“Over the long term, pension plans are the best savings tool,” the advertising slogans say. “Leave it to an expert to manage your money.” But if you look at the results of a recent study by two faculty members at the IESE business school, it’s clear that investors should not be seduced by such talk. The study was carried out by Pablo Fernández, professor of corporate finance at the IESE, and Vicente J. Bermejo, research assistant at the same institution, and is titled, “The profitability of pension funds in Spain, 1991- 2007.”


In Spain these kinds of retirement funds provide lower rates of return than the country’s inflation rate, and less than returns from government bonds and the stock market. Over the past 10 to 17 years, the average profitability of retirement funds was lower than the return from government bonds. “Only two of the 170 plans that operated through the entire 17-year period had a higher profitability than bonds,” Fernández and Bermejo write. Comparisons with the Index of the Madrid Stock Exchange are equally disappointing.” Not one of the 170 plans with 17 years or more of experience outperformed the stock exchange index. That happened for only “three of the 511 plans that are 10 years old; two of the 1,597 plans that are five years old, and two of the 2,007 plans that are three years old.”


Despite such results, Spaniards don’t seem to be very worried. More and more people in Spain are confident that their pension plans will enable them to enjoy their “golden years” without worrying about the economy. In 60% of all cases, people say that they invest in these plans because they help them accumulate savings for retirement. An estimated 32% of respondents said they invest in order to lower their taxes, and another 31% said they do it because of the [higher] financial returns they generate [compared with alternative investments]. Whatever their reasoning, by the end of last year 10.4 million Spaniards – four times as many as 10 years ago – had holdings worth €86.6 billion in 3,185 retirement plans.


As Fernández told Universia-Knowledge at Wharton, some investors already anticipated the results of the study because of their own experience, but others were surprised by the findings, especially because of the way these pension funds advertise [their allegedly high rates of return]. After reading an early version of the study, one person sent the following comment to Fernandez and Bermejo: “The results surprised me a great deal. I believed that the returns were much better than they turned out to be. Contributors to the funds focus on tax advantages (associated with having a pension plan) without looking deep into the returns that people actually get from those investments.” In that respect, Fernández adds, “except for a few cases, investing in these pension plans doesn’t turn out to be a very good investment.”


High Commission Rates


Why do these investments get such poor results? First of all, they charge investors high commission rates; an average of between 1% and 2% but sometimes even as high as 2.5%. This adds up to a lot of money over the years,” says Fernández. According to Spain’s Director General of Insurance and Retirement Funds, 36% of all funds charged commissions in 2007 that amounted to between 2% and 2.5% of the value [of the fund holdings], while 24% of the funds charged between 1.5% and 2%. Overall, these commissions cost investors a total of one billion euros in 2007.


According to Fernández, these numbers show that most fund managers don’t deserve the commissions they earn. “When an investor brings his money to a fund manager for him to manage, he expects to get a higher rate of return than what you would get without any special [financial] knowledge.” That’s why investors are prepared to pay those commissions.


But hiring a manager guarantees the investor nothing. Over the last decade, 66% of all funds managed for individuals (by one or more financial institutions, banks or insurance companies) earned profits that were lower than the country’s inflation rate. In addition, 95% of all pension funds earned less than 5.76% a year, which is the [current] rate of return on ten-year Spanish government bonds. However, funds differ significantly when it comes to their rates of return. There are six categories of funds, including short-term fixed income funds, long-term fixed income funds, and mixed funds. An estimated 128 funds have a mixture of income sources and have been in operation for five years. Among them, the most profitable fund enjoyed [annual] returns of 17.22% while the least profitable earned 0.13% a year.


The high commissions that managers charge are only partially responsible for the plans’ poor performance. “They don’t tell you that in 2007, more than half of the funds (64.6%) invested [exclusively] in fixed income and ‘treasuries’ [government bonds],” says Fernández. How much sense does it make for someone younger than 60 years old to have a pension fund that invests [only] i n s hort-term fixed income instruments?  Or a fund that [exclusively] invests in long-term fixed income instruments?


Fernández says that active fund managers provide few benefits. Managers merely buy and sell frequently, changing the composition of their portfolios again and again. “Buying and selling things provides a lower return on your fund because it generates higher commissions,” he notes. According to data provided by most Spanish funds, “it is impossible to know if active managers have (on balance) created any value for participants (in retirement plans), although they have clearly created value for the stock market traders who buy and sell shares (and receive commissions from pension plan participants).


The authors recommend that pension fund managers inform their participants about the transactions they make, and about the amount of money they spend on commissions. Most funds do not do that. They also think it would be useful if fund managers provided data about the returns on investment that they would have made if they had not made so many changes in their portfolio. “That way, we would know exactly how much value the active manager has contributed (or, taken away, in most cases).”


Spain is not the only country where this kind of data is inadequate. In their study, Fernández and Bermejo compare their findings from Spain with research done in other locations, including the U.S. and the United Kingdom . Those studies arrived at similar conclusions, but there were two big differences: “In almost every country, fund performance was a little worse, on average, than what people would have earned if they had invested directly in the stock market or in other kinds of investments. However, the difference [between the two figures] was smaller [outside Spain] than [it was] inside Spain. On the other hand, in Spain a larger number of firms outperformed the average,”says Fernández.


Outside Spain, “managers in those countries do a better job, and focus more on investing in variable income instruments. In addition, I suppose that there are more people [outside Spain] who are looking at what managers are doing [with their investments], and protesting,” he says.


Fernández and Bermejo advise investors to invest in funds that not only have low costs and commissions, but which match the performance of stock market indexes. On the other hand, they recommend that investors avoid funds that are actively managed, “especially if their historic performance is far from stellar.”


Government Responsibility


According to Fernández and Bermejo, data from around the world provides no justification at all for investing in [pension] funds [simply] because they offer tax advantages. “In many cases, investors have squandered their tax advantages because the government has induced people to invest in funds that invest i n s hort-term (less than five-year)” funds. The commissions [on those funds] were high and the funds were managed inefficiently, they say. Clearly, they add, “the State [government] needs to take some responsibility for the losses that millions of fund contributors have suffered and are continuing to suffer.”


Fernández says the government implicitly “encourages people to invest their money in the kinds of products that have clearly performed poorly for investors. If people had invested i n s hares of state-owned companies or in government bonds, they would have done much better than what the government is trying to encourage people to do.”


One reader commented to the authors: “So long as there are tax advantages to investing in pension funds, the only thing to do is to look beyond the [fund] ratings and choose those funds that have performed less poorly than the others. Or you can choose a fund that provides you with the most attractive DVD or other incentive for investing in it.”


Since investing in retirement funds has tax advantages, notes Fernández, the government can encourage you to make a long-term investment. However, “it should [also] be possible for investors to set up their own accounts and build their own portfolios without having to rely on other people who receive very high commissions [for managing the portfolio].”


On the other hand, notes Fernández, “The government could suggest that people invest in funds that meet certain criteria. It could encourage people to invest in the right kinds of funds by offering people a tax deduction [for doing that], while not giving that kind of tax deduction to people who invest in other kinds of funds. All this would be based on funds’ previous performance. Or the government could decide to no longer give special [tax] treatment just to people who invest in [pension] funds [in general]. It seems to me that the government should make it a priority for people to save money in general, and to save for their retirement. But when other people are charging you money to do that, and then you lose your tax preferences after four or five years, then it doesn’t make much sense.”


Another reader of the study commented that “The subject of setting up internal pension plans for employees remains open for discussion [in our company]. For us, that approach doesn’t seem very attractive given our current returns on investment. Nowadays it’s all about what to do in the future with that money. Invest it in a [pension] fund that puts employees’ capital at risk? Raise employees’ salaries, and let them make their own decisions? Give employees courses about the stock market and let them spend their money [on their own]? At least they will have some fun [doing that]. They will be able to make changes in their investments, and move into those funds that seem to be doing a better job.”


Fernández recommends that investors “study how well a particular fund has performed on a historical basis (from five to 10 years), and then maybe decide not to invest in funds [at all] and do something [else] with their [retirement] accounts. In other words, they can put invest in their retirement accounts individually, rather than through a fund.”