A case for performance fees in DB plans

The looming retirement crisis in the United States has made it very clear that every participant in the management of retirement assets is now under increased pressure to support the investment needs of the aging U.S. population.

In the face of this oncoming crisis, each of these participants — from investment managers to actuaries to consultants to custodians and the plan sponsor — needs to review their activities to determine what steps can be taken.

With regard to investment managers in particular, one obvious area where progress can be made toward heading off this crisis relates to the performance of portfolios. Of course, improving the quality and consistency of returns is not trivial, and, in many cases, can be subject to the cyclical nature of the markets.

So while improving gross investment returns is a laudable and important goal, careful attention to how investment managers are compensated for their efforts can provide another, arguably more predictable, way to have a positive impact on the net returns that the plans and individuals will actually see.

To this end, compensating managers using performance-based fees can be, in many instances, a preferred strategy for plan sponsors and consultants compared with an all asset-based management fee structure.

Institutional plan sponsors seeking to invest in long-only equities traditionally have come to favor a “flat” asset-based fee structure, as offered by traditional relative-return investment managers.

There are several reasons a plan sponsor might like this approach. A fixed asset-based fee allows all investors to have a general understanding of the dollar amount to be paid. This can be helpful for budgeting purposes and in setting expectations for stakeholders.

Additionally, for those plan sponsors who are extremely confident in their ability to choose “superior” investment managers for their portfolio (those plan sponsors managers who think they can choose top-quartile managers, for example), fixed asset-based fees might make sense. Why pay more for outperformance?

Investors in “alternative” products (such as hedge funds and private equity funds) have become accustomed to fee structures that combine asset- and performance-based fees. In particular, performance fees are believed to be an important part of aligning the incentives of manager and investor.

As these alternative investment managers have started to cover traditional asset management space, it should not be surprising that they might be open to adopting fee structures that go beyond pure asset-based structures. In some cases, these managers are willing to go as far as structuring a fee schedule that has no base management fee while collecting a percentage of relative outperformance (for example, a manager might propose a “zero and 30” structure, where there is no asset-based fee charged but instead managers split profits exceeding the return of a benchmark in the proportion of 70% to the client and 30% to the manager). Effectively, this means the manager is only paid a fee if the client makes money or achieves relative outperformance to a benchmark.

We believe that performance-based fees should be a strong consideration of plan sponsors and investors. While one of the obvious potential benefits of employing a performance-based fee is the alignment of interests between the investor and manager, there are several other arguments that support consideration of a performance-based fee.

First, in many cases, managers base their fee schedules on inflated expectations for excess return (usually 1% to 2% annually over a market cycle). With a performance-based fee structure, there is no “guessing” as to potential value-add. A performance-based fee structure will only cost the plan sponsor more when outperformance is greater than the target outperformance, and will always cost less than a management-based fee structure in times of underperformance relative to performance objectives.

The absence of a management-based fee also allows a quicker recovery from drawdowns. Since net and gross performance will always be the same for negative performance, the underperforming manager will not cost the plan anymore than the “underperformance,” while an asset-based fee manager's net performance is worse. In fact, an argument could be made that having a performance-based fee structure might enable clients to keep managers longer than they would ordinarily do, providing both the plan sponsor and manager the opportunity for a turnaround.

Given some of the arguments above, why might some plan sponsors be reluctant to use performance-based fees?

Investors might be concerned that a manager earning fees based on performance might take on excessive amounts of risk to potentially boost performance (manage to a greater tracking error). One way to reduce some of this anxiety is to report the ex-post return/risk results of all accounts in a particular strategy. By doing so, the manager reveals to the investor that the portfolio is staying within the risk taking parameters of the fund/account's mandate and other clients.

Some investors mighty simply find paying a manager 25% to 30% of the outperformance to somehow be an unpalatable headline figure. Still others might perceive a fiduciary duty in limiting payment to an investment manager. In addition, some allocators might be uneasy with paying a greater dollar amount to managers in times of relative outperformance, especially if absolute performance is negative.

Finally, for budgeting purposes it is true that a performance-based fee can vary quite a bit depending on the realized gross performance.

However, it is important to remember that under the performance-fee model, these greater fees are only achieved when the investor is outperforming the fund's return target relative to the benchmark. In such cases of outperformance, the client receives a disproportionate share of the outperformance (e.g., 70% of outperformance under a 0/30 model).

Despite the arguments for a performance-based fee approach, it remains true that if a plan sponsor were able to successfully choose managers that all ended up in the upper quartile of performance, they would be more likely to pay a larger dollar amount to their managers in fees (when using a performance-fee based approach).

However, in general, ending up with a basket of top-quartile managers is extremely difficult. Assuming median performance is, in our opinion, a more conservative and likely scenario, under which performance-based fee approaches are likely to result in higher net-of-fees performance.

Even if enlightened plan sponsors understand the likelihood of attaining median rather than top-quartile performance, some might instinctively believe that paying a fixed percentage fee on assets managed will result in better net performance than paying a small base fee with a performance sharing element.

Table 1 compares the different return scenarios of a fixed 50-basis-point annual management-based fee and a 0/30% performance-based fee structure applied to the eVestment Large Cap Core Universe of 350 strategies for calendar year 2010. Given the median return of -0.88%, the asset-based fee example would result in a net performance of -1.38%, while the “net” performance in a 0/30% structure would still be -88 basis points.

When we extend the analysis to the last three years, in Table 2, and assuming the same 50-basis-point asset-based fee, the median net of fees performance is only 0.34%. The performance-based fee structure would result in net of fees performance of 0.49%, representing a savings of 15 basis points to an investor paying a performance-based fee.

Although 15 basis points might not seem like much, an extra 15 basis points per year for 10 years on a $100 million portfolio earning 10% per year would result in an increase in value in the account of more than $3.5 million.

Given the significant cost to plan sponsors of using poorly performing managers on asset-based fees, there are truly unmistakable benefits to a performance-based fee structure where the interests of the allocator and manager are absolutely aligned. While an asset-based fee structure is currently the typical offering for equity allocators, the average manager is clearly not adding value. Once plan sponsors look past their apprehension of paying for performance, this new (to the long-only equity investor, at least) structure, the alignment of interest with managers, and potential cost savings to the investor will prove incredibly beneficial.

Recent developments suggest that acceptance of performance fees in the long-only world might be growing. Two leading asset consulting firms in Australia have authored a guideline note highlighting six principles for fee negotiations with managers. These principles include the use of performance fees and a target for the payment of alpha between 25% and 33%. We couldn't agree more. n