Do Teachers Pensions Need Trumpian Negotiators?

Do Teachers Pensions Need Trumpian Negotiators?

The American Federation of Teachers (AFT) has issued a lengthy rebuke to and critique of the fee structure of the alternatives investment industry; in a position paper it calls The Big Squeeze.

Should the title be considered obscure, the subtitle is clearer about the paper’s thesis, “How Money Managers’ Fees Crush State Budgets and Workers’ Retirement Hopes.”

Much of the paper sounds like fairly typical populist posturing, as for example the statement that “the top 25 hedge fund managers earned more in 2015 than all the kindergarten teachers in the U.S. combined.”  One wonders, “How did the top 25 NBA players do against kindergarten teachers?”

The authors of this piece would presumably not approve of that analogy, because in their view the hedge fund stars, though not the sports world’s stars, are “robber barons,” enriching themselves “through the extraction of fees from public employee retirement savings.”

The paper begins with an overly simple declaration that the 2 + 20 fee arrangement is “typical.” As regular readers of AllAboutAlpha surely know, such a fund structure has been under competitive pressure for a long time, and for many hedge fund managers the infamous 2 + 20 is simply the benchmark whence the discounting begins. AFT acknowledges that fact eventually, deep inside this paper, conceding that “some pension funds have already begun negotiating a lower rate” and that 1.8 + 18 might be a more accurate summary of the existing market reality.

Taming the Barons

As the term “robber baron” suggests, it is the position of the AFT that it isn’t rational for pensions to pay the fees they currently pay to alternative investment vehicles. By way of making that suggestion explicit, the authors proceed to cite a study published in 2015 by the Maryland Public Policy Institute that found (in the AFT paraphrase) that state pension funds “that paid the highest fees as a percent of assets recorded worse investment returns, on average [than] those paying the lowest fees.”

The authors make the distinct point that the typical fee arrangement produces an inequitable sharing of risk with “downside risk exposure [falling] exclusively on the investor, who pays fees regardless of how well the investment performs.”

Making those points, though, isn’t the chief focus of the study. Its concern, rather, is with the question how might these robber barons best be tamed? In a world in which employees need pension fund managers, and pension fund managers in turn need some exposure to alternatives markets, if only for the sake of portfolio diversification: what should the fund managers do differently?

The AFT’s answer is that pension managers should negotiate better deals. Specifically, they should pay only half of what they now pay. This means halving the 1.8% to 0.9% as a percent of AUM as a management fee, and the 18% to 9% as the percent of annual profits to be captured by alpha seeking managers.

Two Obvious Points

One has to make a couple of points about this suggestion. First, it is very much in tune with our Age of Trump. The idea is that ‘our side’ (whether conceived of in occupational or in national terms) is getting a “bad deal” because our negotiators have been weak. If only the negotiators were stronger, and had made and stuck to a bolder set of demands, those demands would be met by the other side, and fairness achieved. AFT wants pension funds to rejigger their operations much as President Trump proposes to have the United States rejigger NAFTA.

The second point: if the objection to fees really is functional, definitionally getting better numbers doesn’t fix it. Wouldn’t it still be the case, after the hypothetical change in numbers, that the investor “pays fees regardless of how well the investment performs”? which was the supposed objection to the system?

If the objection is functional, then the objection can’t be directed at both the management fee and the performance fee. The reason even poorly performance gets rewarded is that there IS a management fee. So a better approach (on those premises, here simply adopted hypothetically) is that pension managers should negotiate to abolish the management fee, requiring asset pursuers to rely entirely upon their performance fee to keep the lights on.

A more sensible analysis might begin from there. Why is there a management fee? In view of the fact that it is subject to market pressures (hence the conceded reduction over time from 2% to 1.8%)—why should one imagine that it is has not yet been sufficiently pressured?

The AFT, though, is plainly interested in giving a scholarly look to its populism, not in doing a rigorous analysis of such matters.

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