State Treasurer Dale Folwell’s aggressive moves to slash the fees that the $92 billion state pension fund pays to outside money managers are winning praise but also are raising important questions about the fund’s investment strategy.
Experts such as Richard Warr, a finance professor at N.C. State University, say the steps taken by Folwell so far are “on the right track.”
Critics, however, contend that Folwell, a Republican who took office in January, is too focused on fulfilling his campaign promise to cut fees paid to money managers. They say the way he has reinvested billions of dollars previously handled by the outside money managers whose contracts he terminated is likely to reap lower returns.
Lower returns can trigger a need for more taxpayer dollars to be pumped into the pension fund. It can even lead to higher employee contributions. More than 950,000 current and retired teachers, state employees, firefighters, police officers and other public employees rely on the pension fund for retirement benefits.
“The concern I have is that cost-cutting seems to be an end in and of itself,” said Andrew Silton, who was chief investment officer for the state pension fund from 2001 to 2005.
At times, according to internal memos reviewed by The News & Observer, Folwell has overruled the recommendations of the pension fund’s investment staff as he shifted money out of stocks and into bonds and “cash,” which means investing in things like short-term U.S. Treasury bills, or T-bills.
The Treasurer’s Office handles those investments in-house and therefore doesn’t incur any fees; outside managers who are retained to invest pools of money on the pension fund’s behalf charge a fee for their services and sometimes receive a slice of any profits as well.
Folwell said in an interview that both his fee-cutting moves and the way that the money was reinvested have been driven solely by his view of what’s best for the pension fund. He denied that shifting money to cash and bonds was designed to avoid fees.
“I’ve inherited an agency where nobody thinks anything is wrong, in so many ways,” he said. “But there are things that are wrong.”
What inspired the fee-cutting efforts?
Folwell promised during his campaign that he would slash investment fees by $100 million during his four-year term if elected. That pledge won him the endorsement of the State Employees Association of North Carolina, a long-time critic of the fees paid by the pension fund.
Although $100 million is a big number, it represents 20 percent of the $513 million in management and incentive fees paid by the pension fund in the 2016 fiscal year. That’s up from $215 million in the 2007 fiscal year.
Folwell said during a conference call with reporters last month that he had cut fees by nearly $50 million to date by terminating some outside money managers and renegotiating fees with others. That put him on track to easily exceed the fee-cutting target he set during his campaign.
Information supplied by the Treasurer’s Office at The News & Observer’s request provides a more complete picture of Folwell’s fee-cutting. Here’s what you need to know.
How much money has been saved?
A final tally isn’t available yet. So far, fees have been cut by $44.8 million on an annualized basis – that is, those savings aren’t immediate but will be realized over a year’s time. Of those savings, $35.8 million will come from terminating money managers and $9 million from renegotiating contracts. Collectively, the 10 money managers that were terminated managed $6.8 billion, all of which was invested in stocks.
There are one-time costs associated with terminating money managers – such as broker’s commissions for selling stock and taxes involving foreign stocks – that haven’t been included in the treasurer’s fee-cutting tallies. Those costs to date have totaled an estimated $9 million – matching the savings from renegotiations – according to the data supplied by the Treasurer’s Office.
At the same time, Folwell also said that there are other savings connected to terminating a manager, such as eliminating audits and plane trips – for example, to attend meetings.
Other renegotiated fees that are in process should save the fund another $16.8 million. The one-time costs associated with those savings haven’t yet been determined.
“That’s an obvious win,” Warr, the N.C. State professor, said of the renegotiated fees. He added that Folwell has some real leverage in negotiations given that he “was elected on a cost-cutting platform.”
Folwell credits his investment staff with renegotiating the fees, although he adds that he got the ball rolling when he called each of the pension fund’s 174 outside managers after he took office.
“On every one of those calls I tell them that I am going to be reducing fees by at least $100 million over four years and what part of that would you like today?” he said. He also said that the pension fund didn’t offer any concessions to obtain the fee reductions.
Why were the money managers’ contracts ended?
Folwell said during last month’s conference call that the money managers that were terminated weren’t performing up to snuff. And while a majority of the money managers were falling short of most, if not all, of the investment benchmarks developed by the treasurer’s investment management staff, that wasn’t the case across the board.
The most notable exception: Longview Global Equity, which easily outpaced all its benchmarks. For example, its 1-year investment return as of Dec. 31 was 9.18 percent, compared with its benchmark of 7.86 percent. Longview’s 5-year return averaged 16.07 percent a year, versus its benchmark of 9.36 percent a year; its 7-year return averaged 12.68 percent a year, versus a benchmark of 7.22 percent.
As with all the returns reported by the Treasurer’s Office, Longview’s returns are net returns – that is, returns after fees are deducted.
Kevin SigRist, the pension fund’s chief investment officer and a holdover from Folwell’s successor – Janet Cowell, a Democrat – recommended terminating Longview. He wrote in a March 14 memo that it was “reasonable” to conclude that when it comes to active managers such as Longivew, their potential for continuing to outperform their benchmarks wasn’t enough to account for their fees “and the risk of future underperformance.”
Gregory Brown, a finance professor at UNC-Chapel Hill, said Folwell’s terminations of money managers to date make sense because research, including his own, shows that when it comes to large-cap stocks, lower-cost index funds, rather than more expensive active managers, “are really the best way to go.”
Similarly, Folwell cited a report by one of the pension fund’s consultants, Callan Associates, that said active managers of large-cap and mid-cap U.S. stocks, on average, have underperformed their benchmarks. That report, he said, was a key to his fee-cutting efforts.
What exactly is the treasurer doing with the pension fund’s investment mix?
Folwell said when he took office the pension fund had too much of its investments in stocks. As of Dec. 31, more than 43 percent was invested in stocks. It’s target is 42 percent. So far, he’s shifted the $6.8 billion previously managed by the terminated money managers to cash and bonds.
That shift reduced the pension fund’s allocation to stocks to 37 percent, according to a May 31 memo by SigRist. That’s well below the fund’s stated target.
North Carolina is one of just a few states where the state treasurer has sole authority over the state pension fund’s investment decisions. Folwell hasn’t always followed staff recommendations.
A May 19 memo written by two investment analysts on the treasurer’s staff, Casey High and Greg Taylor, recommended that an additional $587 million previously invested with three terminated money managers that were active investors in stocks be reinvested in a stock index fund. That would have significantly reduced fees because active investors that pick and choose individual stocks charge much more than managers who invest in passive index funds that mimic a group of stocks, such as the Standard & Poor’s 500.
Instead, however, that money also is being shifted to cash and bonds.
Rhonda Smith, director of public equity, wrote in a May 1 memo that the investment staff was “uncomfortable” that the pension fund’s allocation to stocks had become out of balance by shifting so much money to cash and bonds. But, she added, “the Treasurer has separately communicated his comfort” with that.
Folwell explained the shift, saying: “In the last fiscal year the pension plan earned less than 1 percent. It underperformed its peer group. I’m trying to change that.”
How’s the shift playing out?
The shift to investment-grade bonds and cash came when stock prices were rising.
Silton, the former chief investment officer, estimated that, as of the beginning of July, transferring investments in stocks to bonds and cash cost the state about $175 million in gains that it would have otherwise reaped by keeping the money in stocks. In his calculations, Silton assumed that the stock investments would have trailed the S&P 500 by 1 percent.
“The point is, (Folwell) saved some fees, but since the (stock) market has gone up, the pension fund would have been way better off if he just left things as they were – even if the outside managers underperformed,” said Silton. He would have preferred that the treasurer shift the money previously invested by active stock managers into lower-fee stock index funds.
To be sure, the pension fund’s performance should be measured over the long haul. Silton himself notes that if the stock market declines the picture would change.
What does the treasurer say?
Folwell questioned Silton’s objectivity and pointed out that the pension fund’s investments in stocks cost it billions of dollars during the recession. He also said that Silton’s analysis involves “looking in the rearview mirror. I don’t have that luxury.”
Folwell anticipates the Investment Advisory Committee will take up the issue of asset allocation targets at its next meeting. For one thing, he said, the fund needs to be “more realistic” about its cash needs.
He noted that in addition to needing $6 billion in cash to pay out pension benefits each year, the pension fund also has nearly $10 billion in “uncalled capital.” Those are funds that the pension fund has committed to hand over to money managers for investing over a period of years that haven’t yet been called for.
What are the future implications of the current investment strategy?
An analysis by the pension fund’s investment staff anticipates that stocks will greatly outperform bonds and cash long-term. Over the next 10 years, the staff concluded in a report it prepared last year, stocks are expected to generate an average annual return of 8 percent, versus 2 percent for cash and from 1.7 percent to 3 percent for investment-grade bonds, depending on the type of bond.
“There are huge transaction and opportunity costs associated with making quick and large changes in the portfolio,” Silton wrote in an email. He estimates that limiting the state’s investments in stocks to 37 percent of its total portfolio could potentially cost the state about $350 million a year if stocks, cash and investment-grade bonds all hit their performance targets.
Meanwhile, Brown, the UNC professor, is concerned that the treasurer may target the pension fund’s private equity managers for future terminations. Those managers invest in privately held businesses or buy publicly held companies and take them private. Cutting them regardless of performance, Brown said, would be a mistake.
Brown said some of Folwell’s public statements “suggest he believes private equity is a bad idea and the evidence suggests otherwise. Historically, returns on private equity have been quite good” – so much so that they justify their high fees.
Warr noted that although the treasurer seems to have lowered the pension fund’s potential returns by shifting money out of stocks, he also lowered the fund’s risk because stocks are more volatile than cash and bonds.
Warr applauds Folwell’s extensive release of information – all of the data and memos cited in this story were provided by the Treasurer’s Office as a result of several requests made since mid-June. In his view, the ultimate test of Folwell’s fee-cutting efforts and the shift to fewer investments in stocks will be how well the pension fund performs over time.
“Can you make your performance target? I don’t know,” Warr said. “That’s the million-dollar question.”
Actually, there’s much more at stake than that.