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In the Nation's Interest

State Pension Fund Managers Start Looking at Fees?

States Are Looking at Their Pension-Fund Investment Fees

After a long period of increasing alternative exposure and greater investment management fees, some funds are taking a second look.

Just last week, CALPERS announced it was consolidating its manager base to reduce fees. This action followed a policy instituted several months ago whereby CALPERS started to liquidate its hedge fund participations.

Two weeks ago, the New Jersey State Senate held a high-profile hearing that examined the performance of alternative versus traditional investments. My testimony, and that of a state employee union official, indicated that alternatives were not meeting benchmark returns. In defense, the state investment council chair suggested that alternatives were a defensive investment option rather than a return enhancement vehicle.

The New York City Comptroller, in April 2015, released a study that concluded that alternatives had not enhanced pension fund returns over a ten year period, in part due to the high fees. The Comptroller administers a number of pension funds for municipal employees, totaling over $150 billion in assets.

Why Is This Trend Underway?

State pension funds have over $3 trillion in investment assets. These include traditional assets such as publicly traded stocks and bonds, as well as alternative assets such as hedge funds, private equity funds, commodities and real estate. Nonetheless, these assets, along with future contributions by state governments and existing workers, don’t seem to be enough to cover projected obligations to retirees. The Pew Charitable Trusts, for example, estimates the shortfall at $1 trillion.

Ideally, a pension fund’s outflows are replenished by inflows. For example, in the fiscal year ended June 30, 2014, the State of New Jersey State paid out $16 billion in benefits. This cash outflow was more than replenished by $22 billion of inflows, including $7 billion in employer contributions, $3 billion in employee contributions and $12 billion in investment income.  However, surplus cash is not always the rule for state pension funds. Some state governments, like Illinois, expect funding problems in the near future as cash leaves the pension fund faster than it comes in.
From the state workers’ point of view, pension funds need to be adequately funded in the present. First, future politicians or future taxpayers have an obligation to authorize extra revenues if the pension fund has a shortfall, but, they may try to avoid this obligation should it arise.  Second, if a state has severe general-obligation debt repayment problems in the future, its pension fund is “bankruptcy remote.” This means the state’s creditors cannot attach the fund’s assets designated for retirees.

From a managerial perspective, a properly financed pension fund enables the state government to plan ongoing treasury operations in a more deliberate fashion.

Typical Investment Portfolio:

A typical state pension fund allocates its investment assets in roughly the following percentages.

Traditional: publicly-traded stocks (U.S. and International)      45%

Traditional: publicly-traded bonds (U.S. and International)      30%

Alternative assets, such as hedge funds and private equity    25%



Most funds “farm-out” investment “buy and sell” decisions (i.e., the investment management process) to third-party managers. As indicated in the table, investment categories are divided into (i) traditional investments; and (ii) alternative investments. States have been increasing exposure to alternatives in the last ten years, as they hope that these assets will have higher returns than traditional investments.


U.S. Publicly-traded Stocks: Common stocks of companies based in the U.S. and listed on a U.S. stock exchange, like IBM and McDonald’s.

International Publicly-traded Stocks: Firms based in foreign countries, such as Germany, France and China. (e.g., Nestle and Alibaba).

Publicly-traded Bonds (Investment Grade): Publicly-traded bonds of companies (or governments) with high credit ratings (BBB or better).

Publicly-traded Bonds (Junk Grade): Publicly-traded bonds rated BB or lower.


Hedge Funds: Investment pools that generally invest in publicly-traded stocks and bonds, or derivatives thereof. Some funds also invest in currencies and commodities. Hedge funds also have the authorization from their investors to “short” securities, i.e., to bet that the value of a security will decline. Hedge funds purport to make profits in both “good” and “bad” stock markets, although historical evidence is lacking to support this premise.

Private Equity: This category is principally represented by leveraged buyout funds (“LBO funds”). LBO funds acquire U.S. companies, for the most part, using large amounts of borrowed money. By buying firms at good prices, improving the acquisitions, and selling the investments after a 5-10 year holding period, the LBO fund hopes to provide its investors with a return, net of fees, substantially higher than the S&P 500 index over the matching time period. The S&P 500 index plus 3% is a conventional target, given the high leverage risk, but LBO funds have had a hard time achieving this target over the last years.

By way of illustration, CALPERS, the largest state pension fund, had a five year (five years ended June 30, 2014) compounded annual return on its private equity portfolio of 18.70%.The S&P 500 plus 3% target was 21.83%, so CALPERS fell short by 3.13%.

Real Estate: Commercial office buildings, industrial parks, apartment buildings and similar assets.

Commodities and Real Assets: Copper, silver, oil, timber and similar assets.

Third Party Management

Active Management: A third party “investment manager” hired by a state pension fund is allocated a certain amount of the fund’s monies, and the fund allows the manager to buy and sell investments with these monies on the Fund’s behalf. The principal objective of this arrangement, which is prevalent in the institutional money management industry, is for the third party manager to use its acumen to exceed certain “benchmark returns” established by the industry for the asset category that the manager has been assigned. For example, a manager buying and selling international stocks may be measured against the MSCI Index (ex U.S.).

Countless academic studies have concluded that “active managers” are unable to beat consistently their benchmark index. Morningstar, the mutual fund research firm, produces an annual study that typically shows 80% of mutual funds (trading public securities) fail to beat their respective indexes. This pattern has furthered the growth of index funds, which copy benchmark indexes on their investors’ behalf, and charge lower fees than active managers.

For these investment selection services, a fund compensates the managers, much like the retail holders of a Fidelity mutual fund pay Fidelity a fee to select investments for the holders within pre-set criteria.

Most third party managers hired by state pension funds are called “active managers.” They research investment opportunities, negotiate investment prices, structure transactions, monitor investments, and then make the eventual sell decision.

Passive Management: In the area of publicly-traded stocks and bonds, there is also an investment style called “passive management.” Here, the manager does little or no analytical work regarding the assets. Instead, the manager simply maintains a portfolio that replicates a benchmark measurement index, like the S&P 500 U.S. index. In this way, the passive portfolio is guaranteed to match the returns of the index.


State pension funds rely heavily on the active management style for publicly traded securities, and use third party managers almost exclusively in the alternatives sector. In July 2013, the Maryland Public Policy Institute published a study, which showed that state pension funds paid over $9 billion annually in money management fees in 2012. Ironically, the study concluded that states paying the higher fees tended to have the lower investment returns. I co-authored the study.

From a fee standpoint, the most expensive asset class is alternatives, where fees on a portfolio are usually a combination of: (i) a minimum fixed of 1.5% per year on assets under management; and (ii) a performance fee payable if the manager exceeds a certain benchmark, with 8% being a popular target. A successful manager may receive 2% to 3% annually, or 200 to 300 basis points.

Active managers of publicly traded stocks and bonds charge lower fees. Twenty to 40 basis points annually on assets under management is a general range.

The least costly portfolio is represented by index managers of publicly traded stocks and bonds. Typical fees are 3 to 5 basis points for a large institution. This translates into a cost that is 1/50th of an alternatives portfolio.

Given the disproportionately large fees for questionable investment performance advantages, it is not surprising that states are beginning to think more carefully about their investment choices.

Guest blogs are the views of the individual and not the official policy of CED.


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