Investment fees too high?

Officials debate merits of study on S.C. pension fund

The Greenville NewsAugust 4, 2013 

THE STATE

Investment officials for South Carolina’s $26 billion pension fund say a national study that concluded it paid the highest investment fee ratio among 35 states without corresponding higher rates of return is flawed.

But a co-author of the study told GreenvilleOnline.com that the basic conclusions of the report are sound, and even if some states have not disclosed all fees, South Carolina deserves its ranking.

“I suspect some states may hide fees but (South Carolina is) so far ahead of the pack, it’s hard to believe that everybody has padded their fees except for South Carolina,” said Jeff Hooke, chairman of the Maryland Tax Study Foundation and a co-author of the study released earlier this month.

The study, published by the Tax Foundation and the Maryland Public Policy Institute, reported that the states with the highest ratio of investment fees had some of the worst investment returns of the group over a five-year period.

“There is simply no correlation between high money management fees and high investment returns,” said John J. Walters, co-author and visiting fellow at the Maryland Public Policy Institute. “Retired state employees and taxpayers across the country are not getting their money’s worth. They deserve a simpler, more effective investment strategy for their retirement savings.”

South Carolina’s pension investment fees have been criticized before, primarily by state Treasurer Curtis Loftis, who has long claimed that the state pays too much in such fees while posting rates of return that compare poorly with other large public pension funds.

The South Carolina Retirement System Investment Commission has defended the fees as necessary and reasonable, given the fund’s allocation in alternative investments such as hedge funds. Its investment plan, fund officials say, is guided not by what its peers do but by its liabilities, funding, risk and legislative directives.

The fund posted a return of 12.39 percent in calendar year 2012, according to the commission, adding about $3 billion in value.

The Maryland think tanks study reported that 10 states paying the highest Wall Street fee ratios saw annualized five-year returns of 1.34 percent while the ten states paying the lowest fee ratios saw annualized returns of 2.38 percent. The five states paying the most were South Carolina, Missouri, Pennsylvania, North Carolina and Maryland, according to the report.

By indexing most of their portfolios, the study concluded that state funds surveyed could save $6 billion in fees annually, while obtaining similar or better returns compared to active managers. The study found that a composite index fund that mimics state pension fund allocations easily beat the 31-state median results.

But officials with South Carolina’s Retirement System Investment Commission say the study depends on state certified financial reports, which do not require that all investment expenses be reported.

“SCRSIC actually is at the forefront of reporting and disclosure, and we reject the attempt to slander us by making false comparisons (themselves within a flawed study) with other states that, as the documentation shows, report very little by comparison,” said Hershel Harper, the state investment commission’s chief investment officer.

The study reported that South Carolina’s pension fund paid a total of $296 million in investment fees for the fiscal year ending last year, or 1.305 percent of the beginning of the year assets, the highest ratio of the 35 states examined. The fund’s five-year rate of return was 1.46 percent, according to the study. The median fee ratio was 0.385 percent, the study reported.

The closest state in fee ratios to South Carolina was Missouri, according to the report, with 0.82 percent.

Only 35 states were used in the study because the authors wanted only to compare those with certified financial reports ending June 30.

But even that limitation did not make an apples-to-apples comparison, South Carolina officials say.

As an example, they point to Florida’s investment report, which notes that its $374 million in investment fees exclude “carry/performance fees for real estate, infrastructure, hedge funds, private equity and overlays.”

John Kuczwanski, a spokesman for the Florida State Board of Administration, said some funds choose not to calculate fees and to separate them out for the purposes of a report would be difficult. He said there are private services that do compare fees and other data between pension funds. Such a service found Florida’s investment fees were near the bottom of 17 pension funds examined in 2011, according to Florida’s 2012 investment report.

“There’s no standard methodology for a true common denominator here,” Harper said. “The way the study was approached, I’m not sure you can make a true comparison.”

Absent a uniform reporting method, Harper said one way of looking at fees is the way an independent consultant employed by the agency did, comparing fees paid by asset class.

“In most cases we were paying less than what the market would actually demand,” he said. “So we feel comfortable for the asset class allocation itself, we’re not overpaying for that.”

Hooke agrees that the likely explanation for South Carolina’s high fee ranking is not that the state is paying above-market cost for services but that it invests so much in alternative investments, which carry higher fees.

“South Carolina has a very high proportion of hedge fund and private equity investment to total assets — about 40 percent — compared to other state funds, which tend to run lower than 20 percent,” he said. “These types of assets (hedge funds and private equity) have the highest fees. This explains most of the S.C. difference, in my view, not phony accounting at other states.”

Sarah Niegsch Corbett, director of the agency’s operational due diligence, said guiding accounting rules for reporting investment fees are not very specific.

“Right now, a lot is left to interpretation,” she said.

Investment commission officials emphasize they are not alleging Florida or any other state is doing anything wrong. They say states are just not required to report all their fees and some do not.

In fact, Corbett said, if South Carolina only reported what it was required, the number would be $53.6 million, a fraction of the total fees it disclosed.

On top of the states which do not report all their fees, state officials say the study erroneously reported North Carolina’s numbers.

Christopher Summers, president of the Maryland Public Policy Institute, and Hooke said the study mistakenly added a quarter for N.C.’s numbers because the state’s year end differed from the pension fund’s year end but the study did correct the error. Summers said it did not affect the median reported for states overall.

Hooke said that is the only mistake that has been pointed out in the study.

“That’s the only state that had a correction,” he said. “That’s what the industry hammers us on, one error out of 300 statistics.”

Officials say another fact that makes comparing the funds difficult is because each has its own investment strategy and is governed by different state laws. Several states, they said, have only recently been allowed to place money into hedge funds or other alternative investments.

Harper said the study’s recommendation about pension funds using more indexing as opposed to alternative investments would not work for South Carolina.

“We take a very long-term view,” he said. “We believe that over the long term, the diversification nature of these assets will actually help us create a better trajectory for a smooth ride and help dampen volatility.”

He said the agency is not trying to maximize a return.

“Someone is making a grave error in judgment if they think our goal is to maximize return, period, and ignore the liabilities,” he said. “We absolutely cannot do that. Nor can you decouple risk and return. I think Finance 101 would clearly show you that if you want higher returns, you take higher risks.”

The fund is only 60 percent funded, officials said.

Harper said other pension funds are tilted more toward risk to earn returns of 8 or 8.5 percent. So he said those funds will earn higher returns in an up market than South Carolina, whose target is 7.5 percent.

But if the market goes the other way, he said, South Carolina may outperform its peers. Even so, Harper said peer rankings are not how the commission structures its investment plan.

“I can’t pay benefits with peer rankings,” he said.

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