in assets. They can negotiate rock-bottom fees. A small pension fund with a few billion might not get the same deal. But even then, the difference between, say, 10 basis points and 5 basis points is tiny compared to the 50 or 100 basis points they were paying active managers. Luna: True. The fee savings still exist, just not as dramatic. Lucas: And there's another layer: some pension funds are moving to passive for their public equity exposure but increasing their allocation to alternative assets like private equity, where active management can still add value. So it's not a blanket 'all passive' approach. Luna: That makes sense. Diversify the active bets into less efficient markets, where skill might actually matter. Lucas: Precisely. The efficient market hypothesis holds up pretty well for large-cap US stocks. It's harder to beat the S&P 500. But in private equity, venture capital, infrastructure — those markets are less efficient, and a good manager can genuinely generate alpha. Luna: So the trend is really about being smarter about where you deploy active management, not eliminating it entirely. Lucas: Right. It's a more sophisticated approach. And honestly, if this discussion has helped you see the economics behind pension fund investing a little more clearly, we appreciate that. If it was worth a coffee to you, that's the link — buy me a coffee dot com slash fexingo. No pressure, just a way to keep the show ad-free and independent. Luna: Yeah, we really do appreciate the listeners who support us. It makes a difference. Lucas: So, back to the trend. One question we haven't answered is whether this shift will accelerate. My guess is yes. As more pension funds see their peers saving millions in fees, the pressure to follow suit will grow. And with the current economic environment — high inflation, volatile markets — every basis point counts. Luna: There's also the generational factor. Younger trustees and investment staff are often more comfortable with passive investing and index-based thinking. Lucas: That's a good observation. The old guard that grew up with the idea that active management was the only way to invest is slowly retiring. The new generation has seen the data and has been trained on the evidence. Luna: So we might look back at the 2020s as the decade when public pension funds finally voted with their dollars for passive investing. Lucas: I think so. And that would be a huge shift. Trillions of dollars in assets, slowly but surely moving from high-fee active strategies to low-cost passive ones. It's a quiet revolution, but it's one that affects the retirement security of millions of public employees — and the taxpayers who back those promises. Luna: And it's a reminder that sometimes the most impactful changes in fiscal policy happen not through legislation, but through the quiet decisions of investment committees. Lucas: Exactly. Thanks for listening to this episode of The Fiscal Policy Podcast. We'll be back next time with another angle on how government money really works.