American exceptionalism: CalPERS gets tough on managers
Christopher O’Dea explores whether CalPERS’s decision to sack half of its fund managers illustrates a broader trend in the institutional market
The decision by the largest US public sector employee pension fund to sack as many as half its investment managers demonstrates that the struggle by large public pension plans to earn enough to pay benefits has entered a new phase – and public plan officials are telling investment managers they’ll have to accept lower fees before officials ask beneficiaries to make larger contributions or accept reduced benefits.
CalPERS, the California Public Employees’ Retirement System, will direct its investment board at its June meeting next week to reduce the number of direct relationships with private equity, real estate and other external investment managers to 100 from 212. A public announcement is slated for Monday.
The move is aimed at reducing the fees CalPERS paid to external managers last year. That may seem to be pocket change for CalPERS, which has assets of more than $305bn (€270bn). But analysts say the pension fund, like many US plans, is facing a reckoning that stems from the uniquely US system of discounting pension plan liabilities with the assumed rate of return on assets. According to Andrew Biggs of the American Enterprise Institute, US pension plans assume an average 7.75% return on their investments, while pension consultants and investment managers say the median projected return over the next 10 years for a pension plan with 70% in equities is just 5.9%.
Assuming lofty returns makes it appear that pension plans’ investment returns will be able to cover payments to retirees. But CalPERS will soon face a duration problem – that is, the increase in its benefit payments will exceed the increase in its asset value from investment activity. “Benefit payments plus operating expenses are starting to exceed net investment income plus contributions,” says David Crane, lecturer on public policy and research scholar at the Stanford University Institute for Economic Policy Research.
Investing costs are number eight on the 10-item Investment Beliefs list CalPERS adopted in 2013, which calls for the fund to use its size to gain negotiating leverage to reduce costs and retain a larger share of economic profits from investing. A former member of the Volcker State Budget Crisis Task Force and the American Society of Actuaries’ Blue Ribbon Panel on the Causes of Public Pension Underfunding, Crane expects more plans will follow CalPERS and look to cut fees to investment managers as a way to help close funding shortfalls, and thereby avoid – or at least forestall – the need to raise participant contributions or cut benefits.
“Pension funds are increasingly asking governments to make up for shortfalls, which in turn forces those governments to cut spending on public services or raise taxes, or both,” says Crane. “The more pension funds can improve net investment income, the less pressure they need to put on governments to cut services or raise taxes. One way to improve net investment income is to reduce fees.”
CalPERS’s move illustrates a broader trend in the institutional market, according to Stephen Ellis, a director at Morningstar Equity Research. Pension funds and other institutional investors “are generally seeking to cull their list”, he says in a report on The Carlyle Group LP. “Some institutional investors may have hundreds of managers to oversee, which means substantial monitoring expenses, and funds want to reduce oversight costs.” The trend favours large managers with diverse strategy offerings, Ellis says, as pension funds today “generally prefer to place funds with established mangers where they have existing limited partner relationships”.
A CalPERS spokesman confirmed that eliminating some external managers will help the fund improve its overall economic position. Last year, it paid external investment managers $1.6bn, $400m of which was a one-time payment to certain real estate managers, according to a CalPERS spokesman. In a conference call about the matter, CalPERS CIO Theodore Eliopoulos said the fund was “taking the next step in what we see as a multi-year effort to reduce risk, cost and complexity so we can deliver the investment returns that are necessary to meet our obligations”.
For more on CalPERS and fees, see the July issue of IPE magazine