Wednesday, August 31, 2016

North Carolina’s Public Pension is Outstanding . . . at Generating Fees

North Carolina’s Public Pension is Outstanding . . . at Generating Fees

The two people running for North Carolina Treasurer appear to have the backgrounds required to manage a large public pension plan.  Dale Folwell is a C.P.A. and has a master’s in accounting.  Dan Blue, III has an M.B.A. and a law degree.  However, it’s going to take much more than an understanding of numbers to develop a sustainable investment plan for the state pension.  Moreover, either candidate is going to be fairly frustrated because whatever their plans, their hands are going to be tied by the current investment policy constructed by Treasurer Janet Cowell.

While the pension plan remains reasonably well funded, especially compared to other states, the funded status of the plan is likely to decline absent a sizable jump in the stock market.  The performance as of June 30, 2016 has failed to meet its investment benchmark for any time period over the last 15 years.[1]  To be sure, the capital markets haven’t delivered large returns in the past decade.  However, during the last decade the S&P 500 has managed to return 7.4%, and investment grade bonds have returned 6.4%, while the North Carolina pension has generated 5.5%.  The expansion of the pension portfolio into new areas of investment has produced, at best, average results. 

The Treasurer has argued that her approach has increased diversity and dampened risk.  Given the number of managers, holdings, and strategies now employed by the pension, the fund is suffering from over-diversification.  It’s like the retail investor who owns 30 or 40 different mutual funds and can’t figure out why the returns are so mediocre.  At the end of the day, all those funds represent the market as a whole less a whole lot of fees and transactions costs.  As to the risk of the portfolio, it appears that the pension has modestly reduced conventional risk (volatility) in exchange for an increase in new risks (currency, liquidity, regulatory, complexity).  However, it’s hard to tell exactly what’s going on because the Treasurer has decided to report returns as a mish-mash of asset classes and strategies.  For example, the Treasurer reports returns for private equity (an asset class) and inflation sensitive (a mix of hedge funds, private equity and other types of commodity managers).  As I’ve written previously, it’s transparency through frosted glass.[2]

Not surprisingly, the fees paid to money managers have skyrocketed.  In the last two years alone, North Carolina’s pension plan has paid over $1 billion in fees ($513 million in 2016, $489 million in 2015).  In fact, something called “other expenses,” which historically were inconsequential, added another $59 million.[3]  When I was Chief Investment Officer a little more than a dozen years ago, our total fees were about $60 million and our other expenses were a few million dollars.  In other words, fees have jumped by about 18% per year over that period, returns have increased by about 5.5% and assets have grown by 3%.[4]  While many public employees and retirees have struggled, it’s been a fantastic time to be a money manager for North Carolina, especially if you are offering anything that can be called an alternative investment.

In fact, the increase in North Carolina’s fees is almost entirely due to the foray into alternative investments.  The alternative managers were paid $427 million or 83% of all fees for managing about $26 billion or 29% of assets in fiscal 2016.  Not only do alternatives generate most of the fees, they also generate 84% of the other costs.   Even if Mr. Folwell or Mr. Blue decide to change course, fees will continue to rise for the next several years because Treasurer Cowell has made alternative investment commitments that cannot be easily reversed.

The evidence for changing course is compelling.  However, Mr. Folwell or Mr. Blue will be find it very difficult to walk away from alternative investments, no matter what they promise in the remaining weeks of the campaign.  As soon as one of them is elected, the money management marketing machine will descend on Raleigh.  They’ll come with the same set of pitch books and whitepapers that seduced Treasurer Cowell and me.   If the newly elected Treasurer calls public pension trustees from other states, he’ll find out that most of them are still wedded to alternative investing.  And if the new Treasurer meets with the state’s consultants or current investment staff, he will get the same story.   The people who built and benefited from the alternative investment fee generator are going to make impassioned arguments for the status quo. 

The race for Treasurer will have trouble competing for attention in a year when we have spirited races for President, Governor, and Senator in North Carolina. However, voters might take some time to acquaint themselves with Mr. Fowell and Mr. Blue because one of them will have the power to either shift the pension on a proper course or keep steering it into the troubling waters of alternative investing.

[4] Asset growth has trailed returns because the pension is paying out more than it takes in, and this trend has grown markedly over the past decade.  Last year the plan paid out $5.6 in benefits and returned contributions, while receiving $2.4 billion in employer and employee contributions.


  1. The stock market is near an all-time high, regardless of the route we got there. Expectations need to be tempered moving forward at best. Underperformance, excessive management fees, lack of disclosure, unethical corporate governance and most troubling is anchoring NC in these questionable investments. Cowell has no moral compass regarding ethics and her corporate board gigs are indicative of her self-serving interest. One foot out the door I guess. I beg to differ regarding your analysis of the next Treasurer. Does not appear Folwell will be swayed by Wall St. marketing machines. Think greater chance Blue may be but he will also face significant pressure from constituents to increase disclosure and cease sending hundreds of millions to Wall St. The state pension is a complicated issue and appears public trust in this office has slowly eroded over the years starting with the Moore administration. Let's not forget this is the people's money, not the Treasurer's. We need the leadership that guided the Broyles administration through 4 decades of growth.

  2. While you might wish for the days of the late Harlen Boyles, it was mainly the financial markets and not his leadership that helped fund the pension. During his tenure stocks rose by about 18% per year and bonds returned 7.4% per year. The rising market covered many sins. After the Boyles' era, stocks have only risen by about 5% per year and bonds by 2% year. So to be fair, Treasurers Moore and Cowell faced much more difficult investment environments. In addition, NC's equity managers in the 1980s and 1990s grossly underperformed the stock market (roughly 5%-6% per annum) over long stretches. It was only after Treasurer Boyles departure that the gross underperformance came to an end. The underperformance probably cost NC taxpayers billions of dollars in unnecessary pension contributions in the least two decades of the 20th century. Moreover, if you study the election reports at the Secretary of State's office you will see that NC's pension managers were a huge source of Treasurer Boyles' campaign finances. I admired Treasurer Boyles and spent many hours talking to him during his tenure and after his retirement. He was a great leader, a savvy politician, and a good teacher. However, he succumbed to the promises of Wall Street and money managers in precisely the same manner as his successors. Mr. Blue and Mr. Folwell will also feel the intense gravitational force of the Street.