(December 2, 2013) – What will $500 million in asset management fees buy? A heck of a lot of trouble, judging by recent controversy surrounding two US public pension funds’ investment expenses.
New York City and South Carolina’s retirement systems each shelled out just under half of a billion dollars to asset managers in the most recent fiscal year. Both public defined benefit schemes outsource effectively all of their assets to external investment firms. Allocations to alternatives are by far the most expensive part of each system’s portfolio.
The catch? Between its five pension funds, New York City’s assets total $144 billion. South Carolina spends roughly the same on a $27 billion portfolio.
Furthermore, in the 2013 fiscal year, New York City’s funds returned 12.12% and South Carolina’s gained a net 9.9%. The former has likewise outpaced its southern peer over three- and five- year performance periods.
But both organizations have come under fire in recent weeks for their half-billion investment expense tabs. Here is an in-depth look as to why, and what those in charge are doing about it.
New York City Retirement Systems ($144 billion AUM)
“Wall Street Fees Paid by NYC’s Pension Funds Climb 28%,” announced a Bloomberg headline on November 22, following the release of the comptroller’s annual report for fiscal 2013. It’s the story no PR person wants to wake up to.
New York City’s five massive retirement funds have long been characterized as a governance nightmare, including by their most recent CIO Larry Schloss and by this publication. As with South Carolina’s state system, New York City outsources all of its asset management, leading to higher fees than it might otherwise incur.
“Of the top 10 US public pension funds—NYC is number five—we’re one of two outsourcing everything,” Schloss told aiCIO last year. (The other fund is Washington State’s.) “It hasn’t at all changed in 70 years. We’ve gone to the moon and invented the internet in 70 years. You’d like to think you can change this, especially with the talent present here in the world’s financial capital.”
Near the end of his tenure, Schloss put forth a proposal to start the insourcing process. It hasn’t gained traction since then, although his estimated timeline for full implementation was an astonishing 10 to 20 years. Until then, the New York City pension system’s costs of doing business land in the pockets of Wall Street-types. Based on the latest fee figures and the official reasoning behind them, those costs will likely continue to mount.
The 28% figure cited by Bloomberg is accurate: New York City’s pension funds spent $472.5 million on investment fees in the 2013 fiscal year, and $370.2 million the year prior. Add in the defined contribution plans and health benefit funds, and the recent payout amounts to $499 million, which is $105 million higher than the previous year. But nearly half of the rise in management expenses can be attributed to growth in the pool of assets needing to be managed. The funds closed FY2013 with a collective $137.4 billion, and 2012 with $122.1 billion—a rise of 13%.
When reached by aiCIO, a spokesperson for the Comptroller’s Office was audibly frustrated at the “rising fees, stagnant performance” angle prevailing in press reports on the data. The comptroller, who is responsible for the retirement funds, pinned the jump in fees on changing asset allocation as opposed to a Wall Street feeding frenzy.
“It’s misleading to cherry pick one year and compare a rise in fees with the rate of return,” the office said in a statement. “Fees rose in FY2013 consistent with the recent expansion into alternative asset classes that diversify the portfolio against events like the stock market collapse in 2008. By making these alternative investments, the funds have helped reduce the risk in the portfolio for both pensioners and taxpayers, particularly in times of stock market distress… The fact is that many alternative investments, such as private equity and real estate, have front loaded fees and don’t generate returns for several years.”
Allocations to alternatives have risen over the past few years, although not by a huge margin according to the latest available data. Taken together, private equity, private real estate, and hedge funds amounted to 11.2% of the systems’ portfolio as of August 31, 2013. A year prior, that portion was 11.1% and in 2011 it was 9.7%. Change comes slowly to New York City’s retirement funds.
From a fee perspective, that’s a good thing. The city’s biggest fund, the $47 billion New York City Employees’ Retirement System, is also the largest municipal pension scheme in the United States. During the 2012 fiscal year, alternatives accounted for 15.8% of the portfolio but 63.5% of its total fee spending.
There is a consensus among consultants and alternative managers alike that fees have fallen overall since the financial crisis. This trend in alternatives, like New York City’s rebalancing towards the asset classes, is operating in the margins. South Carolina’s $11 billon alternatives program, representing nearly half of its total portfolio, is not.
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South Carolina Retirement System ($27 billion AUM)
The South Carolina Retirement System Investment Commission (RSIC) has initiated a major shift in asset management in an attempt to reduce its extraordinarily high annual fees, last clocking in at $419 million. Spearheaded by the newly appointed COO Greg Ryberg, the commission has requested $1.2 million from the state legislature to build out internal management and back office capabilities.
“Our goal is to bring a lot of the functions internal, to control our destiny relative to the fees,” former state Sen. Ryberg told aiCIO. “We are looking to staff up in order to handle more of our investments and operations, and to establish proper personnel level.”
The $27 billion fund’s management fees are significantly higher than those of other pension plans—the fees equal 157 basis points (bps) of total assets compared to an average of 57 bps, according to fund consultant Hewit EnnisKnupp.
The consultancy further reported that South Carolina was paying well above the norm in performance-based fees and add-on expenses. It recommended not only reducing current fees but also aggressively negotiating terms when hiring new managers.
According to the investment commission’s annual report, fees have jumped 33% from the last fiscal year. The report also revealed that strategic partnership costs have accounted for more than half of the hefty sum—as of June 30, 2013, RSIC paid $233 million to its asset management "partners."
“There are good fees and bad fees,” Ryberg said. “We hope to reduce the bad fees—those we pay upfront on committed capital. Unfortunately, the price of admission into some of these funds is extremely high.”
Ryberg continued to say that the commission is on track to reducing its number of strategic partnerships: “When we first made investments, we didn’t have the staff to do all of the due diligence so we had to hire external managers. But some of these strategic partnerships will unwind and untie.”
South Carolina has already curtailed six of its original 14 partnerships and is expecting to lose two more in the near future.
However, this enterprise to cut management fees has been overshadowed by a very public—and personal—dispute between State Treasurer Curtis Loftis and COO Ryberg. Both men hold sway over the fund as RSIC voting members.
“I find myself in an odd position as a member of the commission,” Loftis told aiCIO. “I want to support the commission but as treasurer, I see a big problem with the top officers. We lack a moral core—particularly in the way we report our operations.”
Loftis said a move from active to passive management would significantly help relieve the fund of its substantial fees—and that appropriate due diligence on the commission’s internal staff is key.
“I’m concerned about due diligence on ourselves,” Loftis said. “We hire consultants everyday to perform due diligence on our external management. Why don’t we do the same for us? We need to talk about whether the commission is capable of managing these large sums of money and exactly how much we’re losing and who’s losing it.”
Transparency, however, is something RSIC still needs work on, according to Loftis. He claimed the commission has remained quiet on a $1 billion loss in its synthetic overlay program run by Russell Investments over the last five years. “Nobody owned this loss,” he said. “The commission’s never really addressed it and until we resolve these types of issues, we’re working at our own peril.”
The treasurer also revealed that until recently, RSIC’s management fees have been shown “discreetly” on its audited financials.
“Under the investment expense line, we only showed about 20% to 25% of our fees. So instead of showing $300 million, we only showed $50 million,” Loftis said. “Over the last three years, $750 million in fees was just netted from the account and was not described elsewhere on the statement.” He said fiscal year 2013 was the first time RSIC has revealed the entirety of its fees, alarming not only the commission but also the South Carolina general assembly.
Ryberg directly opposed Loftis’ claims: “The South Carolina public pension plan is the only plan in the country that fully discloses its fees. And as for our disclosures in the past, we have always been consistent with every other pension plan in the country.”
Loftis continued to state that certain members of the commission have been using the $27 billion as their own cash cow. He said Chairman Reynold Williams and his law firm even made $150,000 off RSIC’s investments in American Timberlands.
“These unelected bureaucrats like the way they’ve been doing business,” Loftis said. “They treat the commission like it’s their own baby. They don’t like the fact that I make criticisms and talk about its top officials in this way.”
The COO responded by saying Loftis’ claims are not only “ludicrous” and “not substantiated” but also “probably untrue.”
“We’re not about politics,” Ryberg said. “We’re moving forward, away from petty distractions. We’re going to spend a good deal of time educating stakeholders and legislators about operational challenges.”
Preliminary hearings for the $1.2 million in-house management request are scheduled throughout December. The proposal will move into House and Senate committees in January and March of next year, perhaps raising the question: Can half of a billion dollars buy cooperation among politicians?
—Leanna Orr & Sage Um