April 21, 2017
Public Safety Personnel Retirement System
State of Arizona
April 21, 2017
PSPRS responds to media claims about pension
The recent portrayal of PSPRS performance and investment fees in the Arizona Republic based on a recent study by the Pew Charitable Trusts was one-sided and deserving of a response.
My name is Allan Martin and I am the general consultant of PSPRS (and many other pension plans across the country) and I have a fiduciary duty to the trust and its members. That means I am professionally, ethically, and legally obligated to provide advice to the PSPRS Board of Trustees that I believe to help the trust perform and provide for members. I can speak to PSPRS performance while I will let PSPRS staff provide details (below) about investment fees.
With that said, it is true that the PSPRS portfolio has underperformed over the 10-year time period that ended with fiscal year 2015. In fact, PSPRS ranked in the bottom 2 percent of a peer group of public funds greater than $1 billion in value. The reasons for this are simple and have been addressed openly with members, employers and the media.
PSPRS, in the early 2000s, and before any of the current staff, board, or consultants were around, invested heavily in Arizona real estate, buying undeveloped land in the hope of building projects like golf-course anchored new communities and retail facilities. This left PSPRS especially vulnerable to the real-estate-triggered crash in the global financial markets in 2007 and 2008. Unfortunately, Arizona real estate values were hit especially hard while legal restrictions required PSPRS to invest heavily in stocks, which also fell dramatically in 2007 and 2008.
The real estate crash happened at about the same time PSPRS secured, after years of unsuccessful attempts, a change in law to allow PSPRS to invest in a broader assortment of investments to reduce the risk associated with pensions that have a large amount of equities (stocks) within their portfolio. This goal was a direct response to the crushing losses during the collapse of the so-called “Dot.Com” industry in 2001-2002 and the annual payments of the statutorily required permanent benefit increase (PBI) payments for retirees that prevented the recovery of investment losses from investment returns.
PSPRS adopted a more conservative, more widely diversified asset allocation during the 2008-2011 period but it took years to transform the pension into the efficient, low-risk plan that it is today.
Incredibly, some of the full results of the PSPRS changes are visible if we move past the Pew report’s ending timeframe, June 30, 2015, by just one year. As of the end of 2016, the PSPRS 10-year return net of fees ranked above 25 percent of its peer group (remember performing at the bottom 2 percent?) that includes about 55 pension plans with portfolios valued at more than $1 billion.
Here are some other facts about PSPRS investments that are worth considering:
- For the past three years as of Dec. 31, 2016, PSPRS net-of-fee returns place it within the top 16 percent of peer pensions
- PSPRS performed within the top third of peer pension plans last fiscal year despite taking less risk than 96 percent of peers
- The $1 billion PSPRS private credit portfolio places it among the top 4 percent of its peer pension plans over the 3-year period ending Dec. 31, 2016
- The performance of the PSPRS $1.3 billion private equity portfolio places it among the top 5 percent of peers over the 3-year period ending Dec. 31, 2016
- Without the legacy real estate allocation, PSPRS returns would have ranked in the top 15 percent of peers for the 10-year period ending Dec. 31, 2016
It is clear that legacy investments in Arizona real estate are the deficiency in the PSPRS portfolio. It is also true that it has taken years of hard work on the part of the current staff and advisors to sell these troubled assets responsibly. The write-offs and sales of properties below the acquisition costs have been accurately reflected in the performance of the plan.
On a personal note, I can say that I count the members of the PSPRS investment team among the most knowledgeable, capable and ethical experts I have had the pleasure of working alongside. PSPRS staff are also recognized among industry leaders, investment fund managers, financial media and even in academic circles for their skill and accomplishments.
Meetings of the PSPRS Board of Trustees are open to the public and PSPRS reports all expenses and fees as part of its commitment to transparency.
Allan C. Martin
NEPC, LLC, partner
- Forty-eight years' investment and consulting experience
- Ranked 2nd Most Influential Consultant in the World by aiCIO Magazine (2012)
- MML Public Fund Consultant of the Year (2008)
- Member: Executive Committee; Non-U.S. Equity Advisory Group
- Previous affiliations:
– Bankers Trust – Managing Director Global Retirement Services
– Dresdner/RCM – Partner, Head of Global Client Service & Marketing
– MBA and BS, Stanford University (Phi Beta Kappa)
We wanted to take a moment to respond to recent media insinuations that PSPRS has sought to avoid difficult questions regarding investment fees, fund performance and comparisons to other pensions. To the contrary, we feel that we have answered these questions – and many others – repeatedly for years. We feel that our responses have been abbreviated, taken out of context, or, in many cases, simply ignored. On Monday, the Arizona Republic presented six questions to PSPRS in a format that would leave the reader to believe they have never been answered. This recent coverage of our pension was initiated by the publication of a report on investment fees by the Pew Charitable Trusts. Below you will find our responses.
PSPRS Administrator Jared Smout
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?
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 its investments?
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.
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.)
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?
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.