Pension funds are increasingly pressuring asset managers to lower their fees on new and existing mandates. Over the past year, more plan sponsors have taken steps to reduce the amount of fees they pay to external asset managers, either by negotiating contracts or by cutting expensive strategies from their portfolios. Managers have responded in turn by making certain concessions and forming special committees to deal with the growing pressure.
Of 86 asset management firms surveyed in February by three of Institutional Investor’s membership groups, 47% reported changing their fee policies for new business over the past year. “Asset managers can no longer afford to be rigid about fees,” said one executive from a U.S.-based asset manager who was quoted in the study. “We have to go into talks with a blank sheet of paper.” Firms that refuse to give in to investors’ demands often pay the price: 43% of the firms surveyed said that they had lost business over the past 12 months because of fees.
All respondents in the “2013 Institutional Fee Discounting Policy Study” were from large asset management firms and are members of II’s U.S. Institute, European Institute, or Institutional Investor Institute. Global Money Management Quarterly is published by Euromoney Institutional Investor, the parent company of II’s membership groups.
The Orange County Initiative
The Orange County Employees’ Retirement System (OCERS) has launched one of the most radical attempts yet to battle fees. The $10.5 billion pension plan recently approved a new investment management fee policy that endorses collaborative fee negotiations and authorizes CIO Girard Miller to speak with other plan sponsors about forming limited-scope pension fund partnerships. The idea is to bundle pension fund assets together in an effort to secure better fee deals.
“Fees are becoming an increasingly large expense for pension funds,” Miller said. OCERS has projected that it will pay $52 million in management fees this year, he said. Grouping its assets with those of other small or mid-sized funds could give OCERS a bigger hand at the bargaining table. “In government, it’s not uncommon to have joint procurement,” Miller said. “But there has never been any effort to formalize or coordinate it with the pension funds, so we’re trying to get a group together to see what we can do collectively.”
The idea is still preliminary, but it’s already garnering attention on the West Coast. OCERS has sent a white paper explaining the initiative to other funds in California, including most, but not all, of the CIOs who are members of the State Association of County Retirement Systems and the California Association of Public Retirement Systems. The eventual goal is to form an organization with enough internal resources to put the plan into action.
Alternatives Under Fire
For OCERS and other plan sponsors, the main target is alternative investments — particularly private equity and hedge funds. As pension funds have jumped into alternatives over the past decade, they have been forced to pay the higher fees that such investments command. But now they are taking action, either by ditching expensive fund-of-funds strategies in favor of direct investments or by eliminating their allocations altogether.
The Kern County Employees’ Retirement Association recently transitioned out of fund-of-hedge-funds and moved into direct investments, hiring specialist consultant Albourne America to assist with the process. Last year, the $3 billion fund ditched Blackstone and K2 Advisors; it is replacing them with eight direct hedge fund mandates, and expects to save about $2.5 million in management fees per year, according to documents from a May 8 board meeting.
Similarly, the Fort Worth Employees’ Retirement Fund decided to go direct a few years ago. It also brought on Albourne, and hired a new investment staff member as well. Robert Hulme, deputy director of investments and operations at the nearly $2 billion pension fund, said that cutting fund-of-funds managers more than paid for the consultant and the new employee: the fund paid less than $400,000 in fees during fiscal year 2010, down from $1.2 million in 2008. Fort Worth now invests directly with 22 hedge funds, he said.
The $15.8 billion Los Angeles Fire & Police Pension Plan is doing away with its hedge fund investments altogether. At a May 2 board meeting, the fund discussed axing its entire $595.1 million hedge fund portfolio, which accounts for 3.77% of its entire portfolio and makes up 17% of all investment management fees, according to fund documents. LAFPP will save about $14.6 million by terminating its hedge fund managers, meeting documents state. Executive Director Tom Lopez said that the fund is currently looking at possible replacements for the hedge fund allocation.
The Fee Fight
Despite these efforts, some industry practitioners say that high fees for hedge funds and private equity managers are unavoidable, and that pension funds will just have to adapt. “That’s been a real hot button, because the fees for alternatives are harder to digest for some investors that are new to the asset class,” said Susan Long McAndrews, partner at private equity firm Pantheon. Nevertheless, she said, high fees are part of the deal. “You cannot go into a good performing, top-quality, middle-market fund and expect to get a fee deal,” McAndrews said.
Smaller private equity firms that are experiencing less investor demand for their products might be more likely to reduce their fees, said McAndrews. But for many large firms, “there’s generally enough demand out there that they don’t have to get into heavy contract negotiations.”
Even if the fees can’t be lowered, some plan sponsors argue that they should at least be made more transparent. “With traditional asset managers, you write out a check,” Miller said. “But a lot of the alternative investments have fees and expenses buried in.” When OCERS went through its 2013 budget, Miller said that it initially reported $22 million in fees for the year. But that number more than doubled when the fund added all of the hidden fees from alternative investments. “The numbers sort of jumped off the page,” Miller said.
Others say that pension funds might not need to invest so ambitiously in alternatives. Brian Rowe,
director of manager research at consulting firm Wurts & Associates, said that pension funds can get sufficiently high returns from public equities and fixed income. “We think of hedge funds as a fee vehicle — it’s not a strategy, it’s just a collection of two and 20,” Rowe said. “Part of the reason that we haven’t allocated aggressively to those alternative spaces is because the fees are so egregious. Asset managers charge more than they’re worth.”
Rowe said that institutional investors have long pushed for lower fees from asset managers and, over time, have succeeded in securing them. “Lowering the fees to get the business in the door is probably a smart move,” Rowe said. “And for the investor, it’s a win.”
Still, asset managers are maintaining certain standards when it comes to lowering fees. According to II’s membership survey, 64% of asset managers deem mandate size to be the most important factor in determining whether a client should be granted a discount. Several asset managers said that they would be more willing to negotiate if the mandate was $250 million or more, according to the study. Client size also proved important, with 46% of respondents saying that they took it into consideration.
“We have to drop fees for large plan sponsors or we don’t compete,” said the COO of one large U.S.-based asset manager who was quoted in the study. Another executive of a U.S.-based manager said that his firm was cutting fees in both the U.S. and Europe to “get our foot in the door.” As an example, he said that his firm would typically offer an 8-12% discount on a global corporate bond mandate that was less than $500 million, and would offer a discount of around 15% for mandates larger than that.
Pension funds understand that there is power in numbers, which is part of the reasoning behind OCERS’ fee policy initiative. By grouping its assets together with other funds, it is hoping to gain an edge in contract negotiations. “We have the ability to package ourselves together — we can commingle our money, invest it with a money manager, and get the same pricing that they give the big guys,” Miller said. “That’s going to have more clout than if it’s just Orange County out here whistling in the wind.”
Preparing For A Fee Face-Off
As pension funds have become more vociferous about fees, some asset managers have responded by forming special committees to deal with negotiations. Doing so also helps firms maintain a unified front. “Salesmen can’t be out there offering any price they want,” said the CFO of one U.S.-based fund manager who was quoted in the study.
Pension funds, meanwhile, show no sign of slowing their efforts to battle fees. Most recently, the Los Angeles Department of Water & Power Retirement Plan (LADWP) terminated its contract with European Investors, Inc., which it had hired for a $25 million global real estate investment trust (REIT) mandate. After negotiating with European Investors and agreeing on an annual management fee of 0.72%, LADWP discovered that the firm was also charging a 0.25% transaction fee upon the its entry and exit from the real estate fund. LADWP subsequently dropped European Investors based on a recommendation from its real estate consultant, Courtland Partners, which described the fees as “excessive and unnecessary,” according to fund documents.
OCERS, meanwhile, is planning to push forth with its plans to reduce fees, even if the collaborative negotiation initiative falls by the wayside. The fund has already sent copies of its new fee policy to its incumbent managers, and intends to discuss the policy — and the possibility of lowering fees —with each firm. The fund will also place more emphasis on fees when choosing new managers, said Miller. “It’s a little bit of a wakeup call to the industry,” he said. “At some point, these ideas are going to take hold.”
Originally appeared in Money Management Intelligence and Global Money Management Quarterly. Link to MMI version here (paywall).