Friday, April 7, 2017

Accounting is the Wrong Lens: North Carolina’s new treasurer is cutting fees

Accounting is the Wrong Lens:  North Carolina’s new treasurer is cutting fees

North Carolina’s new Treasurer Dale Folwell says that the state public pension plan and health insurance fund are in trouble[1].  The two funds represent completely different levels of challenges.  The health insurance fund is in trouble.  Rather than building reserves to fund the future health expenditures of employees and retirees, the state has operated it on a pay-as-you go basis.  An aging cohort of beneficiaries and escalating expenses has turned health care into a $42 billion long-term problem. 

The pension has challenges as the Treasurer correctly points out.  Investment performance has lagged the 7.25% investment assumption over most periods, which means that the assets have not grown quickly enough to keep pace with the pension’s obligation to employees and retirees.  As the Treasurer, rightfully notes, any shortfall has to be made up by the taxpayers.   However, giving the insurance fund and pension plan equal billing is a wrong and puts the pension at risk of being diminished or eliminated in North Carolina’s current political environment.

How is the Treasurer going to solve the pension problem?  Like an accountant.   Treasurer Folwell frequently touts his credentials as a CPA, and accounting is a noble and useful profession.  However, accounting and investing are at the opposite ends of finance.  Accounting is rearview look at balance sheets and income statements.  An accountant can tell you where you’ve been financially and how you’ve done.  However, accounting principals don’t tell you where you need to go as an investor.

An investment process shaped by lawyers further complicates the new Treasurer’s task of addressing the investment performance of the pension.  In the previous administration, policies and procedures ruled the day[2].  Former Treasurer Cowell instituted reams of new policies and instituted several levels of legal review.  Just like accounting, the law and sound policies are important to a pension plan, but they are not a substitute for investment judgment and skills.  Treasurer Folwell should probably take the time to pare back the role of legal review and procedure in the investment process.

Promising fee cuts is a good way to campaign for Treasurer.  It’s easy for the public to understand.   However, fee reductions should not be a primary goal of managing an investment portfolio whether it’s the state pension or your 401(K).  Instead, keeping fees low should be a by-product of sound investment management.  In other words, the Treasurer should be focused on asset allocation, returns, and risk.  Once those key parameters are set, fees become a relevant by-product.

The Treasurer wants to reduce state pension fees by $100 million over the next four years.  He campaigned on the promise to reduce fees, and true to his word, he’s taken the first steps toward that goal.   I’ve written repeatedly about the escalating level of management and incentive fees paid out by the NC pension plan.[3]  Last year, total fees were more than $600 million according to a recent presentation to the Investment Advisory Council.[4]  The rapid rise in fees is due entirely to the pension’s foray into alternative investments.

In the first meeting with his Investment Advisory Council, the Treasurer’s promise to cut fees was front and center.  In my opinion this was a mistake.  Instead the Treasurer should be developing a strategy to slowly and thoughtfully reduce the pension’s exposure to alternative investments.  He should be analyzing the returns and risks of making this shift.  He should be identifying the real estate and private equity managers and strategies that he wants to preserve as he shifts the portfolio’s emphasis.

By emphasizing fee reductions and moving quickly and publicly the Treasurer is committing the cardinal sin of letting the marketplace know in advance what the pension is going to do.  It’s like playing bridge with all your cards exposed.  For example, we know from the IAC presentation materials that the Treasurer is going to try to sell some of the pension’s private exposure in order to drive down fees.  However, selling illiquid private equity exposure is best done quietly in order to maximize the value of the sales.  We can also surmise that it will difficult to manage the pension’s private equity program, since it appears that the pension will be constrained in continuing to invest with some of better managers or pursue new opportunities.

Campaigning, accounting, and investing are three distinct areas of expertise.   The Treasurer made a reasonable promise to his voters to reduce investment fees.  Now that he’s an investor, it’s not a great idea to treat the process of reducing fees like a United Way campaign by continually telling the public how close he is to his goal.  As an accountant, it’s extremely valuable to get a clear perspective on the financial challenges of the health insurance and pension funds.  However, as an investor he needs to put the challenge of each fund into proper perspective.

As a good politician the Treasurer should seek as much publicity as possible when the savings on fees reaches $100 million.  As a fiduciary for the public employees and retirees of North Carolina, he should manage the pension plan around return and risk, and let the savings accumulate quietly.

[3] my most recent post was

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