Shedding More Light on Fees a State Pension Fund Pays Wall Street

Maryland lawmakers are considering a bill that would impose added requirements on the state’s pension fund to disclose certain fees for investments like hedge funds and private equity.

These fees have totalled upwards of one hundred million dollars for the retirement system in some recent years, but representatives for the fund emphasize that they are tied to the size of investment profits and grow as the fund itself sees greater returns.

The roughly $50 billion fund covers state and higher education employees, as well as some local government workers.

An earlier draft of the bill would have tightened restrictions on the fees it can pay annually. That language was opposed by the pension system’s board of trustees and stripped from a version of the legislation that passed the House 138-0 earlier this month.

State and local public pension funds pay billions of dollars in investment fees each year, research has shown.

Critics question whether some of these costs are worth it and suggest funds could achieve similar returns and levels of risk with less expensive investment options.

Delegate Kumar Barve, a Democrat who has served in the state General Assembly since the early 1990s, is a lead sponsor of the bill and says he’s not giving up on the parts of it that were scrapped.

“I expect to win after two or three years,” he said by phone this week.

Barve says he wants to start a discussion about moving Maryland’s pension fund more toward an index investing approach that tracks with indexes like the S&P 500 and the Russell 2000.

“Pension funds throughout the United States, not just Maryland, are doing a disservice to retirees by investing with hedge fund managers and private equity funds,” he said.

“A lot of these funds don't have returns that are as good as index market funds and they charge much more money.”

He acknowledges that any major shift in how the state pension fund’s assets are allocated won’t happen overnight. “But at a minimum I think we ought to have a very clear understanding of what the true fees are,” he added. “I think we need to do more of an analysis of that.”

The Maryland State Retirement and Pension System already reports many of the investment management fees it pays. These totalled about $372 million in fiscal 2018 and around $333 million in fiscal 2017, according to a fiscal note attached to Barve’s bill.

But managers who oversee investments like private equity funds and private real estate funds earn what’s known as “carried interest”—a percentage of the profits the investments generate.

Maryland’s pension fund is currently not required to report carried interest. House Bill 821 calls for it to do so annually for its assets.

The fund paid about $428 million in carried interest between 2014 and 2017 and about $136 million in 2017 alone, according to calculations the fund shared with Route Fifty this week.

Michael Golden, director of external affairs for the Maryland State Retirement and Pension System, stressed in an email: “For every dollar in carried interest they get, we make four! The higher the carried interest, the more money we make.”

Maryland State Retirement and Pension System staff testified on behalf of the system’s board of trustees in opposition to Barve’s original bill—the draft of the legislation that would have included new restrictions on the investment fees that the system can incur.

The fund is now subject to a fee cap of 0.5 percent of the market value of its assets. But this doesn’t apply to real estate and “alternative investments,” like private equity and hedge funds.

Barve’s bill as first proposed would have limited the future fees that the fund can pay for “external investment management” during the course of a fiscal year to 0.45 percent of the market value of its invested assets on the last day of the previous fiscal year.

It would have applied this cap to real estate and alternative investments as well, and blocked agreements requiring fee payments for unrealized investment gains.

Andrew Palmer, the system’s chief investment officer, told lawmakers in testimony that while he appreciated the motivation behind the bill, its proposed fee limits would hamper the pension fund’s ability to generate returns and properly allocate assets.

“Lower fee products are not expected to produce the required returns,” he said.

Golden, the system's director of external affairs, adds: “the point that was being made in our testimony is that we can’t tie the trustees’ hands as to what they can and cannot invest in.”

He says that the pension system has not taken a position on the slimmed down version of the pension legislation, which includes only the carried interest reporting provisions. But he noted that it did endorse other legislation that proposed the same requirements.

“The bottom line is we're all for transparency,” Golden said.

Asked why the fund didn’t report carried interest previously, he emphasized that it had been calculating it in the past and has reported it to its board and to the public when requested. “It just wasn't part of the normal public disclosure,” Golden said.

Reporting carried interest tends to be the exception, rather than the rule, for state pension funds, according to a report published by the Maryland Public Policy Institute last year. Researchers found only six states, out of 33 they looked at, report it regularly.

The fiscal note attached to the Maryland bill notes that the California Public Employees’ Retirement System and the Pennsylvania Public School Employees’ Retirement System have both recently released reports revealing carried interest their investment partners earned.

CalPERS reported that the figure was $700 million in fiscal 2015 and the Pennsylvania school employee system said its figure was $5.1 billion between 1980 and 2017.

After paying benefits, the market value of the assets in Maryland’s pension system were $51.8 billion on June 30 last year, up roughly $2.8 billion from $49.1 billion in 2017. The fund’s annual financial report says its “dollar-weighted” rate of return was about eight percent.

The increase in value, the report says, “is primarily due to positive net returns in equities, real estate, and private alternative investments.”

It shows that about $19 billion of the fund’s assets were in alternative investments last year.

And it includes a “alternative investments relationship listing” with dozens of firms, like Blackstone Capital Partners, real estate giant CBRE, and Quantum Energy Partners, a private equity and venture capital firm focused on oil and natural gas.

Jeff Hooke, is a senior finance lecturer at Johns Hopkins University's Carey School of Business, and a senior fellow at the Maryland Public Policy Institute, which bills itself as supporting “free enterprise, limited government, and civil society.”

He has worked on studies looking at Maryland’s state pension fund, the fees that it and other funds pay, and how returns for funds that pay investment managers large sums stack up against index investing.

A paper he co-authored last year found that over a 10-year time period, ending in 2017, a 60 percent stock, 40 percent bond index returned 6.4 percent in gains on an annualized basis. 

The same figure was 4.2 percent for Maryland’s fund and the median for funds in the state's peer group was 5.4 percent.

“Most states don’t beat the index,” Hooke said.

“I guess maybe there’s been some noises by a few states of indexing a little more,” he added. “But I don’t see a mass movement.”

The paper recommends that Maryland's pension fund index the bulk of its portfolio with a blend of stock and bonds, and suggests this could lower the fees that it is paying to Wall Street to around $25 million each year, a fraction of what they are now.

Maryland’s retirement system has cast doubt on some of the fee estimates Hooke has used in his work. But he maintains that the figures are in the ballpark. “It’s a huge number,” he said of the fees. "I'm surprised the legislature doesn't take more of an interest."

Gov. Larry Hogan, a Republican, has not taken a position on the pension fee reporting legislation, according to a spokesperson. A state Senate committee is scheduled to discuss the bill on Thursday.