CalSTRS Wants to Increase Internal Management

Hundreds of millions in cost savings could be at stake, but building additional external capabilities won’t be easy.

The $230 billion California State Teachers’ Retirement System’s (CalSTRS) long-range plan to increase internal management of assets is built on one key tenet: potential savings of hundreds of millions of dollars in fees paid to external managers.

CalSTRS statistics show that in 2017, the last year for which full statistics are available, the pension’s costs to manage its internal assets was $30 million.

External management is a different story. It cost $1.8 billion (including incentive fees) for outside managers to invest CalSTRS’s money.

Fifty-six percent of the plan’s assets are managed externally, 44% internally.

No one on CalSTRS investment staff, from CalSTRS Chief Investment Officer Chris Ailman to asset class portfolio officers, thinks it’s realistic that the plan would ever be 100% internally managed and save almost $1.8 billion.

However, documents from the system’s investment committee meetings over the first half of 2019 and a video stream of the May 9 meeting, show that building internal management is a key goal in efforts to reap significant cost savings.

The effort for cost savings comes at a critical time for CalSTRS, the second-largest US retirement plan.

The plan is only 65.5% funded as of June 30, 2018, a number that is expected to drop after the plan posts its investment returns for this fiscal year at the end of next month. It has been a volatile year for pension plans primarily due to the ups and downs of the stock market. Few, if any, plans are expected to meet their anticipated rates of return.

CalSTRS’s expected rate of return each year is 7%, a rate some critics say is unrealistic. In any case, saving external fees by increasing internal management can give CalSTRS a better chance of meeting its returns projections, argue investment staffers.

“It’s imperative that we succeed,” CalSTRS Deputy CIO Scott Chan said at the May 9 meeting on efforts to increase external management.

CalSTRS staff memos indicate implementing external management on a much larger scale would span years. They also say that the pension plan will need to revise its structure, which is hindered by the fact that the retirement system is part of state government and can’t move quickly to hire specialized investment personnel.

“Internal investment management requires specialized skills to evaluate investment opportunities in a fast-paced environment,” said one May 9 investment staff memo. “Unlike fund investing with external managers or with [private equity] general partners, staff’s involvement includes every major decision on strategy, asset purchase, sale, renovation, as well as all leverage decisions.”

The memo says that CalSTRS will need to reinvent its recruitment approach of investment professionals to attract world-class talent. This, it said, would include partnering with external resources such as professional recruitment firms, along with building CalSTRS’s own human resources team. 

“In addition, the ability to hire the right individuals also hinges on remaining competitive with overall compensation packages,” the memo says.  

CalSTRS has made the largest progress in internal management in its $28.3 billion fixed income portfolio. Pension plan statistics show that 85% of the assets class is internally managed. CalSTRS’s largest asset group, the $119.5 billion global equity portfolio, is around 50% internally managed.

The plan also has a heavy concentration of direct-type investments in its $31.9 real estate portfolio. Separate accounts and joint ventures comprises 62% of the total portfolio, but CalSTRS pays fees to managers who ran the separate accounts or who are involved in the joint ventures.

Compounding the issue of increasing internal management of assets is that the largest group of fees paid to external managers in 2017 was to private equity managers. The CalSTRS statistics show that $521 million was paid in management fees and carry (profit sharing) with private equity managers.

Ailman has said in the past that it would be difficult and take years for CalSTRS to be able to run its own direct equity program, similar to what Canadian pension plans do. Instead, Ailman has advocated a first step is building CalSTRS’s private equity co-investment program, in which pension plans can invest alongside equity general partners, often with no fees or carry. Those efforts are currently underway.

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