Leo Kolivakis is a blogger, trader and independent senior pension and investment analyst. This post was originally published at Pension Pulse.
Rupert Hargreaves of ValueWalk reports, State Pension Funds Take On More Risk, Higher Fees For Worse Returns:
State and locally run retirement systems are increasingly turning to alternative and complex investments to help boost returns but these decisions may not be the best for all stakeholders involved, that’s according to a new report from The Pew Charitable Trusts.
The report, which is the latest in a series of reports from Pew on the topic, uses data from the 73 largest state-sponsored pension funds, which collectively have assets under management of over $2.8 trillion (about 95 percent of all state pension fund investments).
The use of alternative investment by pension funds varies widely across the industry. The use of alternative investments for the 73 largest public funds analyzed by Pew within its report varies from 0 to over 50% of fund portfolios. There are also vast differences in returns and returns reporting.
State Pension Funds Take On More Risk, Higher Fees For Worse Returns
For the 41 largest state funds that can be clearly compared against target returns—those reporting performance after accounting for management fees and on a fiscal year basis— the average annual target return in 2015 was 7.7 %. Actual annualized returns over ten years, however, averaged 6.6 % and ranged from 4.7 % to 8.1 % a year. Only one of the 41 (and two of all 73 funds) exceeded their target return in 2015.
At the same time, the majority of funds report on the basis of a fiscal year ending June 30 and include 10-year performance returns minus the fees paid to investment managers, although 12 funds report on a different period and more than a third provide ten year returns only “gross of fees.”
States also vary in whether they include performance-based fees for certain investments, known as carried interest, for private equity. States that disclose the cost of carried interest report higher fees than states that do not.
Over the past three decades, public pension funds have increasingly relied on more complex investments to reduce volatility and improve returns. A difference of just one percentage point in annual returns on the $3.6 trillion managed by the US pension industry equates to a $36 billion impact on pension assets.
However, while asset managers have been diversifying into assets such as real estate, hedge funds, and infrastructure in an attempt to reduce volatility and improve returns, Pew’s research shows US public pension plans’ exposure to financial market uncertainty has increased dramatically over the past 25 years. Between 1992 and 2015 the expected equity risk premium for public funds increased from less than 1% to more than 4%, as bond yields declined in the assumed rates of return remained relatively stable. What’s more, research shows that the asset allocation required to yield target returns today has more than twice as volatile as the allocations used 20 years ago as measured by the standard deviation of returns.
Given the fact that the majority of pension funds target a long-term return rate of 7% to 8%, with three only falling outside the range and given the current depressed interest rates available on fixed income securities, is easy to see why funds are investing in more complex instruments in an attempt to improve returns.
Indeed, Pew notes public pension funds more than doubled allocations to alternative investments between 2006 and 2014 with the average allocation rising from 11% of assets to 25% on assets. The higher expected return on these assets has allowed pension funds to keep return assumptions relatively constant.
But while managers have diversified in an attempt to improve returns, it seems exactly the opposite is happening. The shift to alternatives has coincided with a substantial increase in fees as well as uncertainty about future realized returns. State pension funds reported investment fees equal to approximately 0.34% of assets in 2014, up from an estimated 0.26% in 2006, which may seem like a small increase but in dollar terms, it equates to over $2 billion.
Pennsylvania’s state public pension funds are some of the highest fee payers in the industry with reported annual fees coming in at more than 0.8% of assets, or 0.9% when unreported carried interest for private equity is included. The dollar cost is $700 million per annum.
In total, the US state pension system paid $10 billion in fees during 2014 this figure includes unreported fees, such as unreported carried interest for private equity. Pew’s analysts estimate that these unreported fees could total over $4 billion annually on the $255 billion private equity assets held by state retirement systems.
Unfortunately, for all the additional risk being taken on, and fees being paid out, alternative investments and not helping state pension funds hit their return targets. 10-year total investment returns for the 41 funds Pew looked at reporting net of fees as of June 30, 2015, ranged from 4.7% to 8.1%, with an average yield of 6.6%. The average return target for these plans was 7.7%. Only one plan met or exceeded investment return targets over the ten-year period ending 2015.
You can click on the images below that accompanied this article:
Let me first thank Ken Akoundi of Investor DNA for bringing this report to my attention. For those of you who like keeping abreast on industry trends, I highly recommend you subscribe to Ken’s daily emails with links to investment and pension news. All you need to do is register here.
Take the time to read this report, it’s excellent and very detailed in its analysis of state funds, highlighting key differences and interesting points on unreported fees and the success of shifting ever more assets into alternative investments like private equity, real estate and hedge funds.
A few things that struck me. First, it’s clear that state pensions are paying billions in hidden fees and something needs to change in terms of reporting these fees:
Comprehensive fee disclosure in annual financial reports is still uncommon, but a few other states have also adopted the practice. The South Carolina Retirement System (SCRS) collects detailed information on portfolio company fees, other fund-level fees, and accrued carried interest in addition to details provided by external managers’ standard invoices. Likewise, the Missouri State Employees’ Retirement System (MOSERS) is particularly thorough in collecting and reporting these fees, not only by asset class but also for each external manager. Both states reported performance fees of over 2 percent of private equity assets for fiscal 2014 in addition to about 1 percent in invoiced management fees.
If the relative size of traditionally unreported investment costs demonstrated by CalPERS, MOSERS, and the SCRS holds true for public pension plans generally, unreported fees could total over $4 billion annually on the $255 billion in private equity assets held by state retirement systems. That’s more than 40 percent over currently reported total investment expenses, which topped $10 billion in 2014. Policymakers, stakeholders, and the public need full disclosure on investment performance and fees to ensure that risks, returns, and costs are balanced to meet funds’ policy goals. Such assessments are unlikely when billions of dollars in fees are not reported.
I totally agree with that last part, we need a lot more fee transparency on all fees paid by asset class and each external manager. In fact, there should be a detailed breakdown of fees paid to brokers, advisors, lawyers, and pretty much all service providers at any public pension plan.
Moreover, it’s completely ridiculous that more than a third of state pensions only provide ten-year returns “gross of fees”. All public pensions should report all their returns net of all fees and costs because that represents the true cost of managing these assets.
It makes you wonder whether they have the appropriate systems to monitor all fees and costs or they are deliberately withholding this information because net of fees, the returns are a lot less over a ten-year period.
The Pew report also highlights mixed results among state pensions in terms of returns following a shift to alternative investment strategies:
Although no clear relationship exists between the use of alternatives and total fund performance, there are examples of top-performing funds with long-standing alternative investment programs. Conversely, funds with recent and rapid entries into alternative markets—including significant allocations to hedge funds—were among those with the weakest 10-year yields.
Among the funds with successful long-standing alternative investment programs, the report cites the Washington Department of Retirement Systems (WDRS):
For example, the Washington Department of Retirement Systems (WDRS) is among the highest-performing public funds and has had a private equities program since 1981, making it one of the earliest adopters of alternative investments. In 2014, the WDRS had 36.3 percent of total investments in alternative asset classes, including 22.3 percent in private equity, 12.4 percent in real estate, and 1.6 percent in other alternatives. Hedge funds were notably absent from the mix. The fund’s long-term experience with the complexities of alternatives is reflected in its performance metrics: The WDRS has one of the highest 10-year returns of plans examined here, at 7.6 percent in 2015, buoyed in large part by the performance of its private equity and real estate holdings.
Now, a few points here. Notice that almost all of the alternative investments at WDRS are in private equity (22.3%) and real estate (12.4%) and more importantly, they were early adopters of such investments and have relationships that go back decades? This means they really know their funds well and likely also do a lot of co-investments with their GPs (general partners or funds they invest in) to lower their overall fees.
Another success in shifting into alternatives was South Dakota’s Retirement System:
Similarly, the South Dakota Retirement System began its private equity and real estate programs in the mid-1990s and realized 10-year returns of over 8 percent in 2015. The fund held nearly 25 percent of assets in alternative investments in 2014, but lowered this to less than 20 percent in 2015, comparable to the 18.3 percent held in alternatives in 2006. The 2015 allocation includes over 10 percent in real estate, 8 percent in private equity, and 1 percent in hedge funds. The fund reports net since inception internal rates of return of 9 percent for private equity and 21.4 percent for real estate, in comparison to the S&P 500 index of 5.8 percent for the same period.
But most state plans have struggled shifting assets into alternatives:
Conversely, plans with more recent shifts into alternatives—especially those with significant investment in hedge funds—are among those that exhibit the lowest returns. For example, the three funds with the weakest 10-year performance among net fiscal year reporters—the Indiana Public Retirement System, the South Carolina Retirement System, and the Arizona Public Safety Personnel Retirement System—are also among the half dozen funds with the largest recent shifts to alternative investments. All three have increased their allocations to alternatives by more than 30 percentage points since 2006. Significantly, these funds also have hedge fund allocations above the median fund, and all three rank in the top quartile for reported fees.
For example, in contrast with the WDRS and South Dakota’s early diversification, South Carolina shifted into alternatives precipitously in 2007 when the state enacted legislation to establish a new retirement system investment commission and provide the needed statutory authority to invest in high-yield, diversified nontraditional assets. Within a year, over 31 percent of plan assets were invested in alternatives, and by 2014 those assets made up nearly 40 percent of the fund’s total.
As detailed in an independent audit, rapid diversification into alternative investments proved difficult for a newly founded, under-resourced investment commission: The South Carolina Retirement System’s 10-year return of only 5 percent in 2015 is among the lowest of the plans studied. Given the long-term, illiquid nature of these investments, correcting misjudgments or realigning investments made quickly during the commission’s first years may prove challenging.
But there are no miracles in alternative assets, just more complexity and higher fees and if not done properly, it’s a total disaster for the plan and its stakeholders.
The report also notes that many states have consistently achieved relatively high returns without a heavy reliance on alternatives:
The Oklahoma Teachers Retirement System (OTRS) stands out in terms of performance among state-sponsored pension funds. It ranked near the top percentile of all public funds in the United States with a 10-year return of 8.3 percent gross of fees in 2015. The OTRS holds 17 percent of its assets in alternatives—below the fund average of 25 percent—with the bulk of its investments in public equities (62 percent) and fixed income (20 percent). Diversifying within the equity portfolio, employing low-fee strategies, and cutting operating costs are explicitly part of the fund’s overall strategy.
The Oklahoma Public Employees Retirement System (OPERS) takes this approach even further, with 70.2 percent of its investments in equity and 29.5 percent in fixed income. The fund holds no alternative investments. OPERS’ investment philosophy is guided by the belief that a pension fund has the longest of investment horizons and, therefore, focuses on factors that affect long-term results. These factors include diversification within and across asset classes as the most effective tool for controlling risk, as well as the use of passive investment management. Still, the fund does employ active investment strategies in less efficient markets (click on image).
The report also highlighted the need for greater standardized reporting to increase transparency:
Public retirement systems’ financial reports are guided by GASB standards, in addition to those of the Government Finance Officers Association (GFOA) and the CFA Institute. Collectively, these guidelines are widely recognized as the minimum standards for responsible accounting and financial reporting practices. For example, both GASB and the CFA Institute require a minimum of 10 years of annual performance reporting; the CFA suggests that plans present more than 10 years of data. The GFOA recommends reporting annualized returns for the preceding 3- and 5-year periods as well.
However, funds apply these standards differently. And because the performance and costs of managing pension investments can significantly affect the long-term costs of providing retirement benefits to public workers, boosting transparency is essential.
In a recent brief on state pension investment reporting, Pew reviewed the disclosure practices of plans across the 50 states and highlighted the need for greater and more consistent transparency on alternative investments. State funds paid more than $10 billion in fees and investment expenses in 2014, their largest expenditure and one that has increased by about 30 percent over the past decade as allocation to alternatives has grown.
However, over one-third of the funds in the study report 10-year performance results before deducting the cost of investment management—referred to as “gross of fees reporting.”
But the biggest problem of all at most US state pensions is they’re delusional, stubbornly clinging on to their pension rate-of-return fantasy which will never materialize. They do this to keep contributions low to make their members and state governments happy but sooner or later, the chicken will come home to roost, and that’s when we all need to worry.
The other problem and I keep referring to this on my blog, is lack of proper governance, which effectively means there is way too much political interference at state pensions, making it extremely hard for them to attract and retain qualified candidates that can manage public, private and hedge fund assets internally, significantly lowering costs of running these state pensions (basically the much touted Canadian pension model).
There are powerful vested interests (ie. extremely wealthy, politically connected private equity and hedge fund managers) who want to maintain the status quo primarily because they are the main beneficiaries of this US pension model which increasingly relies on external managers to attain an unattainable bogey.
But after reading this report, you need to ask some hard questions as to whether this shift into alternatives, especially hedge funds, has benefitted US state pensions net of all the billions in fees being doled out.
“Ok Leo, but what’s the alternative? You yourself have pointed out there is a major beta bubble going on in markets and now that the next economic shoe is dropping and the Fed is considering to shrink its balance sheet, what are these state pensions suppose to do?”
Good question. First, every investor needs a reality check and to prepare for lower returns ahead. Second, if deflation is coming, it will decimate all pensions, especially chronically underfunded pensions. They need to mitigate downside risks as much as possible and in a deflationary environment, the truth is only good old US long bonds (TLT) are the ultimate diversifier.
But bond yields are low and headed lower, which effectively means pensions need to diversify and take intelligent risks to make their required rate-of-return. Here is where it gets tricky. There are intelligent ways to take on more risk while reducing overall volatility of your funded status (think HOOPP, Ontario Teachers’ and other large Canadian public pensions) and dumb ways to increase your risk which will only make your general partners very wealthy but not benefit your plan’s funded status in a significant and positive way (think of most US state pensions).
My only gripe with The Pew Charitable Trusts report is it doesn’t focus on funded status to tie in all other information they present in the report. Pensions are all about managing assets and liabilities and it would have made the report a lot better if they focused first and foremost on funded status of each state pension, not just returns and fees.
Still, take the time to read the entire report and you have to only hope that one day Pew will do the same report for Canada’s large public pensions and compare the results to their US counterparts.