Pennsylvania's Pension Fury?
Fury has erupted in Pennsylvania over huge fees paid by the Quaker state’s two largest public pension funds to investment managers on Wall Street.It looks like all hell is breaking loose in Pennsylvania and I will be the first to admit that I was aware something was cooking here as I was approached months ago by a lady consulting the state treasurer telling me they're looking closely at fees being paid out to alternative investment managers at SERS and PSERS.
Joseph Torsella, state treasurer, has accused Pennsylvania Public School Employees’ Retirement System (PSERS) and Pennsylvania State Employees’ Retirement System (SERS) of wasting $5.5bn paid as fees to Wall Street investment managers whose funds performed poorly.
The dispute follows similar rows in Maryland and California, where pension officials were forced to admit their failure over decades to disclose multimillion-dollar payments to private equity managers.
Unfunded pension liabilities across US state and local governments now exceed $6tn.
“The pension crisis is national,” said Jeff Hooke, a senior finance lecturer at Johns Hopkins University’s Carey business school.
Mr Torsella’s claim brings into question the secrecy surrounding private equity contracts. It also highlights the issue of whether it is appropriate for public pension schemes to use costly investment managers when the outlook for returns is deteriorating.
He said both PSERS and SERS would have achieved better returns at a lower cost by following a simple passive index-tracking strategy.
“We have paid Wall Street handsomely for mediocre returns. Lavish fees [ . . .] represent not just a waste of money but an abuse of the trust of the people,” said Mr Torsella.
A review has begun into the management of the funds, which also aims to find $3bn savings over 30 years. It will also examine investment performance and fees paid.
Mr Torsella estimated that PSERS could have avoided $3.9bn in fees if it had followed a simple equity-bond global index strategy. It would also have delivered better returns in seven of the past 10 years.
The smaller SERS could have saved $1.6bn in fees. An index-tracking strategy would have outperformed the pension fund’s investment portfolio in six of the past 10 years.
“The numbers clearly show that one simple low-cost passive strategy would have performed far better and saved a fortune,” said Mr Torsella. The treasurer has also called for both pension funds to abandon the use of placement agents — middlemen who facilitate introductions to investment managers in return for a fee.
The review body will present its findings to the state governor before the end of the year.
PSERS oversees assets of $53.5bn on behalf of more than 600,000 members. It says in its annual report that it paid $474m in “investment expenses” in the year to June 2017.
Alternative investments, including private equity, private debt and venture capital, account for 15.2 per cent of the system’s assets but 21.7 per cent of fees paid.
PSERS said it was “one of the most transparent” of the large US public pension funds because it disclosed data on management fees paid to private equity managers. Its annual report makes no mention, however, of performance fees, known as carried interest, paid to private equity managers.
The pension fund said: “PSERS has recently begun to collect performance-fee data for private markets (private equity, private debt and real estate) but it is not available yet.”
SERS oversees assets of more than $29bn on behalf of 239,000 members. It paid out $135m in 2017 in investment expenses, including fees to managers. About $70m in fees was paid to 147 private equity managers in 2016, the latest year for which data are available. Private equity accounts for 16 per cent of SERS’ assets but more than 40 per cent of the fees paid to investment managers.
SERS also does not disclose performance fees paid to private equity managers. It said the fund continually looked for savings. “We look forward to any new viable ideas that the Review Commission may bring forward,” said a spokesman.
The tension in Pennsylvania echoes issues in California, home to the two largest US public pension plans.
In 2015 these were forced to admit that they had no record of $7.5bn performance fees paid to private equity managers over more than 20 years.
After investing in a new reporting system, the California Public Employees’ Retirement System (Calpers), revealed in 2015 that it had paid $3.4bn in carried interest to private equity managers over 25 years. Calpers also admitted that the estimate was incomplete. Nine managers refused to provide historical data and Calpers was also unable to recover details of carried interest paid to private equity funds that had already matured.
The revelations prompted John Chiang, California state treasurer, to sponsor legislation requiring public pension funds to disclose management fees, fee offsets, fund expenses and carried interest paid to private equity and hedge fund managers.
The California State Teachers’ Retirement System (Calstrs), the second-largest public pension scheme, is yet to disclose the information on fees demanded by Mr Chiang.
Officials such as Mr Chiang and Mr Torsella have led efforts to improve transparency.
The National Association of State Treasurers, a body representing officials from 47 US states, made a call in 2016 for pension funds to report all private equity fees and expenses so that scheme members could fully understand the cost of investments.
Maryland’s $49bn state pension scheme was forced to admit in May that it had paid $87.4m in previously undisclosed performance fees to its private equity managers for the year to December 2016.
The Maryland Public Policy Institute, a think-tank, estimated that the state pension lost nearly $9bn income over 10 years after paying higher-than-average investment fees to Wall Street managers and in exchange for lower-than-average returns.
Mr Hooke, said pension fund executives were too easily seduced by the active management promises sold by Wall Street professionals.
Closing the $6tn funding gap could require tax increases or cuts in pension benefits unless improvements are made in the performance of public pension funds.
“It is time to fix America’s broken state and municipal pension system so workers and taxpayers receive a fair deal,” said Mr Hooke.
I put her in touch with a bunch of people I knew in Canada and never heard back from her. I also carefully explained the Canadian pension model to her so she understands that the success is built on two principles:
- World-class governance: Allows Canada's pensions to hire top talent across public and private markets and pay them properly. This is why over 70% of the assets are typically managed internally, lowering fees and costs, adding meaningful alpha over benchmark index returns over the long run.
- A shared-risk model: This means when pensions run into trouble and there is a deficit, the risk of the plan is shared which in turn means higher contributions, lower benefits or both. Pension plans in Canada with a shared-risk model have adopted conditional inflation protection to partially of fully remove cost-of-living-adjustments for a period until the plan's funded status is fully restored again.
But to develop a solid, long-term co-investment program where pensions can invest alongside a GP on larger transactions where they pay no fees, they first have to invest in the traditional funds where they pay big fees and they need to hire qualified people to evaluate co-investment opportunities as they arise.
Still, if done properly, a good co-investment program allows pensions to scale into private equity and maintain target allocations without paying a bundle on fees.
I mention this because I guarantee you very few US public pensions have developed their co-investment program to rival that of Canada's large public pensions which is why they're paying insane fees to their private equity managers per dollars invested in their PE portfolio.
The other thing I'd look into is whether the performance of these funds is worth the fees they've been paying into them.
Importantly, is the private equity portfolio too diversified and offering mediocre returns once you factor in leverage and illiquidity?
I recently wrote a comment on pensions taking aim at private equity funds for increasing their use of credit lines to leverage up their returns. Someone emailed me afterward asking me "whether funds get paid their carry on the IRR including the effect of leverage or excuding it"?
I told him I have no clue but my guess is they get paid the carry including the use of leverage much like hedge funds do.
On the issue of management fees and carry (performance fees), it's simply indefensible for any public pension fund not to report these fees in detail in every annual report.
I have nothing against paying fees, especially if a manager is delivering good solid returns over a long period, but for Pete's sake, report what you pay in carry and management fees, and other related costs.
Where I disagree with Joseph Torsella, the state treasurer, is when he compares the performance of SERS' and PSERS’ total portfolio with alternative investments to a simple global bond-equity index portfolio over the last ten years.
This is pure data mining. Since bottoming out in March 2009, we have had one of the greatest bull markets in stocks and bonds so it's stupid to compare alternatives to an index portfolio during a roaring bull market.
I'll go a step further. The big party in equities and passive index allocation is coming to an abrupt end sooner than most are prepared for. The next bear market will be long and painful.
This is why now is the time to invest in alternatives including hedge funds but make sure you're doing so intelligently reducing fees and aligning interests properly.
You need to compare an alternatives portfolio over a very long period that includes bear markets because that is when these investments should kick in to lower downside risks.
I'm not saying there aren't problems at SERS and PSERS in regards to their approach to alternatives but switching over to index funds is the dumbest thing you can do at this time of the cycle.
That's why I keep telling US pensions to focus on governance and a shared-risk model but nothing seems to be changing down south, it's business as usual which guarantees mediocre long-term results.
Below, Jay Bowen, Bowen, Hanes & Company chief investment officer, discusses pension reform and the unfunded public pension liability crisis in the United States.
Now, I'm on record being very suspicious about Tampa's hot pension fund and have openly questioned its use of one sole asset manager, Bowen, Hanes & Co (see their portfolio of stocks here, it's over 145, not 60, and it's a pretty standard portfolio of well-known names so I find it hard they delivered the returns they claim below).
I am definitely not promoting Tampa's firefighter pension approach especially for a large state plan. That's simply nuts but listen to some of the points he raises below which are interesting. Still, I don't agree with him on adopting an indexing aproach at this time, I find that irresponsible and dangerous.
The time for alternatives is now but choose more liquid alternatives (hedge funds) and do your due diligence right. If you're going to invest in private equity, make sure you're also co-investing with your GPs on larger transactions to scale into the asset class and lower overall fees, but in order to do this properly, you need to hire and pay talented people to come work at your pension.