What if pension funds grabbed the reins?
Apr. 18, 2012 — Public and private pension funds in the United States collectively have trillions of dollars in combined assets. They own more than a third of all domestic equity, with stakes in most public U.S. companies, and large holdings of corporate and government bonds, real estate, and infrastructure. They are unique in that they are both very large and have a much longer investment horizon than most other types of investors.
But, with few exceptions, American pension funds do not self-manage the majority of those assets, and they ignore the flexibility that their long-term horizon can bring, experts said. They employ private firms to invest their assets for them, often with a short-term focus and at a high cost. Many of their trustees are political appointees without any experience in finance. And so, instead of being viewed as powerful financial players, with the capacity to initiate deals and lead markets, pension funds act — and are treated by the financial advisors they employ — more like large customers.
“Collectively, pension funds have a huge amount of potential power,” said James Hawley, a professor of business at St. Mary’s College and an expert in fund management. “For the most part, that power is not being used.”
Some of the largest public pension funds in Canada, though, have taken a very different approach than their American cousins. Set up as quasi-independent entities, the funds have appointed board members with strong backgrounds in economics and finance and, over the course of the last two decades, have developed and rely largely on in-house investment management teams.
Claude Lemoureaux, who was the chief executive officer of the Ontario Teachers’ Pension Plan when, in 1990, it adopted a new governance structure and began to develop its team, said that one of the most obvious advantages of managing investments internally is the cost-savings that come from avoiding the high fees charged by private firms.
“When you get up to a certain size, the amount you’re paying in fees is enormous,” he said. “It absolutely does not make sense to rely completely on external management.” (See sidebar “Paying for internal expertise”.)
The in-house expertise has allowed Ontario Teachers’ to source and close dozens of high-profile deals. The fund currently owns two airports, a lottery in the United Kingdom, two water utilities in Chile, several shopping malls in the United States, and the Toronto Maple Leafs, among other investments. The fund managers will often put deals together themselves, and sometimes even raise capital from other pension funds and private equity firms, which means that the fund can take a larger share of the investment return.
Many of the other large public funds in Canada have emulated the OTPP’s approach, including the Ontario Municipal Employees Retirement System (OMERS), the Canada Pension Plan Investment Board (CPPIB), the Caisse de dèpôt et placement du Quèbec, and the Alberta Investment Management Corporation (AIMCo).
Paying for internal expertise
To retain skilled dealmakers, the Ontario Teachers’ Pension Plan pays them significantly more than American funds pay their top employees. But Lemoureaux said that the fund still saves millions of dollars a year, a claim that has been born out by several studies.
A 2010 study by CEM Benchmarking of 360 pension funds showed that funds that manage a high percentage of their assets internally had similar performance levels before fees were deducted; after fees, however, internally managed funds performed significantly better.
Over the last ten years, these public funds have made several large and profitable deals. The CPPIB, for example, invested $300 million for a twelve percent share in Skype, the internet communications provider, and earned back more than three times that amount when the company was sold to Microsoft last year.
Direct investment also allows the Canadian pension funds to have a greater influence in the companies in which they invest, said Ajay Chadha, head of the private equity and pension practice at Pricewaterhouse Coopers, a consultant to many of the Canadian funds. “If they have an investment that isn’t performing to its potential, they aren’t just going to sit around and hope things get better,” he said. “They are quite vocal, and that’s something you don’t see from pension funds in the U.S.”
On the whole, the results have been impressive, Chadha said. Ontario Teachers’ has had the highest total returns among the biggest public and private pension funds in the world over the last decade.
Correcting a misalignment of interests
Large pension funds in the United States have become increasingly interested in what the Canadian funds are doing. Christopher Ailman, the Chief Investment Officer of the California State Teachers Retirement System, has said that if he were to start a pension fund from scratch, he would follow the Canadian model.
While cost-savings represent one obvious reason to consider doing so, experts said that there are a number of other advantages of internal asset management and direct investment.
Experts in corporate governance have long pointed out that relying heavily on external asset managers can create a misalignment of interests between the fund managers, the plan beneficiaries, and the private firms who are managing their money: the private firms have their own goals, interests, and strategies which may not be the same as, or be compatible with, those of the funds.
One strategy that is being discussed among American pension funds is attempting to negotiate terms with external managers that would make sure that the managers do not make money if the fund loses money. But, more fundamentally, the misalignment of interests can also mean that pension funds are losing out on whole classes of investment opportunities entirely. According to Jim Leech, the current president and chief executive officer of Ontario Teachers, pension plans are a unique kind of investor. “We have the power to combine a large capital pool with a long term investment horizon, something that is extremely novel today,” he has said.