North Carolina revs up internal management

As North Carolina Retirement Systems officials celebrated reaching $90 billion in assets this month, they also prepared to look more like their peers when it comes to internal asset management.

Until now, the ninth largest U.S. public pension fund by defined benefit assets came in 13th among state pension plans for assets managed internally, according to Pensions & Investments data as of Sept. 30.

But in a budget bill signed into law Aug. 7 by Gov. Pat McCrory, state Treasurer Janet Cowell, sole trustee for the Raleigh-based state pension system, won approval for 10 of the 14 new investment staff positions she had sought. It also gives the treasurer's office some flexibility in hiring procedures and paying market rates for salaries. Legislators agreed with Ms. Cowell's argument that managing more investments internally would make the overall investment program more cost-effective. The personnel costs of the new positions would be returned 10 times over, Ms. Cowell projected, despite the pension system already being in the 40th percentile of peer funds in total investment management costs, according to its investment consultant, Hewitt EnnisKnupp.

The priority after filling the positions will be to review funds-of-funds contracts “and other legacy relationships” for possible restructuring or termination, said Schorr Johnson, spokesman for Ms. Cowell.

As of Sept. 30, North Carolina managed $26 billion internally, out of a total of $83 billion. Hewitt EnnisKnupp said in a 2013 study that North Carolina's 26-person investment division staffing level ranked well below other systems of its size, with a ratio of one person per $3.2 billion in assets, all handling domestic fixed income. In comparison, the then-$86 billion State of Wisconsin Investment Board, Madison, had 148 people, a ratio of one person per $584 million of assets.

Wisconsin investment staffers manage 57% of all assets, including $17 billion in domestic equities, according to Pensions &Investments data.

The new North Carolina staff positions — five portfolio managers and five investment analysts — will replace current external managers in global equity, private equity, opportunistic financing, real estate and inflation-sensitive strategies. Mr. Johnson said the pension system does not plan to use a search firm to recruit and fill the positions, but instead investment staffers will interview a wide spectrum of potential managers and analysts. There is no specific timetable.

North Carolina Chief Investment Officer Kevin SigRist said some new people would be assigned to risk management, while more internal public equity investing might come eventually. The most noticeable cost savings are expected from phasing out the $2.6 billion in funds of funds, Mr. SigRist said.

North Carolina's move to grow its internal asset management team is part of a bigger trend toward in-house management, said Yariv Itah, managing partner at management consulting firm Casey, Quirk & Associates LLC, Darien, Conn. “A significant number of pension plans are at least thinking about it. It's only in the beginning phases, but it is a trend that will accelerate,” Mr. Itah said.

As of Sept. 30, 26% of defined benefit plans among the 200 largest U.S. retirement plans reported internal management of some portion of plan assets. “The primary driving forces behind it are control and fees,” Mr. Itah said, with fees of particular concern to public funds.

“There is a shift going on in how institutions think about investing,” said Kurt Winkelmann, managing director and global head of research for MSCI Inc. in New York. “They really spend a lot of time thinking about the long-term mission of the organization.” In North Carolina's case, “they have enough capital and they can start to exploit scale. There is reasonable availability of data and analytics to help them,” he said.

When it comes to making the cost-savings argument to legislators responsible for personnel appropriations, “it's not that difficult to model,” Mr. Itah said. “You know the best deal you can negotiate and you can roughly tell what it will cost you in terms of staff.”

Modeling the quality of portfolio management when it comes to investment returns is another matter, Mr. Itah said: “That is the alternative cost. It is significant risk that you need to be comfortable with.”

For pension funds considering internal management, the first step is to add up the spending on manager fees and staff, then look at each asset category's investment performance. “How do I feel about their ability to generate returns? I would make the whole thing a discussion of return source vs. return source,” Mr. Winkelmann said. “Then make sure the risk that's embedded within the entire investment program is consistent with long-term objectives.”

Deborah Allan, spokeswoman for the C$140.8 billion (US$131.1 billion) Ontario Teachers' Pension Plan, Toronto, said the pension fund was “built for success” when it was created in 1990 by allowing for internal investment management. While the pension fund started with C$20 billion and “baby steps,” she said, it now manages 80% of the portfolio internally across every asset class. Executives there attribute 78% of their returns to internal management.

“Our costs are manageable, and we have professional investment staff (that) we pay well. You get what you pay for,” Ms. Allan said.

Mr. Itah of Casey Quirk said there is more than one approach to getting started with in-house management. One option is to build up expertise in an asset class like equities, where the investment is primarily about data and exposure. “You can just have a team that manages the beta exposures, and leave the investments that are heavy in alpha to an outside team.” said Mr. Itah, who sees several public pension fund officials considering that option. He declined to name the pension funds.

Others are also thinking about building the ability to replicate alpha, which “is very difficult,” Mr. Itah said. “It's a pretty big deal to go insourcing. Today, most plans end in the discovery and consideration and planning phase. Most of the complications have to do with, "How do you structure the team?'”

In North Carolina, critics of the fees paid to external money managers added measures to the law. The State Employees Association of North Carolina, an affiliate of the Service Employees International Union, pushed through a provision for an annual third-party audit of the investment program.

Ms. Cowell is not done asking for changes, either. When the state Legislature convenes in January, she intends to request the four staff positions left out of this year's budget, among other things. n