Of the many failings of the flawed financial system alluded to by John Bogle, undoubtedly the most egregious flaw is the pay for play scandals that continue to rock the public pension universe.  

Rife with conflicts of interest, consultants are handsomely paid to put in a good word to ensure that their benefactors wind up on the short list of money managers who can get their hands on the hundreds of billions of dollars of pension plans.

In just the last two weeks alone, big-name players have been publicly shamed and penalized for their roles in facilitating fraud and kickbacks:

• Industry big-wig Marsh McLennan, parent of institutional consultant Mercer, paid a whopping $400 million to settle a class action lawsuit that was led by the Public Retirement Systems of Ohio, its State Teachers' Retirement Plan and its Bureau of Workers' Compensation, as well as the Investment Division of the New Jersey Department of Treasury.
  
  According to the Ohio attorney general Richard Cordray, “The pension funds claimed the company violated securities laws by steering the schemes' business to insurance companies that paid Marsh & McLennan kickbacks known as "contingent commissions." The complaint said the firm allegedly generated fake bids to protect these insurance companies from competitors, according to Global Pensions.

• JP Morgan settled last week with the SEC to get out from under charges that the company made unlawful payments to friends of public officials to win municipal bond business for a $1.4 billion sewer project in Alabama.
  
  The SEC charged that JP Morgan and two of its former managing directors funneled about $8.2 million to close friends of several Jefferson County commissioners. As a result, the commissioners were swayed to select JP Morgan’s securities division to be the major underwriter for the bond offering.
  The settlement cost JP Morgan nearly $750 million. The company was forced to pay a $75 million fine and forfeit $647 million in fees from the business, according to Yahoo Finance.

• News continues to unfold about the pay for play scandal that struck Calpers, the biggest public pension plan in the US. Al Villalobos, former Calpers board member and president of Arvco Financial Ventures, has been fingered as the middleman recipient of as much as $65 million in fees for coordinating the introductions of fund managers to the Calpers board.
  
  Against the backdrop of similar scandals throughout the country, the SEC has proposed a ban on placement agents for state and municipal pension plans.
  
  The Calpers scandal arises at a time of intense scrutiny for California’s public officials, and leaves California taxpayers likely incited with anger at the prospect of having to make up the pensions plan’s shortfall. The fund lost $50 billion during the recent financial crisis, shrinking the fund by more than 23% through June 30, 2009, and racking up the fund’s worst fiscal year ever, according to The Wall Street Journal.  In contrast, the median return of public-pension funds with $5 billion or more was a 19% decline, according to the Journal. 
  
  The alleged $65 million in kickbacks to Villalobos led to the investment of some $16 billion of Calpers money.

The beat-the-benchmark objective easily facilitates pay to play scandals. If pension plans simply bought and held the market indexes, they would accomplish two objectives:

1. They would earn market rates of return that are commensurate with their risk capacity.
   and…
2. They would easily eradicate the pay for play scandals that plague the industry.

The US government’s pension planners seemed to have figured this out already. That is why some $200 billion of assets in the Federal Thrift Savings Plan (TSP) is invested exclusively in low-cost index funds (TSP.gov).

So, what would have been the outcome for the Calpers pension fund if it had simply bought, held and rebalanced a risk-appropriate Index Portfolio with risk and return characteristics consistent with IFA's advice?

The results are below. As you can see, for the 26-year time period from July 1983 through June 2009, the Calpers fund carried slightly higher risk than IFA’s Index Portfolio 65, but delivered 1.6% less annualized returns. It also had a risk of 12%, but only obtained the return of IFA's index Portfolio 35, which had an annualized return of 9.16% and risk of about 7.5%.

For Calpers Data: http://www.calpers.ca.gov/eip-docs/about/facts/investme.pdf
For IFA Data: ifabt.com

The beat-the-benchmark objective is a flawed one for all investors, individual and institutional. It leads to risk-adjusted underperformance. At the institutional level where highly paid money managers vie for the control of billions of dollars, the beat-the-benchmark objective can easily facilitate payoffs and conflicts of interest as financially motivated consultants may easily sway their recommendations to favor those who most lavishly grease their palms. By simply investing in low-cost index funds, these institutions could avoid the frustrating below-benchmark performance that results from the layers of high fees for speculation, and they can be assured that conflcits of interest will be virtually eliminated. After all, with low-cost index funds investing there is not enough profit from fees to even grease the palms of the decision makers.