The Costs and Benefits of Investing in Alternatives
State treasurer Curtis Loftis Jr. says South Carolina is paying too much in investment fees, but others argue that the performance is worth it.
At the South Carolina Retirement System Investment Commission (RSIC), the debate over investment fees — namely, whether it’s worth it for the state to pay them — is dominating the usual introspection that comes with New Year’s. Toward the end of 2013, a bipartisan panel was created to look into criticisms made by Curtis Loftis Jr., South Carolina state treasurer, regarding RSIC’s investment fees for the approximately $27 billion fund behind the South Carolina Retirement Systems. But others say that the fees are a cost of using alternative investment strategies, in which the pension has, as of June last year, just under 40 percent.
Loftis, who sees himself as a conservative reformer and has the backing of local Tea Party groups, claims during fiscal year 2013 the state paid $420 million in investment fees, worth some 157 basis points of the state pension plan’s assets under management. The average state pays approximately 57 basis points, he notes. “We have made some progress,” Loftis explains. “When I joined the commission in 2011, we were still adding strategic partnerships. Because of all this noise, we are now removing strategic partnerships. We had 14. We are down to eight, and we will be down to six shortly.”
The breakdown of the South Carolina pension fund’s alternative assets includes 5 percent of its overall portfolio in hedge funds, 3.7 percent in real estate and 2.7 percent in commodities (see accompanying chart).
|Large Cap Equity||9.7%||9.0%||0.7%|
|Small/ Mid Cap Equity||5.2%||5.0%||0.2%|
|Emerging Markets Equity||5.6%||8.0%||-2.4%|
|Core Fixed Income||9.2%||10.0%||-0.8%|
|Investment Grade Credit||2.0%||2.0%||0.0%|
|Global Fixed Income||1.8%||1.0%||0.8%|
|High Yield Fixed Income||5.0%||6.0%||-1.0%|
|Emerging Markets Debt||5.4%||6.0%||-0.6%|
|Cash and Short-Duration Fixed||10.7%||7.0%||3.7%|
|GAA / Risk Parity||10.0%||10.0%||0.0%|
|1 Portfolio Exposure reflects adjusted notional exposure of each asset class on a plan level. Target allocations are consistent with the Annual Investment Plan.|
Each partnership has been relatively complicated and created excess fee structures for the pension fund, says Loftis. As the partnerships diminish, so will the fees. “We did not create the most expensive pension portfolio in America overnight, and these fees are not going to be removed overnight,” notes Loftis. He argues that the state’s average annual per capita income of $34,266 — ranking 48th out of 50 states — leaves much of the onus on fund managers with regard to fees. “We shouldn’t be paying $420 million — the highest fee ratio in the country — to some of the wealthiest people in the world,” he says. As a point of comparison, the $144 billion New York City Retirement Systems, which encompasses five funds that collectively are the country’s fifth-largest public pension fund overall, paid $472.5 million in investment fees during fiscal year 2013.
Among those skeptical of Loftis’s claims is Greg Ryberg, former state senator and chief operating officer of RSIC. “South Carolina pays more fees than some because it does not invest in a straight 60-40 portfolio,” Ryberg said in an e-mail to Institutional Investor. “That’s because it must mitigate risk due to a funded level of approximately 55 percent.” The former senator says that South Carolina’s fees have increased along with the performance of its managers. “So, for approximately $200 million in performance fees, we earned $800 million with a lower risk profile than the S&P,” he adds. “RSIC fees, if reported at the minimum legal requirement, such as do Florida and Utah, would run about $55 million.”
Ryberg also asserts that the total amount of fees paid by each public fund is unknown, and any assertion to the contrary, and therefore any purportedly legitimate comparison, is false. No standard reporting protocol or definitive study exists, he says.
Loftis counters that these are misleading arguments. He agrees that some funds may underreport their fees, but even if other public pensions are not reporting 10 or 20 basis points’ worth of fees, South Carolina is still reporting at least double what other pension funds are paying.
Loftis’s tenure in office has not been without controversy, especially in regard to management of the pension fund. Last February five out of the six RSIC commissioners who have voting rights called for his censure on the ground that Loftis was “engaging in false, misleading and deceitful rhetoric” against the commission, showing as examples several media interviews dating from 2009 in which he voiced discontent with the RSIC’s investment practices and policies. Loftis maintains that as state treasurer, it is his right to publicly critique management of the state’s public pension fund.
Findings from the commission suggest that the alternative assets in South Carolina’s pension fund have not fared badly of late. The portfolio’s hedge fund assets earned 12.21 percent in 2013, surpassing the HFRI fund weighted composite index’s 8.14 percent year-to-date return as of November 2013. The pension fund’s real estate holdings were up 17.61 percent for the year, compared with 10.52 percent for the National Council of Real Estate Investment Fiduciaries property index in 2013. Commodities had the biggest drop out of the fund’s asset classes, down 9.33 percent on the year. Overall, the South Carolina pension plan had a total return of 9.99 percent for the fiscal year ended June 30, 2013. Its ten-year annualized return was 4.98 percent.
According to a study published in July by Cliffwater, which provides advisory services on alternative investments for institutional investors from its offices in New York and Marina del Rey, California, the top 20 best-performing state pension funds in the ten years ending June 30, 2012, had an average allocation of 29 percent in alternatives (the South Carolina Retirement Systems was not among those listed). But out of the approximately $2.6 trillion in assets held by public pensions in the U.S., roughly 25 percent is in alternatives.
The Employees’ Retirement System of Rhode Island has 26 percent, or nearly $2 billion of its $7.7 billion portfolio, in venture capital, private equity and hedge funds. Gina Raimondo, Rhode Island state general treasurer, has earned nationwide recognition for turning around the fund, which was 48 percent funded when she took office in 2011. But the fund’s allocations in alternative investments have sparked criticism. The Providence Journal reported that the pension’s investment expenses for the year ended June 30 were $70 million. Another figure, by Benchmark Financial Services, a forensic firm that the Rhode Island Council 94 of the American Federation of State, County and Municipal Employees, AFL-CIO, brought on to investigate the Rhode Island pension fund’s alternative allocations, puts this figure at some $11.5 million for the same period.
That fees have been increasing is not in question. Alternative investments mean higher fees. “Investment management expenses paid by public pension funds have been increasing,” says Austin, Texas–based Keith Brainard, research director for the National Association of State Retirement Administrators. “As far as I can tell, they increase primarily due to growing allocations to alternatives such as private equity, hedge funds and also real estate.”
Something to consider, explains Brainard, is that South Carolina was one of the last states to divest of its all-bond portfolio into higher-risk investments. Having this debate when the fund went from all bonds to one of the largest allocations of alternatives in a period of roughly 15 years is, according to Brainard, “ironic.” He continues, “I don’t know these board members, but from a distance it would seem that the investment board has been supportive of the asset allocation that features a large allocation to alternatives.”
Brainard adds that each state has its own risks, liabilities, demographics and obligations, and comparisons of state pension funds can only go so far. “It doesn’t mean they are invalid; one just has to understand the larger context in which the comparison is being made,” he explains.
As for the South Carolina pension fund, hearings on general matters are scheduled during the next few months, and for his part, Loftis says he will be going around the state explaining his case. In the meantime, Loftis is advocating for term limits for RSIC commissioners and the addition of three or four more commissioners to help beef up the administration talent pool and increase transparency of the fund.
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