Wyoming Pension: Time for a Fund Manager Fee Structure Makeover

The $6.5 billion Wyoming Retirement System's John Johnson and Jeffrey Straayer say that fee structures for fund managers need to shift control into the hands of asset owners -- the chief investment officers and other investing heads of pensions.

(July 26, 2012) — The $6.5 billion Wyoming Retirement System says it’s time for “capital owners,” or public pension funds more specifically, to change the way they compensate their fund managers, because as of now, the managers are often the ones getting most of the benefits — even when they underperform.

Thus, according to the public pension fund’s John Johnson, chief investment officer, and Jeffrey Straayer, a senior investment officer, the Wyoming scheme is changing its methodology of fund manager compensation. It has introduced a revised fee structure in a request for proposal (RFP) in March and is expecting implementation by mid to late August. While traditionally, fund manager fee structures used by pension funds lead to overpaying managers when they’re doing well, managers maintain that payment when they’re underperforming, according to Johnson. Most asset owners have fund manager fee structures that include a high fixed active fee with a performance fee added to it, which leads to a tendency among fund managers to index and gather assets to attain the highest fees, Johnson said. “That business model shifts risk to the pension fund rather than the risk being on the fund managers,” he said.

Consequently, Johnson and Straayer are introducing the idea of a performance fee bank — an idea they say that was generated by conversations with a range of money managers, particularly Goldman Sachs. The concept in a nutshell: If a fund manager employed by the Wyoming Retirement System generates return above a certain benchmark, they are paid for it. The Wyoming fund’s new fee structure creates a performance fee bank in which fund managers are paid a base fee that is near passive as opposed to an active base fee that rewards managers if they generate returns that match the benchmark.

“We wanted to create a holdback period rather than a clawback period,” Straayer noted. “With clawbacks, if fund managers are paid in excess of what they should have been paid, a pension’s investment head must ask them to repay what’s been lost, which is a problem.”

Johnson added: “Our experience has been that managers generate alpha and then lose it all, yet they still get paid a high fee because we need to pay an active management fee for passive returns.”

The Wyoming Retirement System, however, wants to pay managers when they consistently beat the market. “The performance fee bank is essentially a high-water mark, because if they don’t outperform the index, the fee bank is reduced. If it goes below zero, managers must build the fee bank back up before we pay out a performance fee,” Straayer asserted.

For Wyoming’s pension fund, the key for fund managers proving their value is only by demonstrating sustained returns, the two pension heads said.

“We’ve spoken with a number of pension folks — they’re intrigued and some of them are taking it to their managers. It’s still a new concept,” Johnson noted. “The reality is that the business is changing, and if managers want to be successful, they need to give value to capital providers.”