It’s common knowledge that sponsors of retirement plans have a fiduciary duty to ensure the fees their plans pay Wall Street money managers for investment advice are reasonable.
Fees paid for investment services have always been an important consideration for fiduciaries of corporate pensions governed by the federal Employee Retirement Income Security Act (ERISA).
State and local government pensions are exempt from ERISA and are lightly governed by state law. However, because ERISA and state law protections both stem from common law fiduciary and trust principles, best practices for public pensions are frequently similar to those found in ERISA.
At the outset, sponsors of public, as well as corporate retirement plans must take steps to understand the sources, amounts, and nature of the fees paid by their plans, as well as the related services performed for such fees. After all, a plan sponsor cannot determine the reasonableness of fees paid without a comprehensive understanding of the plan’s services and fees.
The shift by public pensions into more complex so-called “alternative” investment vehicles, such as hedge, private equity and venture funds, as well as fund of funds, has brought dramatically higher investment fees—fees which are more much more difficult for pensions to monitor. Disclosed fees, as a percentage of assets, have increased by about 30 percent over the past decade, as use of alternative assets has more than doubled since 2006.
In addition, public funds are paying more than $4 billion annually in unreported fees associated with alternative investments, according to Pew Charitable Trusts. The hidden costs of private equity investments – which include carried interest, monitoring costs, and portfolio company fees – were not reported as investment expenses among most of the 73 large public funds Pew examined, according to a 2017 report from the non-profit group.
More disturbing, a recent internal review by the SEC found that a majority of private-equity firms, inflate fees and expenses charged to companies in which they hold stakes. More than half of about 400 private-equity firms that SEC staff examined charged unjustified fees and expenses without notifying investors.
So, pensions which choose to gamble in asset classes—such as private equity funds— specifically cited by regulators for charging bogus fees in violation of the federal securities laws must establish heightened safeguards to ensure that all fees paid to such managers are properly reviewed and determined to be legitimate, as well as fully disclosed to participants. They’ve got to be especially careful.
CEM Investment Benchmarking is a private Canadian company which many state and local government pensions in the U.S. retain to annually analyze their investment costs and performance.
According to a recent Summary of the Oversight of the State Teachers Retirement System of Ohio:
“CEM Investment Benchmarking annually presents a report to the board comparing STRS Ohio’s investment costs and performance to those of our peers. The report consistently shows STRS Ohio’s performance ranks in the top 25 percent of our peer group and our investment costs are low compared to our peers.”
In my opinion, the above summary disclosure by this pension regarding CEM findings may, at a minimum, be so incomplete as to be potentially misleading. I believe disclosure of the full 136-page CEM report, not merely the Executive Summary or Key Takeaways section, is necessary for pension stakeholders to form a complete understanding of CEM’s findings.
The information CEM provides to pensions, their stakeholders and other investors globally relates to the investment performance and cost of $15 trillion in participating assets. CEM acknowledges:
“We provide our clients with objective, actionable benchmarking insight into how to maximize value for money in investments and pension administration.”
“Our reports and insights provide actionable insights and are used strategically as well as to help meet fiduciary responsibilities.”
In other words, both pensions and stakeholders rely upon CEM findings, as disclosed, in evaluating and executing investment strategies. The cost information the firm provides is intended to, and does, impact the investments pensions select because costs are understood to materially impact performance.
For this reason, I believe it is appropriate for legislators, regulators, law enforcement and pension stakeholders to examine whether the investment cost and other information disclosed to pension stakeholders by the firm and its pension clients is accurate, as well as fully and fairly presented.
When I recently requested information from STRS Ohio related to CEM’s contract, reports and analyses, I was told by STRS legal counsel there was no contract, or any other form of agreement between the pension and CEM. That was surprising to me given that the contract relates to over $90 billion in assets; the duties of the parties to the contract are complex; and any errors or misunderstandings between the parties could have a huge impact upon the pension. The documents I did receive were substantially redacted at the request of CEM.
CEM’s explanation of their redactions was:
“The redactions have been made in line with the definition of “Trade secret” as defined in Ohio Code 1333.61 Uniform trade secrets act definitions as follows:
(D) "Trade secret" means information, including the whole or any portion or phase of any scientific or technical information, design, process, procedure, formula, pattern, compilation, program, device, method, technique, or improvement, or any business information or plans, financial information, or listing of names, addresses, or telephone numbers, that satisfies both of the following:
(1) It derives independent economic value, actual or potential, from not being generally known to, and not being readily ascertainable by proper means by, other persons who can obtain economic value from its disclosure or use.
(2) It is the subject of efforts that are reasonable under the circumstances to maintain its secrecy.
We have redacted our cost data as well as certain formulas and methods used in the preparation of the report. The information that has been redacted is not publicly available and is only provided to our paying clients. The redacted cost data has been provided to us by our clients and forms our proprietary cost database. This data and database is not available from other public sources and forms the basis for our analysis. It is key to our business model that the data not be publicly released. Note that I have not redacted return information since 1) much of this data could be gleaned from publicly available sources (CAFRs) and is not core to our product."
Apparently, all redactions were made or demanded by CEM and the pension neither confirmed nor disputed CEM’s rationale for its redactions. Conspicuously redacted from the reports were the identities of the public pension funds that CEM chose as STRS’s peers for cost and performance comparison. CEM also redacted data about STRS’s performance, including investment costs, external money manager fees, and performance information on STRS’s investments.
CEM offered no explanation as to how it could claim that STRS’s own internal data can be CEM’s “trade secret.”
Since I believe public pensions should be facilitating, not thwarting, transparency and compliance with Ohio public records laws, on May 21, 2021, I filed a complaint for writ mandamus with the Supreme Court of Ohio seeking the STRS public records related to CEM. Later, immediately following an initial mediation, STRS finally provided the CEM documents I had requested in full—now without any redactions.
Here’s what I could gather from the unredacted, formerly “trade secret” protected, reports.
It is my understanding that clients provide the firm with all of the data regarding the pension investment costs and performance, which CEM analyzes. Indeed, CEM acknowledges in the language above that “the redacted cost data has been provided to us by our clients and forms our proprietary cost database.”
“The analysis is as accurate as possible based upon fees as reported to us by our clients (emphasis added),” says CEM.
However, in interviews CEM representatives advised me:
- Pensions may not know the costs of all their investments;
- Pensions may decline to provide CEM with known cost information which pensions are not “overly comfortable with;”
- CEM does not independently collect any cost information from investment managers which might verify or contradict the fees as reported by pension clients; and
- Cost and performance estimates created by CEM have been utilized with respect to many pension investments.
The CEM reports I have reviewed stated that the information contained therein is proprietary and confidential and may not be disclosed to third parties without the express written mutual consent of both CEM and STRS. While the reports repeatedly state that the most meaningful comparisons for returns, value added and cost performance are to “your custom peer group,” it is noted: “To preserve client confidentiality, given potential access to documents as permitted by the Freedom of Information Act, we do not disclose your peers’ names in this document.” In other words, information which is critical for assessing the value of the peer group analysis has been intentionally withheld from the document to avoid potential disclosure of said information to the public under applicable state law.
In my opinion, there is no valid reason a single U.S. public pension, let alone “custom peer groups” of such funds should agree to provide in-depth, “sensitive” financial information related to trillions in public assets to a private investment services company—for purposes of analyses supposedly prepared for the benefit of, and certainly paid for by, the U.S. funds—and further agree to withhold the details of said analyses from pension stakeholders. After all, the information provided to CEM relates to stakeholder money.
At least one other state pension, South Carolina, has rightly released its entire 136-page CEM analysis to the public. Thus, it appears any supposed concerns regarding the proprietary and confidential nature of information contained in CEM analyses are not insurmountable.
Further, the December 2018 Final Report and Recommendations of the Public Pension Management and Asset Investment Review Commission of the Commonwealth of Pennsylvania recommended that the Commonwealth’s two largest pensions collaborate on a detailed CEM administrative and investment cost benchmarking analysis, and make the detailed report(s) available to the public (not only the Executive Summary).
In Pennsylvania and South Carolina, unlike Ohio, there is recognition that the public deserves to see the entire CEM report, not select passages.
Failure to disclose names of pensions in the custom peer group renders the peer analysis unauditable. Worse still, pension stakeholders cannot even be certain that disclosure of the names in the custom peer group was made to, as well as understood and accepted by, the STRS board consistent with the board’s fiduciary duties. To further complicate matters, CEM notes—without explanation—that the STRS peer group may change from year-to-year.
Paradoxically, according to CEM itself, “in every other country in the world, pensions—such as Canada’s largest pension, the $221 billion Ontario Teachers’ Pension Plan—willingly disclose their custom peer groups (emphasis added).” Only American public pensions, subject to expansive state open records laws, demand secrecy, CEM representatives told me.
In summary, if favorable summaries of CEM analyses are to be happily announced to U.S. public pension stakeholders—for the American public to rely upon—then I believe there should be no hesitancy in disclosing the underlying data and documents supporting those conclusions.
In support of my views regarding the importance of transparency, I noticed that CEM says the following in its reports: “The value of the information contained in these reports is only as good as the quality of the data received.” If the public cannot see the underlying data, then it is impossible to assess its validity.
CEM’s website unequivocally states that “Transparency Matters.”
Says CEM’s Mike Heale: "Trust is a critically important success factor. Transparency builds trust. Transparency is the right thing to do and the smart thing to do.”
Indeed, CEM offers a custom Transparency Benchmarking Service for funds which it claims “helps funds speed up the implementation of transparency best practices and builds a great foundation for transparency leadership in our industry.”
On the other hand, the firm’s website includes numerous assurances to clients regarding confidentiality.
Preaching transparency while promising confidentiality may be problematic, in my opinion.
The unredacted STRS Ohio 2018 report I reviewed initially states in the Key Takeaways section of the Executive Summary that the pension’s 5-year net total return of 6.25 percent was in the top quartile and above the fund’s 6.09 percent 5-year policy return. The 5-year net value added was 0.16 percent. As noted by CEM, “Total returns, by themselves, provide little insight into the reasons behind relative performance. Therefore, we separate total return into its more meaningful components: policy return and value added.” Policy return is the return a pension would receive if it passively invested its assets i.e., bought appropriate index funds. Value added indicates the extra return provided by active management.
A footnote later in the report discloses that “to enable fairer comparisons, the policy returns for all participants except your fund were adjusted to reflect private equity benchmarks based on lagged, investable public-market indices. If CEM used this same adjustment for your fund, your 5-year policy return would be 6.8 percent, 0.7 percent higher than the pension’s actual 5-year policy return of 6.1 percent. Mirroring this, the 5-year total fund net value added of 0.16 percent would be 0.7 percent lower” or, by my estimate, -0.54 percent.
In other words, a fairer comparison (says CEM)—not included in the Key Takeaways—reveals that the pension underperformed its 5-year policy return, producing a negative value added—the very two components of the pension’s total return which CEM claims are more meaningful. A negative net value added means that the pension did not benefit from active management, i.e., STRS would have earned over $400 million more annually, or over $2 billion for the five-year period by simply passively indexing its investments according to its policy mix. These findings are strikingly different from those announced by STRS, in my opinion.
The Key Takeaways section of the CEM report also states that the pension’s investment cost of 40.1 basis points was below its benchmark cost of 54.5 basis points which suggests that the fund was low cost compared to its peers., i.e., was low cost because it paid less than its peers for similar services and had a lower cost for implementing its style.
The report later states that the investment costs were $279.1 million or 36.9 basis points and $302.8 million or 40.1 basis points when hedge fund performance fees and private equity base management fee offsets were added. However, it is disclosed that transaction costs and private asset performance fees were not included in the latter total.
The report indicates that CEM excluded external private asset performance fees and all transaction costs from the pension’s total cost because “only a limited number of participants were able to provide complete data.” In other words, either most of the 17 unnamed U.S. public pensions included in the custom peer group failed to diligently monitor the complete fees paid related to these high-cost, high-risk opaque investments, i.e., did not know the complete costs, or the pensions were aware of the complete fees but refused to disclose them—either of which would serve to reduce each pension and the group’s overall costs reported to CEM.
In Appendix A, performance fees of $160.8 million are estimated by CEM in 2018. This figure is a mere estimate provided by CEM, as an accommodation to its pension clients and without confirmation from the investment managers. In my opinion, the default fees (which are based upon pension reported medians) are likely underestimates.
Appendix A- Data Summary: Comments and defaults, is an extensive list of base and performance fee default cost estimates applied by CEM to 75 of the Ohio pension’s investments over the period either because (according to CEM):
- STRS did not provide cost information to CEM; or
- STRS failed to provide support for the unusually low-cost information reported to CEM; or
- To enable CEM comparisons of the total cost of different implementation styles.
These base and performance fee default costs are significant—some in excess of 2 percent.
Unlike the base fee estimates, the performance fee estimates “are not included in the pension’s total fund cost or in benchmark analysis,” says CEM. It is unclear to me why these default costs are not included. Obviously, failure to include the significant performance fee default costs in the pension’s total fund cost or in benchmark analysis—for whatever reason—serves to make the pension appear lower cost and more competitively managed.
In my opinion, if, during the data confirmation process CEM and the pension discussed the disturbing fact that certain investment management costs were unknown to STRS, or, worse still, known but not provided for some reason, the sole acceptable, prudent course would have been to demand full disclosure of all costs from the pension and its managers, as opposed to continuing to invest billions in the highest-cost, highest-risk, most opaque assets blithely ignorant of (or concealing) the true costs—using problematic median default estimates as support for the strategy.
Again, pension fiduciaries have a legal duty to monitor all investment and other costs for reasonableness—not merely guess, or estimate, what those costs might be.
Use of median default estimates in managing a $90 billion plan securing the retirement of hundreds of thousands of state teachers fails to meet applicable fiduciary standards, in my opinion.
True costs are always ascertainable and should always be used in order to safeguard assets.
When performance fees of $160.8 million are added in, the revised fee total rises from $279.1 million, then $302.8 million to $463.6 million or 61.3 basis points, versus the 40.1 basis points noted in the Key Takeaways. This cost is significantly greater than the fund’s benchmark cost of 54.5 basis points, suggesting that STRS was high cost compared to its peers, i.e., paid more than peers for similar services and had a higher cost for implementing its style. Again, these findings appear to be strikingly different from those announced by the pension.
However, it appears that even the $463.6 million estimated total cost is incomplete.
In 2015, CEM concluded that the difference between what pensions reported as expenses and what they actually charged investors averaged at least two percentage points a year. And this estimate, CEM acknowledged, was probably low. CEM has stated private equity fund of funds costs average over 5 percent. Professor Ludovic Phalippou, at the Said School of Business at Oxford, found that the average private equity buyout fund charged more than 7 percent in fees each year.
More recently, in 2020, CEM concluded that pensions are reporting, at best, only half of their investment management costs.
“Our research indicates that, at best, only half of true total investment management costs are included in asset owner financial statements. Across the industry this means an enormous amount of costs actually incurred go unreported. Tens of billions of dollars are not reported by asset owners.”
“We believe our estimate that 49 per cent of costs go unreported in financial statements of annual reports is conservative and the extent of under-reporting is likely to be higher across the entire industry.”
My forensic investigations routinely uncover fees related to alternative funds and fund of funds in the 7-10 percent range. My 2014 forensic investigation of the $87 billion State Employees’ Retirement System of the State of North Carolina revealed that the pension paid undisclosed fees approximately $500 million, in addition to the $500 million in fees it disclosed.
In my opinion, there is ample reason to believe the total fees at STRS are nearly double what the pension is reporting, amounting to almost $1 billion annually.
More disturbing, since STRS investment managers may withdraw their fees from pension accounts in the absence of any diligent monitoring by STRS, the risk of looting, i.e., illegitimate withdrawals, is dangerously high, in my opinion.
There is no point speculating as to the true all-in investment costs at any pension, in my opinion. Absent an accounting and full transparency, pension stakeholders can never be certain of the true costs; with scrutiny, the true costs can be precisely determined and publicly disclosed, consistent with applicable fiduciary duties—restoring financial integrity to the pension.
As CEM notes in a private equity whitepaper, cost disclosure and transparency can lead to better decisions. Says CEM:
“Clearly there currently are challenges with collecting full private equity costs, but the exercise can yield benefits beyond improved disclosure and transparency. Understanding true costs can lead to lower costs through negotiation with managers. Additionally, understanding costs may lead to more efficient investment vehicle selection because high costs will materially impact private equity performance.”
In conclusion, there is never any justification for a pension to fail to demand full disclosure of fees from investment managers since failure to understand true costs may lead to less efficient investment vehicle selection and negatively impact performance. Pension participants and taxpayers deserve to know the truth. Like I said earlier… it’s stakeholders’ money.
Likewise, there is never any justification for a pension to fail to provide full disclosure of fees to stakeholders. Public pensions investing public monies must be accountable to the public.
