Managing against escalating pension investment fees.

• Author: Miller, Girard

Like other public pension plans of similar size, the Orange County (California) Employees Retirement System has migrated toward a broadly diversified portfolio with substantial commitments to alternative investments. Excluding real estate, more than 25 percent of the system's $11 billion portfolio was invested in alternative investments at the end of 2013. Projected fees for targeted performance, including indirect fees paid to advisors through the investment funds they offer, total approximately $90 million a year, of which $30 million is billed directly and roughly $60 million is charged to the respective investment funds and netted against performance. The latter indirect advisory fees had not been visible to decision makers under traditional governmental budgeting and financial reporting conventions, and some were concerned and surprised when trustees were enlightened as to the magnitude of the "total cost" of investment fees in an October 2012 budget workshop. At that time, the retirement board identified fees and risk management as its two top priorities for the investment committee in 2013.

Staff developed a comprehensive fee policy, which was adopted by the board investment committee in April 2013 (available at http://www.ocers. org, under the finance and investments tab). It provides guidance to marketers and a framework for negotiations with investment advisors who are invited to make finals presentations, as well as tips for incumbent managers who are updating the staff or attending biennial meetings with the system's manager monitoring subcommittee.

THE FEE POLICY

The fee policy encourages staff and consultants to obtain the lowest possible fees using traditional measures and techniques. These include "most favored nations" clauses; comparisons with peers; negotiating early in the selection process via consultants who have bargaining power through their broad client base; and pitting competitors against each other in or before final presentations. Beyond simply seeking the lowest possible fees, however, the fee policy also focuses on alignment of interests, including the use of performance based fees. The policy provides specific guidance to investment managers and staff regarding the preferred structure of fulcrum fees (fees centered on a target, or "fulcrum," performance level, which are increased or decreased for better or worse performance) and performance fees (additional, performance-based fees paid when an investment manager achieves an investment return that beats a specified benchmark). The policy also addresses the design of hurdle rates (the minimum rate of return required for payment of performance fees) and fee caps. The policy does not take a "one size fits all" approach because there will be some instances in which a low fixed fee is more suitable than a performance fee, and in some markets, the formula for an optimal performance fee is premised on expected returns that vary from one strategy or sector to another.

The OCERS fee policy emphasizes that fees are only one factor to consider in selecting investment managers. Demonstrated track records, proven investment talent, repeatable investment processes, competitive and strategic investment advantages, and qualitative factors are the primary factors to consider in evaluating expected returns from a manager. The policy also acknowledges that expected returns are just that--they are uncertain and variable. Fees are certain, however, and can be known in advance. Therefore, fees rise to a higher level of importance when screening finalists and close contenders during the selection process. The policy thus states that "absent an evidently superior investment strategy and capability, or a discernible reason to expect materially superior investment performance from a competitor looking forward, OCERS will give selection preference to firms that offer the most advantageous fee structures."

PREFERENCE FOR PERFORMANCE FEES

As a general rule, the OCERS fee policy expresses a preference for performance-based fees that align the interests of the investment manager with the system's stakeholders, so long as the cost is expected to compare favorably or reasonably to a flat fixed fee when performance meets expectations. On the other hand, many investment management firms value the certainty of a fixed-income stream over the uncertainty of performance fees and will price accordingly, so a fixed-fee proposal from the same manager will sometimes offer a superior, lower pricing alternative that should result in lower costs over time. There are also times when a given manager may not be able to offer a performance-based fee in its least costly delivery mechanism; sometimes a fixed fee in a commingled fund offers the lowest costs, and there may be other administrative factors to consider (such as the cost and risks of establishing international swap dealer agreements) in a separate account structure in order to obtain a performance fee. The accuracy of performance often needs to be internally audited, which imposes an additional cost on the system, although that is usually trivial in comparison with the fees themselves.

OCERS's performance fee philosophy is that a base fee is appropriate to provide sufficient operating income for the manager to "keep the lights on." Because firms vary in size and structure, no single base fee level is appropriate to all investment disciplines. The OCERS fee policy generally encourages base fees that fall between...