Tuesday, October 29, 2013

Are U.S. Pension Funds Going Canadian?

James Comtois of Pensions & Investments reports, MassPRIM taking closer look at cost structure:
The Massachusetts Pension Reserves Investment Management Board launched the first phase of a cost-saving and return-enhancing program that follows in the footsteps of public funds from other states that, in turn, are following in the footsteps of several Canadian plans.

Phase 1 initiatives of Project SAVE include renegotiating some public equity and hedge fund manager contracts to reduce fees for the $53.9 billion Boston-based fund; investing in hedge funds rather than hedge funds of funds and exploring more passive hedge fund strategies; looking at more private equity co-investing; establishing a cash overlay; and restructuring how the fund handles claims-filing procedures and recovery from class-action litigation proceeds.

“I noticed we spend a significant amount of time talking about returns, and although that's very important, we never took an in-depth look at our cost structure,” Michael Trotsky, MassPRIM's executive director and chief investment officer, said in a telephone interview. “Not all initiatives are just around cost savings; we're looking broadly at how we're running our business.”

Project SAVE, which stands for strategic analysis for value enhancement, was created by Mr. Trotsky earlier this year to find ways to reduce costs and potentially increase returns for MassPRIM. Some of these initiatives have been implemented; others are scheduled to go into effect in early 2014. MassPRIM expects these Phase 1 initiatives to either save the fund or provide return enhancements of $101.2 million per year.
Inspiration from SWIB

MassPRIM was inspired in part by a few other pension plans that have initiated similar programs. The $86.4 billion State of Wisconsin Investment Board, Madison, has been a big influence on the Massachusetts fund. For example, SWIB saves on fees by managing a substantial amount internally, whereas MassPRIM does no in-house management.

Wisconsin manages 56% of assets internally and is looking to increase that figure. Spokeswoman Vicki Hearing said SWIB manages 86% of U.S. equities, 52% of international equities and 50% of fixed income internally. It also manages nearly all of its Treasury inflation-protected securities investments in-house.

SWIB is also seeking to reduce expenses by direct investing or co-investing in private equity.

“SWIB seems to be a step or two ahead of everyone in this regard,” said Timothy Vaill, a member of MassPRIM's investment committee and the former chairman and CEO of Boston Private Financial Holdings Inc., who retired from the Boston-based bank holding company in 2010. “We visited them and had a good discussion with them.”

According to research from CEM Benchmarking, a Toronto-based benchmarking services firm that MassPRIM hired to study the fund's performance, many of MassPRIM's peers manage on average 24% of all assets internally.

SWIB wasn't the only asset owner that MassPRIM studied.

The $272.7 billion California Public Employees' Retirement System, Sacramento, manages 83% of its public equity portfolio internally and is looking to increase that percentage. The $47 billion Alaska Permanent Fund, Juneau, does co-investing and some direct investing in infrastructure and private equity, and plans to manage a portion of these public and private assets internally.

Mr. Vaill added that MassPRIM is also “watching the state of Oregon very closely,” as the Tigard-based Oregon Investment Council is proposing legislation that would grant it greater autonomy over running the $63 billion Oregon Public Employees Retirement Fund. MassPRIM also is looking at the $115.9 billion Teacher Retirement System of Texas, Austin, which is reducing expenses by co-investing with New York-based private equity firm KKR & Co. LP.

MassPRIM and other state funds actually are following in the footsteps of Canadian pension plans. Plans like the Toronto-based C$129.5 billion ($124 billion) Ontario Teachers' Pension Plan, Montreal-based C$185.9 billion Caisse de Depot et Placement du Quebec and Toronto-based C$60.8 billion Ontario Municipal Employees Retirement System have been able to make bold investments by managing assets internally through autonomous in-house teams and management subsidiaries such as the Quebec fund's Ivanhoe Cambridge and OMERS Capital Markets.

“We're looking at the Canadian funds as an example,” said Oregon Investment Council spokesman James Sinks regarding the proposed state legislation granting the Oregon fund greater operating independence.

Mr. Vaill also said MassPRIM executives spoke with some Canadian pension funds.
Maximizing legal claims

Where MassPRIM is branching out from its peers is through its litigation initiative. Through this aspect of Project SAVE, the fund developed a methodology with the help of its legal counsel to maximize claim recoveries and ensure that MassPRIM captures every available dollar in class action lawsuits.

Although MassPRIM officials are researching the advantages of making direct real estate investments and running some equity and fixed-income assets in-house, Mr. Trotsky noted that the rollout for these Phase 2 initiatives for Project SAVE “won't be for a while.”
The rollout won't be for a while but I commend Mr. Trotsky for taking the initiative to reduce expenses at MassPRIM by bringing more assets internally. Every U.S. state pension fund should be looking at ways to cut costs but to do this properly, they first need to adopt Canadian-style governance.

Interestingly, MassPRIM's private equity program was recently reported as being the best in the United States over the last ten and five years. They are among state pension funds that made a killing in private equity:
Private equity has been a winning bet for large public pensions, according to a new study.

Private equity delivered a 10 percent median annualized return to 146 public pension managing more than $1 billion over the last 10 years, according to a new report from industry trade association The Private Equity Growth Capital Council.

By comparison, the pensions earned a 6.5 percent annualized return on their total investments during the same period. Private equity also outperformed other investments, including stocks (5.8 percent); bonds (6.6 percent); and real estate (6.7 percent), according to the study.

Private equity is a bright spot in an otherwise troubled landscape for public pensions. Still hurt by the financial crisis, public plans are only 73 percent funded as of 2012, according to the Boston College Center for Retirement Research.

The Massachusetts Pension Reserves Investment Trust Fund earned the top rate of return from its PE portfolio with 15.4 percent annualized returns over 10 years.

Other top pension PE players over the same period were the Teacher Retirement System of Texas (15.5 percent); the Houston Firefighters' Relief and Retirement Fund (13.6 percent); the Minnesota State Board of Investment (14.4 percent); and the Iowa Public Employees' Retirement System (14.1 percent).

"We're delighted. It's a testament not only to the current staff, but to the legacy of those who launched and built a long-term track record second to none," said Michael Trotsky, executive director and chief investment officer for the Massachusetts pension.

"Private equity is an important asset class. It provides diversification and has been a leading contributor to our high returns since the mid-1980s."

Trotsky said the pension has about 10 percent of its money in PE—around the national average for large public retirement funds—and has no plans to change that. The state used 103 different PE firms as last year, including The Blackstone Group, Kohlberg Kravis Roberts and Bain Capital.


The PEGCC study also ranked pensions with the largest allocations to private equity.

The biggest is the California Public Employees'Retirement System, with $34.2 billion invested. Other huge allocators include the California State Teachers' Retirement System ($22.6 billion); the Washington State Department of Retirement Systems ($16.1 billion); the New York State and Local Retirement System ($14.9 billion); and the Oregon Public Employees Retirement System ($14.1 billion).

"Time and again private equity has proven that it's the single best asset class for public pensions, by delivering superior returns over long time horizons," Steve Judge, president and CEO of the PEGCC, said in a statement.

"Private equity continues to strengthen the retirement security of the millions of American police officers, firefighters, teachers and administrators who rely on hard-earned pension benefits. There is no doubt that private equity returns are essential to improving the pension funding equation."
I covered the PEGCC study in a recent comment on why pension funds love Wall Street and told my readers to take all these reports from consultants and industry trade groups touting alternatives with a grain of salt. Importantly, returns in private equity over the next ten years won't be anywhere close to what they were in the last ten years, especially now that fresh signs of a PE bubble are emerging.

But what struck me from the article above is that MassPRIM has 10% of its assets (roughly $5 billion) invested in private equity using 103 different PE firms. I would love for someone to track the fees paid out to these private equity funds over the last ten years because I can tell you right away, they run in the hundreds of millions.

In the record low interest rate environment we're in right now, fees matter a lot. There is a reason why some large hedge funds are chopping fees in half and why many pension funds are increasingly looking to cut costs and bring assets in-house, following their Canadian counterparts which are dodging Wall Street everywhere they can. Costs matter a lot and it doesn't make sense to dole out huge fees, praying for an alternatives miracle, especially when you get mediocre performance in return.

And to be clear, large Canadian funds still rely heavily on private equity funds. They are not all flying solo but the trend is definitely to cut costs as much as possible and rely on external funds only when they have to because of the size of the deals or because they cannot replicate a strategy internally.

One thing all of Canada's top ten got right is governance and compensation. Senior public pension fund managers are compensated much better here than in the United States. Sure, their hefty payouts are scrutinized by the media but they are paid to deliver results over a rolling four-year period and that is why they get paid so well (we can argue whether they're overcompensated but that is market rate for experienced people in finance who deliver strong results).

I mention compensation because it's a huge problem in the United States. Ashby Monk wrote an article last June for Institutional Investor on why MassPRIM can't hold onto talent, explicitly focusing on low compensation. He rightly notes that MassPRIM has become a revolving door where people come to advance their career rather than the interests of the organization. That's what happens when you don't compensate pension fund managers properly for such important jobs (it took MassPRIM over a year to find someone to head their private equity).

Finally, there is another reason why Massachusetts has to look into cutting pension costs. According to the Massachusetts Taxpayer Foundation, the unfunded liabilities of the Massachusetts public pension system grew last year and reforms to ease the burdens had almost no effect:
State and municipal retirement funds in Massachusetts had $146 billion in unfunded liabilities at the end of 2012, the study by the Massachusetts Taxpayer Foundation said. With $63 billion on hand, that leaves a gap of $83 billion.

Reform measures to lower benefits owed new workers were passed by the state legislature in 2011 and took effect in April 2012. They included raising the retirement age from 55 to 60. The expected savings were projected to be $5 billion over 30 years. The study said the saving this year totaled $500,000 in the fund for state workers.

The amount of unfunded liabilities has grown the report notes. For instance, the state’s funding gap for teachers and state workers was $3.5 billion in 2000. In 2012, it reached $21.5 billion. Municipalities saw the gap grow from $13.5 billion in 2000 to $14.7 billion last year.

The failure of the funds to meet annual return on investment targets of 8 percent to 8.25 percent and delays of governmental payments to the system contributed to the growing amount of unfunded liabilities, the report said. In a move to restrict short-term contributions, payment schedules were extended from 2018 to 2040. Delaying the payments allowed governments to keep cash in the short-term, but dramatically raised long-term costs, the study said.

Other factors that contributed to the pension funds problems include early retirement incentives and enhanced benefits approved by the legislature.

Retiree health care benefits add an extra burden on municipalities and the state. The cost of paying for benefits already owed is pegged at $46 billion, the study said. It called the benefits “exceedingly generous,” in allowing retirees hired before April 2012 to retire at age 55 and making them eligible for full benefits with 10 years of service time.

Pension problems and how to address them have roiled governments from California to Rhode Island. In some states, constitutional guarantees are obstacles to making changes to promised retirement benefits. Unions often fight changes to benefits they say were fairly negotiated under collective bargaining rights.
I've already covered the pension rate-of-return fantasy and think it's high time U.S. public pension plans incorporate sensible reforms including reforms on governance so they can finally start paying pension fund managers appropriately.

Below, Stanford University Public Policy Lecturer David Crane discusses why state pensions are shifting investment strategies. He speaks with Trish Regan on Bloomberg Television's "Street Smart." Again, read my comment on why pension funds love Wall Street.