Fox & Hounds: Deciphering Public Pension Fund Investment Fee Reports

Recently there has been a good deal of press about public pension funds moving $600 billion to “alternative investments” managed by hedge funds and private equity funds.  Some commentators, such as Matt Taibbi of Rolling Stone and David Sirota of Salon, criticize alternative investments as transfers of wealth to Wall Street because alternative investment managers charge high fees.  But the public pension fund managers making those allocations to alternative investments and agreeing to pay those fees say alternative investments produce greater returns than do other investments, even after paying big fees.   Not everyone believes them.

It’s easy to understand the cynicism.  Alternative investment management fees are big, and many reports by public pension funds about alternative investments are at best confusing and at worst misleading. But there are some good models out there.

One is the State Investment Commission of Rhode Island (SICRI), which provides an easy-to-navigate website with extensive detail about fees.  From its annual reports, readers can see how much the pension fund spends generally on investment expenses, how those expenses are by category, and how much is paid to each outside manager.   The report even includes a “Frequently Asked Questions” section to explain alternative investment fees in plain language.

For example, a visitor to its website can easily find and read that the fund devoted $70 million in total to investment expenses of which $21 million went to 11 hedge fund managers. Of that $21 million, $1.8 million went to (as one example) Wexford Spectrum Fund LP, one of those hedge fund managers.  That $1.8 million is then broken down to show how much was derived from an annual management fee ($.7 million) and how much was derived from an annual performance fee ($1.1 million).  Deeper still, the report discloses the terms of its contract with Wexford (an annual management fee equal to 1.5% of assets and an annual performance fee equal to 20% of the profits).

A counter-example is that of the California State Teachers Retirement System (CalSTRS), which invests much more in alternatives than does Rhode Island but provides much less information.  CalSTRS is one of the country’s largest investors in alternatives, having committed almost $40 billion to that sector.   It pioneered public pension investment into alternatives (with very good results in my opinion).  But a visit to its website tells readers next to nothing about the fees it is paying.

Unlike Rhode Island, CalSTRS doesn’t provide basic fee information.   So far as I can tell from the website, the closest one can come to learning anything in that regard is to infer from two pages, one that presumably shows a gross return before fees and another that presumably shows the return after fees.  The difference is 2.30% per annum, which fits with the usual fee structures of alternative investments.  But there’s no explanation and no detail.

Even the website’s “Investment Terms Glossary” contains no reference to fees or expenses.  The closest it comes to divulging information about compensation to alternatives managers is a reference to “Carried Interest,” which is the performance fee usually equal to 20% of profits.  But there is no listing of fees paid, either in aggregate or per manager.

The issue of fees being paid by public pension funds to Wall Street for managing alternative investments is likely to stay in the news.  Like CalSTRS and Rhode Island’s pension funds, many public pension funds have huge deficits requiring ever-greater draws from state and local budgets.  One way to reduce those draws is to increase investment earnings. Public pension fund managers — justifiably in my view — see alternative investments as a way to help do that, even if it means paying larger investment management fees.  This helps explain why the Illinois Municipal Retirement Fund just boosted its allocation to alternatives by 50% and why fees paid by New York City’s pension funds to Wall Street climbed 28% over the last year, to nearly $500 million per year.  But when so much money is at stake and the fees are so large, journalists and citizens are bound to ask the questions being asked by Sirota and Taibbi.  In CalSTRS’s case, there is an additional reason for more detail, which is that the fund is seeking a 30-year, $240 billion bailout from state taxpayers.

In my view, public pension funds should be permitted to make alternative investments (provided, of course, that selections are based only on merit).  But they should divulge compensation arrangements and amounts, and do so in an accessible manner.

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