STUMP » Articles » Public Pension Assets: Our Funds were in Alternatives, and All We Got Were These Lousy High Fees » 1 August 2017, 12:30

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Public Pension Assets: Our Funds were in Alternatives, and All We Got Were These Lousy High Fees  


1 August 2017, 12:30

So after yesterday’s sunny piece, the rest of the week has less happy results. Some of these

First, let’s start with research from Pew Trusts:

State Public Pension Funds Increase Use of Complex Investments


State and locally run retirement systems currently manage over $3.6 trillion in public pension fund investments, most of which are held by states. Broadly, half of these assets are invested in stocks; a quarter in bonds and cash; and another quarter in what are known as alternative investments, such as private equity, hedge funds, real estate, and commodities.

Although governments and employees contribute to pension funds, investment earnings on plan assets are expected to pay for about 60 percent of promised benefits. In a bid to boost investment returns and diversify investment portfolios, public pension plans in recent decades have shifted funds away from low-risk, fixed-income investments such as government and high-grade corporate bonds. During the 1980s and 1990s, plans significantly increased their reliance on stocks, also known as equities. And over the past decade, funds have increasingly turned to alternative investments to achieve investment return targets.

Greater investment in equities and alternatives can provide higher financial returns but also bring heightened volatility and risk of shortfalls. Most funds exceeded their investment return targets during the bull market of the 1990s but then suffered losses during the volatile financial markets of the 2000s—leading to higher pension costs for state and local budgets. The volatility inherent in public funds’ investment strategies can be seen in more recent results as well, with large funds posting fiscal year gains of over 12 percent in 2013 and 17 percent in 2014, but only 2 percent in 2012, 4 percent in 2015, and 1 percent in 2016.

The shift toward more complex investment vehicles has also brought higher investment fees. State funds reported paying more than $10 billion in fees and investment-related costs in 2014, which amounted to their largest expense. Those fees, as a percentage of assets, have increased by about 30 percent over the past decade, a boost closely correlated with the rising use of alternative assets, which has more than doubled since 2006. Additionally, state funds are paying billions of dollars in unreported performance fees associated with these alternative investments.

Accounting and disclosure practices also vary widely among pension plans and have not kept pace with increasingly complex investments and fee structures, underscoring the need for additional public information on plan performance and attention to the effects of investment fees on plan health. Full and accurate reporting of asset allocation, performance, and fee details is essential to determining public pension plans’ ability to pay promised retirement benefits. With more than $3.6 trillion in assets—and the retirement security of 19 million current and former state and local employees at stake—sound and transparent investment strategies are critical.

There are various findings and recommendations, one of which popped out at me:

The use of alternative investments varies widely—from none to over half of fund portfolios. While examples exist of top performers with long-standing alternative investment programs, the funds with recent and rapid entries into alternative markets—including significant allocations to hedge funds—reported the weakest 10- year returns. Although longer time horizons will allow better evaluation of these investment strategies, funds and policymakers should carefully examine risks, returns, and fees in the meantime.

Ah, chasing returns. It might not be that the alternative assets themselves suck, but that one has sucky performance pushing one into alternatives.

Pew nicely provides a spreadsheet, but there’s not much to it. That said, it gives me something to compare against… AND I notice there’s two bases for reporting returns — Gross of Fees & Net of Fees. Yes, this makes things a bit difficult to compare. There are also timing differences.

The full report in PDF is here.

I will pull out one graph, and come back to it later:

Yikes, some of those plans have super-high allocations. What the heck is in there?


Here’s a contrasting message.

Yale Endowment Defends High Management Fees:

While many pension funds are switching to passive investments to save money on fees, Yale University’s endowment has staunchly defended its actively managed investing strategy against so-called “fee bashers” in its most recent annual report.

“In recent years, a broad range of market commentators have decried excessive fees paid to hedge funds and private equity funds,” said the Yale Endowment in its 2016 annual report. It went on to say that what the “fee bashers miss is that the important metric is net returns, not gross fees.”

Yale said its investment strategy emphasizes long-term active management of equity-oriented, often illiquid assets. It added that performance-based compensation earned by outside active investment managers reflects the endowment’s outperformance, and boasted that it had the highest investment returns among all colleges and universities over the past 20 and 30 years, citing Cambridge Associates.

Some items:

  • Yale is a private institution
  • The Yale endowment has been well-known for its excellent returns
  • That endowment is tax-free. Hmmm, I wonder how much is actually spent on students.

Let’s check:

The target spending rate approved by the Yale Corporation currently stands at 5.25%. According to the smoothing rule, Endowment spending in a given year sums to 80% of the previous year’s spending and 20% of the targeted long-term spending rate applied to the fiscal year-end market value two years prior. The spending amount determined by the formula is adjusted for inflation and constrained so that the calculated rate is at least 4.0%, and not more than 6.5%, of the Endowment’s inflation-adjusted market value two years prior.

Jeez, that’s a lot of words.

Bottom line:

Distributions to the operating budget rose from $616 million in fiscal 2006 to $1.2 billion in fiscal 2016. The University projects spending of $1.2 billion from the Endowment in fiscal 2017, representing approximately 34% of revenues.

Okay, fair enough.

But the policy is such that the endowment will ever grow. Given it’s supposed to fund operational costs in perpetuity, I guess I can see the point of that policy.


Cash-Strapped Pension Funds, and the Hefty Investment Fees They Pay

Where are the pensioners’ yachts?

That riff on Fred Schwed Jr.’s famous Wall Street tell-all book — which explains why bankers and brokers own yachts, but the customers who take their advice do not — came to mind recently. I was reading a new report detailing how outsize money management fees are crippling the nation’s public pensions.

We’re talking about the fees charged by hedge funds and private equity firms to invest pension fund money — fees that enrich the wealthy but imperil workers, retirees and taxpayers.

State and local pensions oversee $3.6 trillion in investments meant to benefit former teachers, firefighters, police officers and other workers. These people rely on their pensions for a comfortable retirement.

Unfortunately, what many of these funds owe to beneficiaries far exceeds their ability to pay. Truth in Accounting, a nonprofit that aims to educate taxpayers on government finances, estimated that the unfunded liability at 500 large pension plans across the nation stood at $1.3 trillion in fiscal year 2015.

That is a mighty deep hole. And many pension fund trustees have responded by increasing their allocation to so-called alternative investments, such as in hedge funds and private equity, rather than sticking to lower-cost vehicles that invest in stocks and bonds. They seem to think that swinging for the fences with the more exotic strategies will close the yawning gap.

These investments beat the market, sometimes. But their enormous fees — as much as 2 percent in management fees and 20 percent of any gains — must always be paid. And these costs push pension funds deeper into the hole.

Consider the Teachers’ Retirement System of the State of Illinois, a $46 billion pension fund. At the end of fiscal 2016, the retirement system’s funded ratio, a measure of its ability to meet its obligations, stood at 39.8 percent, on an actuarial basis. It had a long-term unfunded liability of $71.4 billion. The fund has 34 percent of its assets in alternatives. And in the 2016 calendar year, its private equity and hedge fund investments underperformed the rise in the Standard & Poor’s 500-stock index.

Meanwhile, the fund incurred almost $750 million in direct investment expenses in fiscal 2016, up 7.6 percent from the previous year.

“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.”


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 dozen funds included in the 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.

The report urges pension fund overseers to work to reduce the fees they pay and adopt policies requiring a full accounting and disclosure of all fees by alternative investment managers.
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.

“We asked them: ‘Who are you? Where are you? How good are you? And how much are we paying you?’” Mr. Folwell said.

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.
“Our history teaches us that well-entrenched special interest groups have a tendency to dominate public policy for their own benefit at the expense of the rest of us,” said Mr. Bergman of Truth in Accounting. “That appears to be the current state of affairs in public pension funds.”

Mr. Bergman said he believes one problem with the current system is that many overseers have a duty only to the fund’s beneficiaries. While that might seem appropriate, it can encourage these fiduciaries to make riskier bets in the hopes of generating better returns.

“If your benefits are guaranteed, as they are in Illinois,” he said, “you have the incentive to take more risk, in part because the insiders and beneficiaries have all the upside and don’t get the downside.”

Because that downside ultimately falls to the taxpayers, Mr. Bergman said, pension fund trustees should also have a duty to them.

“We need fundamental changes in fiduciary duties in public pension funds,” he said, “to align the incentives more closely not just with beneficiaries but with taxpayers as well.” A good idea.

Well, I don’t think the pension fund trustees need to be thinking of the taxpayers, in terms of alignment of interest.


They do need to be thinking primarily of the beneficiaries…. and the likelihood that the taxpayers will pony up if asset bets go sour.

I think it has been shown that taxpayers will not necessarily be willing or even able to fill the big holes in funds such as Calpers and Illinois TRS has.

Heck, look at what happened with Dallas Police and Fire: crazy liabilities (8% guarantee DROP?!? COME ON) drove crazy investments, and now the pension members are not going to get what they thought they were promised.

It doesn’t matter how much one shouts “BUT IT’S UNCONSTITUTIONAL!”

Judges can’t make money magically appear in the pension funds. They can’t tax people who aren’t there. They can’t take away more money than people actually have.

So no, the pension fund trustees do not need to change their alignment. They need to change their assumptions that the taxpayer put will always be an option. It may not be.

Therefore, it’s in the pension beneficiaries’ interest not to make crazy asset bets. Remember Dallas.


The Pew Trusts people have a more limited data set than what is available through the Public Plans Database.

Here is a recent brief from the center behind the database:

A First Look at Alternative Investments and Public Pensions

by Jean-Pierre Aubry, Anqi Chen and Alicia H. Munnell

The brief’s key findings are:

Public pension plans have boosted their holdings in alternative assets, defined as private equity, hedge funds, real estate, and commodities.

This shift reflects a search for higher returns, a hedge for other investment risks, and diversification.

The question is how the shift has affected returns and volatility over two periods: 2005-2015 and 2010-2015.

In terms of returns, a 10-percent increase in the average allocation to alternatives was associated with a reduction of 30-45 basis points, primarily due to hedge funds.

In terms of volatility, alternatives did not have a statistically significant effect. Hedge funds reduced volatility, but real estate and commodities increased it.

This analysis is only a first look at this area; further research is clearly warranted.

Let’s take a look at the full report.

Here is a graph showing how allocations to alternatives has increased:

So, equities very slightly decreased, while it seems alternatives (alts) are taking the place of fixed income assets.

This table shows returns by asset class over particular years:

You’ll see that hedge funds and commodities have done very poorly in recent years. Note that the classes you see up top are some of the major asset class types that are thrown in the alt bucket. Some are alt-ier than others, it seems.

I have one final graph to show — this gives a histogram of percentage allocated to alts, compared for two different years: 2005 and 2015.

Wow. This shows the story much more than the simple line graph does. The amount playing in the alt space is about the same — only 6-7% of funds had no alts whatsoever.

The big difference is how much of their overall portfolio was in alts, and that changed drastically for some funds.

In 2005, none of the plans in the database had more than 30% of their portfolios in alternative assets.

In 2015, over 30% of the plans had more than 30% of their portfolios in alts. Some even had over half their portfolios in alts.

The top one being Dallas Police and Fire:

Note that 100% of ARC (or near enough) was being paid — Dallas Police & Fire has usually paid full required contributions. At the time, for the data investigated, the plan was measured as 64% funded.

The next year it dropped to 45% fundedness. Indeed, the plan was near 80% fundedness in 2012 (oooh, so “healthy”), and you can see how rapidly it dropped.

As one can see above, with the Yale Endowment Fund, fancy-pants investing is not necessarily a bad thing. But one does wonder if the public pension trustees are as sophisticated as the Yale Endowment trustees.

Can they really provide appropriate oversight for such complicated investments and the asset managers they hire to manage them?

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