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Ever worked at a restaurant? That’s not the question one may expect when reading a financial publication on fund manager fees, but it relates more closely than one might think. A group of waitresses and waiters at a restaurant will have a range of fates when it comes to their tips. Scenario A: They put their tips into one bucket, and then separate them equally at the end of the night. Scenario B: They are each paid purely by their own tips. Scenario C: They are paid a base fee, plus a percentage of tips earned. The $6.5 billion Wyoming Retirement System would say Scenario C is the best option.
The Cheyenne-based pension has reworked the way they calculate fees for their managers in an effort to lower costs, compensate managers more fairly (in their view), and improve the incentive structure that guides manager decisions. According to fund Chief Investment Officer John Johnson and Senior Investment Officer Jeffrey Straayer, fee structures for fund managers need to shift control into the hands of asset owners. Traditionally, fund-manager fee structures paid by pension funds have led to overpaying managers when they’re doing well, yet managers maintain that payment when they’re underperforming, according to Johnson. Most asset owners have fund-manager fee structures that include high fixed fees with a performance fee added, which leads to fund managers indexing and gathering assets to maximize their paycheck, Johnson says. “That business model shifts risk to the pension fund rather than to the fund managers.”
The gist of the new concept used in Wyoming: If a fund manager employed by the system generates a return above a certain benchmark, they are paid for it. The fund’s new fee structure creates a performance fee bank in which managers are paid a base fee, and only later are paid performance fees if, in fact, the performance warrants it. The Wyoming pension’s revised fee structure slows payment to the manager, emphasizing sustained returns while better aligning interests on both sides of the fee arrangement, Johnson and Straayer agree.
The question, then, is whether this would be beneficial on a larger scale, among other types of institutions. Asset managers, for one, might not love the idea. The new structure adds greater variability in terms of their performance fee and, overall, it lowers their base fee. “If I’m a manager and I outperform on average, I would be willing to do this if I get paid significantly more if I outperform, offsetting the risk that during a bad year, I get a low fee,” says Jeffrey Margolis, founder of Margolis Advisory Group. “If institutions use this as leverage on managers, they might not have as much of a choice as they used to,” Margolis concludes, qualifying his statement with “but I don’t see that as likely in the near-term.” Furthermore, Margolis notes that widespread implementation of such a fee arrangement among pension funds and other institutional investors may eventually be detrimental for the institutions themselves. “You don’t want an unstable manager overseeing money.”
Despite the skepticism over Wyoming’s new structure, other commentators note that the traditional fee arrangement for fund managers is littered with weaknesses. A 2011 article published in the Journal of Alternative Investments by Eric Hirschberg delves into the underlying conflict between investors and managers: “Providers of risk capital (‘investors’) and employers of risk capital (‘managers’) are often at odds over the terms and conditions that each party believes are in their best interests. Providers typically want high degrees of liquidity and transparency with compensation-based performance measures infrequent as possible… . Managers, on the other hand, typically want long periods of committed capital, minimal transparency, and frequent compensation-based performance measures. They believe that capital lockups let them provide liquidity when others are demanding it, allocate to investments more rationally, and maintain investment infrastructure and human resources during adverse investment periods.” According to the author, while each participant’s desires are optimal for the role they have undertaken, it is far from clear that either is in the best interests of the capital itself. At least one potential manager agrees: Goldman Sachs, which encouraged the implementation of the new structure for Wyoming’s pension, has been quite vocal in its belief that a wider-scale embrace of the idea would lead to not only a better alignment of interests, but also to more motivated fund managers who are more reasonable with risk taken.
“I think that at the end of the day, this new fee structure would foster collaborative, long-term relationships between investors and money managers rather than short-term ones that likely end badly,” says Straayer. Culture, however, is slow to change. For some asset owners, flat fees might be simpler. For others, performance fees might be the focus to encourage return and innovation. The question asset owners will need to ask themselves to judge whether this fee structure is right for them, Straayer says: “Do you value an alignment of interest between investment manager and investor above shorter-term return?” Ultimately, he says, a better alignment—as Wyoming’s fee structure aims to achieve—will result in better returns over the long run. But will the money managers—or waiters, in the vein of the restaurant analogy—be onboard?