More changes ahead for N.C. retirement system

After years of controversy over the now-$86.1 billion North Carolina Retirement Systems' sole trustee structure, Treasurer Janet Cowell is about to work herself out of that job.

The Investment Fiduciary Governance Commission, a special review panel convened by Ms. Cowell, recommended April 24 that the state create a board of trustees, the structure public pension funds in all but a few states use.

And once implemented, the switch will give Ms. Cowell more time to devote to investment decisions and her priority of increasing allocations to alternatives. But that promises a whole new controversy, following a forensic investigation conducted on behalf of the State Employees Association of North Carolina questioning the fees and level of disclosure provided by alternative money managers.

SEANC officials ordered the investigation by Benchmark Financial Services, Ocean Ridge, Fla., in part to force the issue of moving away from the sole trustee model. Another impetus was Ms. Cowell's success in 2013 in convincing state legislators to let her investment team raise alternative allocations.

While the overall cap on alternatives only grew to 35% from 34% of assets, legislators allowed higher limits within specific asset classes. The new caps are 10% on real estate, 8.5% on hedge funds, 8.75% on private equity and other private investments, and 7.5% each on inflation and credit strategies.

Before that, hedge funds had been capped at 6.5% and private equity was counted under an “other alternatives” cap of 7.5%. Officials at SEANC, an affiliate of the Service Employees International Union, are concerned about both the risk and performance of those asset classes, and are particularly critical of the fees paid to those managers, said spokeswoman Toni Davis.

“I understand that everybody has concerns about performance and fees — all fair concerns,” said Ms. Cowell. “The department has worked very hard on those issues.”

A May 2013 review of the Raleigh-based pension fund's investment fees by the fiduciary services unit of Hewitt EnnisKnupp found that private equity and real estate fees were “reasonable” compared to a universe of similar-sized investments in those asset classes, while fees for most credit strategies and inflation-protection investments were below industry averages. Hewitt EnnisKnupp is the pension fund's investment consultant that is also advising the governance review panel.

But Edward Siedle, Benchmark president, argued that true fees and expenses for alternative investments are not known and have yet to be disclosed by Ms. Cowell's office. He pointed to a fiscal 2013 report from Ms. Cowell that identified $416 million in external fees and a footnote that said: “Consistent with industry convention, cost figures do not include the fees and expenses of investment managers that are held within fund-of-funds vehicles.”

Between funds-of-funds fees and undisclosed fees for underlying managers, performance, real estate management and property fees and other trading costs, the total was closer to $1 billion in fees paid to all of North Carolina's money managers during the fiscal year ended June 30, Mr. Siedle estimated.

SEANC has asked the Securities and Exchange Commission to investigate fees paid to money managers doing business with the pension fund and will ask the state Attorney General Roy Cooper to investigate possible reporting violations by the treasurer's office, said Ms. Davis. An SEC spokeswoman declined to comment.

Performance figures compiled by Hewitt EnnisKnupp for the governance review panel showed that private equity returns of 4% over a trailing five-year period ended Sept. 30, 2013, underperformed the 8% benchmark. The consultant's report said that was due in part to some investments dating back to 2006 to 2008 — when the financial turmoil began — and because 28% of those assets are in higher-fee funds of funds, from which Ms. Cowell and her team are moving away.

Hedge funds over the same trailing five-year period had a five-year return of 0.9%, underperforming the 3.1% benchmark, according to the Hewitt EnnisKnupp report.

While a fund of funds in private equity or hedge funds “could result in over-diversification, additional layering of fees and the inability to reallocate in rapidly changing market environments,” a better option “is direct investments with multistrategy managers with a relative value or event-driven focus,” Hewitt EnnisKnupp said.

Current alternative investments represent 21.5% of the fund's assets, or about $18.7 billion, treasurer spokesman Schorr Johnson said. The pension fund's investment advisory committee recently decided to start doing more in those classes, but it will be gradual, said Mr. Johnson.

“There should be scrutiny of fees. We are disclosing everything that we pay directly, and we are open to working with the Legislature to consider more disclosure. We are comfortable that we are getting good deals and we are not trying to hide fees,” he said. “On the whole, the (Benchmark) report is simply wrong.”

When the North Carolina Legislature convenes in May, Ms. Cowell is also expected to ask to require that placement agents register as lobbyists, part of several reforms she launched in December.

Ms. Cowell also wants to do more investing in-house. Hewitt EnnisKnupp noted to the governance review panel that North Carolina's investment division staffing level ranks well below other systems of its size, with 26 staff members handling $84 billion in assets, a ratio of one person per $3.2 billion. The comparably sized State of Wisconsin Investment Board, Madison, has 148 people for $86 billion, a ratio of one person per $584 million.

North Carolina manages 31% of its defined benefit assets internally, all in domestic fixed income, Pensions & Investments' data show. Wisconsin manages 57% of its assets internally, including $17 billion in domestic equities, according to P&I.

Ms. Cowell is ready to take sole pension trustee out of the treasurer's job description. While she has instituted several checks and balances in recent years, “there is always the risk that someone without the appropriate expertise will be elected to the post,” she told the review panel.

The recommended switch to a board of trustees calls for the treasurer to serve as statutory chair and a voting member of a nine-member board appointed by several sources, including the treasurer, governor and Legislature. Commission members also recommended that board members have demonstrated expertise in institutional investment, accounting, risk management, business or technology as well as prior corporate or non-profit board experience.

The panel also recommended adding a sunset clause to confidential investment contracts to ensure that information will eventually be made public, and to have an independent expert periodically review the investment program to ensure that investment management fees and trading costs are within industry norms.

The next step is for Ms. Cowell to craft recommendations based on the panel's work that would enable the Legislature to make the legal changes when it convenes in May.