This isn't magic or a testament to how great anyone is. This is because PSPRS has the highest share of alternative investments. ... Our costs may look high compared to other systems that may not make the same efforts to report all fees and investment expenses.It's not magic, huh? That's good to know because I was wondering why PSPRS hadn't tried to hire Penn & Teller to manage their investments. Nor is it a testament to anyone's skill, either? That's funny since that is generally what rankings tell us, but I suppose those managing the 69 funds that outperformed PSPRS were just having an incredible run of luck for the ten-year period that Pew analyzed.
I do not mean to pile on Mr. Palmer as he is just the spokesman for PSPRS and may have not fully prepared a response to the Pew Report, but this is what he said in his official capacity for PSPRS. I had not posted anything on the Pew Report since I was waiting for PSPRS to send out a more fully thought-out response. That response finally came out to today. This is PSPRS' response to both the Arizona Republic article and Pew Report. I had expected another party line response from PSPRS Board of Trustees Chairman Brian Tobin, but this time PSPRS brought out some different people. The response starts with a short statement from Allan C. Martin, a partner in the independent investment advisor NEPC, LLC. I am assuming that the rationale for including Mr. Martin's statement is that he is an objective party. He restates PSPRS' standard line about how they are in this percentile of these particular funds over this specific timeframe, which is kind of like assessing the performance of the Atlanta Falcons midway through the third quarter of Super Bowl LI. The fact that PSPRS was 70th out of 72 funds and the Falcons lost the game are really not important if you just look at the numbers in just the right way. This nonsense is what we continually hear from PSPRS to explain away its underperformance.
Before I finish discussing Mr. Martin's portion, I would like to point out a few more things about NEPC, LLC. PSPRS' fiscal year (FY) 2016 annual report lists NEPC's fees as $436,848. In FY 2015, PSPRS paid NEPC $321,332, FY 2014 $326,501, and FY 2013 $326,886. This is the disclaimer NEPC places at the end of its reports to PSPRS:
This report may contain forward-looking statements that are based on NEPC's estimates, opinions, and beliefs, but NEPC cannot guarantee that any plan will achieve it targeted return or meet other goals.The reader can reach his own conclusions about PSPRS and NEPC from this additional information.
The rest of PSPRS' response comes from PSPRS Administrator Jared Smout. There is a lot to say about Mr. Smout's statement, which comes in the form of him answering his own questions, but first we have to emphasize one very important thing. As much as PSPRS tries to portray itself as a victim of Pew and the Arizona Republic, it was not targeted by either organization. Pew analyzed 73 public pension funds and found PSPRS to be the third worst performing in the ten-year period ending in FY 2015, and the Arizona Republic just reported this fact. The self-righteous indignation of Mr. Smout and other PSPRS cheerleaders does not change the fact that all the public pensions competed in the same financial markets as PSPRS and likely had their own unique problems to deal with. Yet all but two performed better than PSPRS. Now let's get to Mr. Smout's statements:
Why PSPRS paid the highest percentage of its investments in fees for outside investment management among the 73 largest public retirement systems in the country?My response to this is: so what? You pay a lot in fees, but you are still one of the worst funds in the nation. That is the problem that is being highlighted here. Most people would expect a positive correlation between higher fees and higher returns. The saying "you get what you pay for" is generally not meant ironically, but apparently at PSPRS, it is. Second, while it may be true that other pensions are not reporting their fees accurately, they are still outperforming PSPRS in the one number that matters, annualized returns.
PSPRS had the highest percentage of alternative asset investments within their portfolio of every pension identified by the Pew Charitable Trusts study. These investments, which include private equity deals like buying and reselling companies or properties, require fees because they are not simple transactions like buying stocks or bonds. However, unlike fees for traditional investments like mutual funds, management fees are often reimbursed. PSPRS invests heavily in alternative asset classes as part of a deliberate strategy to minimize the risk of our portfolio, which has grown to more than $9 billion.
Additionally, the Pew report concluded – and even warned – that pensions are not reporting their fees accurately, or, in many cases, not reporting them at all. We, on the other hand, take the time and effort to report all of our investment expenses. A lot of plans don’t want to put in the work and they really don’t want to report totals when it is politically easier to keep them hidden. The Pew report advised that this exact type of disparity made their numbers unreliable for direct comparisons among pensions.
Why in 2016, PSPRS spent nearly $129 million on investment management fees, while earning less than 1 percent return ($49 million) on it investments?
Once again, Mr .Smout is harping on fees paid to alternative investments. Let me simplify what Mr. Smout is trying to say here. Paying high fees is fine as long as the return surpasses those fees. Would you rather pay $2 in fees to earn $3 or pay $20 to earn $40? In the second case, you paid ten times the fees but returned twice as much, so strictly looking at the dollar amount paid in fees is not a fair measure of value because high fees in one asset class could be more than covered by even higher earnings in that asset class, and a loss in another asset class with low fees would eat into the profits of other asset classes with higher fees. PSPRS earned 0.63% in FY 2016 and paid 0.43% in fees, so in aggregate, PSPRS did not pay more in fees than it earned on its investments. This is a misperception left by the Arizona Republic article. Of course, Mr. Smout still cannot help himself from making excuses about the same markets all the pensions were investing in or using his own special metrics to make PSPRS look good.This question confuses “investment management fees” for investment expenses. There are two types of fees for alternative investments: management fees and performance fees. Management fees are up-front costs that are often – at least with PSPRS, which bargains its fees down with investment funds-reimbursed. For example, last fiscal year the trust paid approximately $87 million in management fees but we estimate that about $57 million of these fees will be paid back with interest in future years. PSPRS, like any institutional investor, must reward its investment managers for strong performance. The typical performance fee amounts to 20 percent of all profits above 8 percent. To be clear, achieving returns that trigger performance fees is a good thing. It means PSPRS is making money for the trust and selecting the right investments. Right now, PSPRS has private credit and private equity investment portfolios that are performing on an elite level compared to other peer pensions. These investments are making the trust money and lowering risk levels by diversifying our investments. For these reasons, alternative asset investments are worth the money for PSPRS and its members. Additionally, all public pension plans, not only PSPRS, had low investment returns last fiscal year ending June 30, 2016. Despite the tough environment characterized by struggling international markets, low interest rates, weak bond returns and geopolitical instability, PSPRS returns were among the top third of comparable pension funds. The PSPRS portfolio also assumed less risk than 96 percent of peer pension investments. Private equity investments generated a net of fee 11.3 percent return and outperformed all PSPRS asset classes
Why PSPRS paid fees of 2 percent to outside firms to manage its investments, while most state retirement funds paid less than one-half of 1 percent on management fees?
In 2015, PSPRS spent months conducting an in-depth fee analysis and shared the findings with the Republic. The examination of hundreds of funds revealed PSPRS paid about less than half the industry standard of 2 percent. Again, the Pew report warned that its data was unreliable and unfit for comparing pensions.
The findings of the fee review were not published by the Republic. Also in 2015, an independent report contracted by the Arizona Auditor General found that PSPRS saved roughly $40 million on its investment fees by hiring attorneys to negotiate with investment fund managers.
So PSPRS did its own in-depth fee analysis and the Arizona Republic didn't publish it? Gee, I wonder why? Probably for the same reason that news outlets didn't publish studies by the Tobacco Institute stating that cigarettes were not harmful. It looks like the Republic was wise to not use PSPRS' numbers because Pew, a disinterested, independent organization, showed that they were wrong. Pew had no incentive to misrepresent the fees PSPRS paid, while PSPRS did. So does PSPRS pay 2% or "about less than half the industry standard of 2 percent"? Mr. Smout never comes out and says that Pew is wrong and should retract its numbers. He just gives a mealy-mouthed explanation of fees in the third paragraph. And he is still perplexed as to why the Arizona Republic wouldn't trust his numbers?Using PSPRS as an example, the challenge associated with fee reporting is that a pension can have several hundred alternative investments that were made and will end at different times. Some investments can take as long as 10 years or more to mature. This can make fee totals appear disproportionately high in years when a plan makes a lot of investments or in low return years like fiscal year 2016. On the flip-side, if a high number of investments mature in a particular year or generate many fee reimbursements, PSPRS could appear to pay very low fees. It is impossible to look at a reported fee total for one year to determine if a pension is overpaying for its alternative investments.
Why PSPRS, a $9 billion trust, has only about half the money required to pay all current and future pension obligations to its members?
There are several reasons for this, all of which PSPRS has openly addressed for several years. Two global financial disasters – the “Dot.Com collapse and housing market crash – are a key factor, especially combined with the statutory formula for awarding pension increases to PSPRS retirees. The current PSPRS low-risk investment strategy that features greater reliance on alternative investments is a direct result of damages PSPRS suffered when it was heavily invested in public equities (stocks). (NOTE: This formula, the Permanent Benefit Increase, or PBI, was discontinued with the passing of Prop 124 in 2016.)
More vacuity from Mr. Smout. Apparently, Mr. Smout doesn't realize that the dot.com and housing market collapse affected the entire world, not just Arizona, and that the other 72 other public pension had to deal with the same financial stresses. Oh, and by the way, so did the Arizona State Retirement System (ASRS) and PSPRS' own Cancer Insurance Plan, both of which have outperformed PSPRS. Yes, the PBI was a problem, but once again, what does this have to do with PSPRS' sub-standard returns?To a lesser extent, asset losses in legacy Arizona real estate investments were also steep enough to push overall investment returns down to below average levels. PSPRS has also been forced to reverse cost-saving pension reforms due to lawsuits and the costs associated with this have had a negative effect on funding levels.
Why the $36.2 billion Arizona State Retirement System for teachers and local and state employees ranks far better than PSPRS, settling among the top third when it comes to performance on investment returns?
ASRS has almost double the public equity exposure than PSPRS. Public equities are cheap but also volatile. If a fund can support short-term volatility then owning more public equities is a sensible strategy. An investor with a higher risk tolerance is able to seek higher investment returns. For many reasons, including the PBI and current funding levels, this level of volatility and risk are not acceptable for PSPRS. The explanation regarding our performance is simple; the trust was disproportionately harmed by legacy real estate investments. Even then, the Trust’s portfolio outperforms 75 percent of its peers on a 10-year basis through the end of 2016, net of fees, which most wouldn’t classify as “underperforming.”
And why ASRS paid less than half (about four-tenths of 1 percent) of what PSPRS paid on investment management fees?
These last two statements are Mr. Smout at his whiniest. You would think he had walked in the door for the first time and just realized the sorry state of PSPRS. In fact, he has worked at PSPRS for 20 years, becoming Deputy Adminstrator in 2011 and Adminstrator in 2015. Are we supposed to feel sorry for Mr. Smout because of the self-perceived disadvantages vis-a-vis ASRS? Maybe it's just possible that ASRS is better managed than PSPRS. Perhaps Paul Matson, who has been Chief Executive of ASRS since 2003, could give Mr. Smout some pointers on how to run a pension.The fees ASRS pays for their alternative investments is in line with what PSPRS pays for alternative investments. The difference between our total fee levels is explained by the percentage of assets that we each have in equities and alternative assets. PSPRS has a higher percentage of its assets in alternative investments, while ASRS has a higher percentage of its assets in public equities, which are inexpensive to buy. Many pension funds are increasing their allocations to alternatives, which they wouldn’t do if they thought it was an inefficient use of capital.
To conclude this long post, Mr. Smout has provided the perfect closing line:
Many pension funds are increasing their allocations to alternatives, which they wouldn’t do if they thought it was an inefficient use of capital.So if you are still unconvinced of the wisdom of PSPRS' investment philosophy, just remember PSPRS is just doing what everyone else is doing, only more so. They have the highest percentage of alternative investments but the third lowest returns. Herd mentality and underpeformance: there's a combination that will fill you with confidence.