CalSTRS' CIO Ailman: Public Pensions Suffer From 'Outdated Model'

(May 16, 2011) — Christopher Ailman, the chief investment officer of the California State Teachers’ Retirement System (CalSTRS), tells aiCIO that public pension plans in the US run on an outdated business model.

“It’s difficult to run an investment company with all the governance rules and the structures,” Ailman says. “I think governance is going to be a very interesting area in the next 10 years for public pension plans, particularly in the US. You’ve already seen the endowments that started in the university campus and found that they couldn’t work well under the university structure…I don’t know when it’s going to happen and I’m not sure what the catalyst is but I think somewhere in the future we’re going to see the Crown corporation idea up in Canada come down in the United States, and people will realize they can run their pension in a different operating environment.”

Ailman adds: “If you think about it — and I’m very vocal with my staff — we’re an investment management company. We’re just trapped within the body of a governmental entity. It doesn’t take a Harvard grad long to figure out that that’s not the right business model to operate in.”

Describing the challenge of attracting, retaining, and recruiting people within a government-run structure, Ailman notes that during the last two years, he has had to furlough his staff for three days a month. “You wouldn’t shut down a money management firm three Fridays a month just arbitrarily. The world keeps moving and the markets keep moving. Our governance structure is one that was designed literally in the early 70s. So here we are 40 years later. I think that means we’re due for an improvement or at least a tuneup. Right now it’s not a politically feasible environment for anything in government. When you run deficits its very difficult to operate and manage across the board.”

At some point, Ailman says, there will be an honest discussion about the correct business model for public pension funds to operate in. “Clearly the Canadian plans have moved much farther ahead,” he says.

Partially because of these governance issues, CalSTRS does not run internal private equity and hedge fund teams like its Canadian fund counterparts. Ailman notes that the $155.4 billion fund is late in embracing hedge funds. For the funds they do access, they only do so directly, and they don’t use hedge fund-of-funds at all. “We think of hedge funds as a business structure, not an asset class. The term has gotten so amorphous and so bland. It doesn’t really mean anything other than two and 20,” he says, referring to hedge funds that typically earn a 20% cut of profits, along with a fee of about 2% of funds under management.

As an extension of the governance issues — and in light of the external hedge fund investments — Ailman believes that some forms of investment outsourcing are valid. With regards to relying on external help, Ailman supports the outsourcing model, mainly for smaller funds that lack internal expertise. “It gets down to a question of economics. When you look at anything we do, whether it’s hiring a lawyer ourselves or a doctor, we all want the best doctor we can afford. The outsourcing CIO function is a model – it makes sense. I actually like the fact that it prices my services. It’s a new industry, we’re going to see some positives and negatives, and it will continue to grow,” he says, adding that outsourcing  the CIO function at public funds will suffer the same thing any outsourced service does, in that the third party will not be 100% focused on that client and will instead be spread out over multiple relationships. “At some point, funds may want that personalized, direct service,” Ailman says.

CalSTRS has also embraced third-party help in a variety of ways with the use of investment consultants. “I think as it would in a corporate setting, we have a series of consultants, three specifically, that work directly with the board. My board is made up with people with expertise in education and a variety of areas. So they want additional help in analyzing the portfolio and overseeing what we do. We have a generalist consultant, which is Pension Consultant Alliance. We have a specialist consultant in real estate and a specialist in private equity because those areas are so complex…at a staff level we need consultants to leverage off the work that we’re doing. We have a pool of five main consultants that we tap into for projects. Then we have an expanded pool of seven firms that are specialists in different areas. And similar to a corporation, we bring them in, hire them for a specific project, get their research, then send them on their way. We take what they do and then decide if we want to implement them or not. We’re not going to rely on a consultant or outhouse things to a consultant.”

Click here to see an aiCIO video with CalSTRS’ CIO Christopher Ailman