Warren Buffett has a word of advice for pension funds and endowments: cut out those high-fee “helpers,” namely consultants, outside managers, and others he deems a drag on returns.
In Berkshire Hathaway’s latest annual letter, Buffett describes US growth over the last 77 years. Why 77 years? That refers to when he bought his first stock: three shares of Cities Service for $114.75. And he did a little math regarding public pension funds and college endowments.
“If my $114.75 had been invested in a no-fee S&P 500 index fund, and all dividends had been reinvested, my stake would have grown to be worth (pre-taxes) $606,811 on January 31, 2019 (the latest data available before the printing of this letter),” he wrote. “That is a gain of 5,288 for 1.”
Buffett added that a $1 million investment by a tax-free institution such as a pension fund or college endowment would have grown to “about $5.3 billion.” But there’s a caveat:
“Let me add one additional calculation that I believe will shock you: If that hypothetical institution had paid only 1% of assets annually to various ‘helpers,’ such as investment managers and consultants, its gain would have been cut in half, to $2.65 billion. That’s what happens over 77 years when the 11.8% annual return actually achieved by the S&P 500 is recalculated at a 10.8% rate.”
Management fees is an issue that institutions are regularly grappling with, as many money managers will either underperform the S&P or match it by investing in index funds. Managers typically demand a 1% cut (2% if they are a hedge fund) regardless of the result. Since a considerable amount of these public pension plans are vastly underfunded, such as Kentucky (31%) and Illinois (36%), these payouts can further hurt funding.
“In the public sector, you know, it’s a disaster,” Buffet said of the pension funding gap in an interview on CNBC’s Squawk Box.
State retirement funds and endowments have been debating on how to correct the issue of paying high fees to these managers, especially if they are putting the money into the S&P and essentially letting the markets do the work for them.
Some, such as the Canada Pension Plan Investment Board ($368.5 billion), internalize more of their staff and provide better compensation. Others, such as Britt Harris’ $45.3 billion University of Texas Investment Management Company (UTIMCO), utilize the “1 or 30” fee structure.
Harris’ approach, a play on the “2 and 20” hedge fund model, gives managers the option to take either a 1% management fee or a 30% performance cut. The model was introduced during his time at the Teacher Retirement System of Texas as a way to deal with underperforming hedges, which the $154 billion pension plan still uses this day.
Harris has not only taken that structure to the endowment, but also adopts it for private equity managers.
Maybe Buffett would approve.