Our Take: Outsourcing Public Fund Management - A Trend In the Making?

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The work of managing public employee retirement funds is poised for a gradual migration from public-sector employees toward private contractors. Taxpayers will end up paying more in fees, but portfolio managers' salaries and bonuses will ultimately scroll off the radar screens of politicians who oversee public retirement funds.

That's my takeaway from recent developments involving public pension funds in California, Texas and Ohio.

The newest twist is playing out in California. This Thursday, the board of the $7.2 billion San Diego County Employees Retirement Association took a step toward transferring all investment management activities from in-house staff to a dedicated external adviser. The favorite appears to be Integrity Capital, which already holds a contract as the San Diego fund's outsourced chief investment officer. A county spokeswoman told Pensions & Investments that Integrity will be eligible to bid on the RFP that could be released as soon as March 26.

Integrity Capital was launched last August by Lee Partridge, who stepped down as deputy CIO at the Texas Teacher Retirement System to pursue his idea of providing similar services to different funds, thus spreading the costs. The San Diego fund is his first client.

The price tag for the CIO outsourcing contract generated plenty of controversy. Based on an initial retainer of 0.55 basis points and an annual advisory fee of 0.85 basis points, Partridge will make at least $882,000 this year and could earn an additional performance bonus of up to $535,000.

A Revolving-Door Job

A San Diego Union-Tribune editorial last September called the outsourcing deal "malodorous" and "noxious." Had the CIO job remained in-house, its occupant would have been limited to $330,000 total compensation. In Texas, Partridge had earned between $360,000 - $380,000.

But the newspaper neglected to mention that Partridge is the San Diego fund's fifth CIO since 1997. "Clearly, chief investment officer is not a career position in our fund," board chairman Doug Rose told Institutional Investor. "Given the salary, if you are doing spectacularly well, you are going to move on to bigger and better things." (To be sure, the four in-house CIOs left for a variety of reasons, none clearly related to pay. The last, David Deutsch, was forced out a year ago after making disastrous hedge fund investments.)

I believe more public funds will move to outsource investment management in order to sidestep political skirmishing over compensation. Of course, contracted fee levels can draw criticism too. But when controversy erupts, public agencies - and even wealthy private universities, as Harvard discovered in 2005 - may find it politically easier to justify paying up for outside management than paying competitive salaries and bonuses to their own staff.

Deferring Rewards in Texas

The Teacher Retirement System (TRS) of Texas - Lee Partridge's former employer - is a case in point. Twice last year, the TRS board voted to defer performance bonuses previously earned by in-house investment staff. As a result, more than 80 eligible employees must wait until 2011 to collect incentive pay they earned for 2008 or 2009. Staff who leave might forfeit their past performance awards, according to the Statesman, a Texas newspaper.

Also in Texas, the top six managers of the University of Texas Investment Management Co. (UTIMCO) agreed last November to defer receiving their bonuses for two years. And the UTIMCO board changed the employees' contract, reserving the right to unilaterally reduce bonuses during years when "extraordinary market conditions" create either very high or very low returns.

Where's My Upside?

In Ohio, meanwhile, directors of that state's teacher retirement system last year reduced maximum incentive payouts and overall compensation targets for investment staff, cut the number of bonus-eligible employees from 90 to 80, and made all staff bonuses in any fiscal year contingent on the fund achieving a positive total return. (However, the board also sweetened the bonus pool for years when the fund enjoys strong positive returns.)

It's significant that the State Teachers Retirement System of Ohio faces pressure from members - active and retired public school teachers - to outsource investment management. The system estimates that fees for external management would have exceeded the cost of in-house management by $112 million in calendar year 2008.

All these changes share a common thread: For some investment professionals who are state or municipal workers, compensation plans are changing in ways that expose compensation to downside market risk - without corresponding upside exposure in most cases. Net-net, they are clearly worse off.

Those professionals may lack market power to jump to private-sector employers right away. But as hiring conditions in asset management improve, that's likely to change.

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