Some Public Pension Funds Taking on Outsized Private Equity and Hedge Fund Fees

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Gretchen Morgenson of the New York Times has a rare bit of encouraging news. Some public pension funds, which collectively are the biggest investors in private equity and are also significant hedge fund investors, are finally pushing back in a concerted manner against outsized fees and costs. Recall that Oxford professor Ludovic Phalippou has estimated total private equity fees and costs at a mind-boggling 7% per year. Reducing that by a percent or two would make a big difference in investors’ net returns. And bringing activities in house (which would admittedly take years) would cut the costs of those who did so a great deal and would also pressure independent managers to cut fees.

One important development may not be obvious to readers of Morgenson’s article:

How these high costs harm pensions is detailed in a new report: “The Big Squeeze: How Money Managers’ Fees Crush State Budgets and Workers’ Retirement Hopes.” The analysis, by the American Federation of Teachers, estimated the costs incurred in alternative investments at 12 large public pensions and determined how much the funds would have saved if they had paid about half the going rate.

The fact that the powerful American Federation of Teachers is making a stink about fund manager fees is a big deal. Heretofore, unions have hesitated about criticizing private equity and hedge fund managers about fee levels publicly, even though quite a few top union officials and spokesmen have made clear that they know that both the fees, and in the case of private equity, the way the fund managers operate is to their detriment. But there is a big difference between griping to allies and taking a public stance.

It appears that the severity of pension shortfalls, which is due in part to deliberate decisions to underfund (New Jersey is the poster child) plus funds that were reasonably healthy being whacked by years of the Fed’s negative real interest rate policies, which hurt investors of all stripes, has finally roused public pension funds to act.

Morgenson describes how the first response to lagging returns was to chase higher risk strategies that offered the hope of getting the pension funds back on an even keel. Pew Foundation looked at 73 state-level pension funds. It found that their allocations to alternative investments increased from 11% in 2006 to 24% in 2014. As the article pointed out:

“States that tend to be in more financial difficulty tend to have higher-risk portfolios,” said Bill Bergman, director of research at Truth in Accounting, who is a former economist and financial market policy analyst at the Federal Reserve Bank of Chicago. “In Illinois, the defense is that in the long run, these investments will be good for us. But they are expensive, opaque and risky.”

Key sections of Morgenson’s story:

The dozen funds included in the [American Federation of Teachers] analysis held almost $800 billion in assets. If fees on their alternative investments had been halved over the last five fiscal years, the 12 funds would have saved $3.7 billion annually and $18.5 billion over the period. Going forward, that reduced-fee structure would save the average pension fund an additional $1.8 billion over five years and almost $8 billion after 15 years….

Dale R. Folwell, the recently elected Republican treasurer of North Carolina and a certified public accountant, is one pension overseer challenging the status quo. The state’s $92 billion pension is one of his responsibilities.

“In the last 16 years, our fees have gone from $50 million to over $600 million,” Mr. Folwell said in an interview. Meanwhile, assets under management grew by only 33 percent over that time.

“When I applied for this job, I said I was going to cut Wall Street fees by $100 million,” Mr. Folwell said. “We’re trying to reduce complexity and build value for our participants.”

Since entering office three months ago, Mr. Folwell said he had telephoned all of the pension’s investment managers — roughly 175 — to make sure they had the state’s interests at heart…

Not everyone made the grade: Mr. Folwell said he had fired nine managers so far. He has also extracted more than $30 million in fee reductions from some managers who remain.

Mr. Folwell is also examining how his fund’s assets are valued. Many alternative investments are illiquid and difficult to assess; because a fund’s fees are based on these valuations, it is imperative that they are not overstated, he said.

Let’s hope that this is a sign that the tide is starting to turn. Fund trustees that have pushed back against hedge and private equity fees and costs, like Chris Tobe in Kentucky, Curt Loftis in South Carolina, and JJ Jelincic at CalPERS, have regularly been attacked, astonishingly not so much by the fund managers, but by the captured staff members who see them as a threat to their overly-cozy relations with fund managers. In some cases, it is because the outside managers are powerful political players in state; in others, the staff has no solution other than “more alternatives” to pension shortfalls.

It appears that too many years of too many fees and not enough performance can no longer be explained away even by the loyalists. And the more the press and public supports the trustees that take on the still-uphill battle, the greater the odds of success. So if you are in North Carolina, please drop a note citing Morgenson’s article to your local paper or TV station and tell them you support Dale Folwell’s efforts. CC your state representatives and Folwell’s office. People like him need your backing.

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  1. jackiebass

    The more I look at the history of the extremely long period of low interest rates, the more I believe it was on purpose. Low rates were implemented by neoliberals that wanted to destroy many things that benefited the average middle class person. What better way than by starving them of resources. Instead of saving people became addicted to borrowing. Those that had a small nest egg used to be able to put it in the bank in a CD and get a good return. At one time you could get 10%. Why bother with the stock market when a safe CD did the job for you. All of that disappeared with low interest rates. You are better off putting your cash under the mattress. As the article shows excessive fees did the same thing to institutional investment. All part of the plan to transfer wealth from the many to the few.

    1. Moneta

      Their goal was not to destroy. It was just choosing the most effortless route. Destruction is the consequence of those choices.

  2. Moneta

    “High risk, high return” means you have a small chance of getting an outsized return and a very real chance of losing.

    For some strange reason many think the risk premium is guaranteed if the investment is held for the long run. If it were, then it would be risk free… therefore no premium.

  3. Moneta

    I’m not convinced that going into alternatives was done to get the plans back on good footing.

    IMO, many plans sponsors are kicking the can down the road. If they did not change their asset mix, they would have had to lower futur returns which would have forced them to make contributions.

    By going into alternatives, they can keep expected returns higher and not have to inject as much money… and when the whole thing implodes, there will be so many casualties that their mismanagement will not stick out like a sore thumb.

    It’s a game of last man standing.

    1. Yves Smith Post author

      It might help if you watch CalPERS and CalSTRS board meetings or read the trade press. There is an entire industry of true believers, with consultants galore supplying the return assumptions. The funds didn’t come up with these beliefs in a vacuum. Plenty of experts hired for their supposed independence feed the high return expectations.

      1. Moneta

        Indeed there are true believers but I believe there are a lot more pretending to be stupid because of money and perks, counting on the greater fools.

    2. Sluggeaux

      IBG/YBG seems to be the philosophy behind the use of alternative investments. Like any good Ponzi, they report rosy returns early — the “risk” isn’t evident until the very end. By then, the politicians who have been under-funding for decades are long gone.

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