U.S. pension funds with significant actively managed portfolios should watch with interest the adoption of performance-based investment fees for equity and bond portfolios by Japan's giant Government Pension Investment Fund.
The GPIF move should show if U.S. funds should consider such fees for their actively managed portfolios — or whether it is an idea whose time has passed.
A few large U.S. pension funds, including the $97.1 billion Minnesota State Board of Investment and the $69.3 billion Massachusetts Pension Reserve Investment Trust, adopted performance-based fees in 1986 and 1987, but they were not widely copied, except for alternative investments such as venture capital and hedge funds. Both funds still use performance fees for some equity managers.
Performance-based fees would seem to be "win-win," as some have described them. When the manager outperforms an agreed-upon target return, the fee rises. When the manager underperforms thae target, the fee declines.
Such fees would seem to perfectly align the interests of the asset owners and the active managers they hire to make those assets grow.
But except for the alternatives area, performance-based fees have not become the predominant form of payment for active stock or bond management, though the Department of Labor approved such fees for private pension funds in 1986 after lobbying by the venture capital and hedge fund industries.
The Department of Labor required that the returns on which the fees were based include both realized and unrealized gains, that they be based on an annual measurement of returns, and that they not only increase fees for outperformance but reduce them for underperformance.
At the time, a survey of almost 1,500 pension executives found that 43% said they would want all managers on performance-based fees.
However, relatively few corporate pension funds adopted such fees for equity and bond fund management after the DOL gave its approval, perhaps because many fund managers resisted. One of the few to adopt performance-based fees was GTE Corp., now known as Verizon Communications after a merger with Bell Atlantic, which in 1987 put all its domestic equity managers on them.
The GTE plan established benchmark passively managed portfolios for each manager and generally required each manager to top its normal portfolio benchmark by 200 basis points to earn its normal fee. A manager returning better than that could earn a higher fee, while underperformance could reduce the fee by as much as 75%.
Active managers with solid records of delivering alpha are in a good position to resist performance-based fees because they already can charge high fees. While performance-based fees could bring them additional earnings, they also could bring volatility to those earnings given that few managers top the benchmarks every year.
Other managers, less certain of their ability to consistently earn excess returns over their benchmarks, have little reason to agree to performance-based fees, which might only reduce their fee income, as some of the GPIF's managers appear to be learning. GPIF's payments to money managers plunged 40% in the most recent fiscal year, according to its annual report. These managers might decide not to seek the opportunity to manage money for funds requiring performance-based fees.
The increased commitments to passive equity management might also have reduced the importance of performance-based fees as a cost control vehicle because indexed portfolios have extremely low costs.
The GPIF move is a large-scale test of the viability of performance-based fees amid the modern investment environment of large-scale indexed management and, in the corporate world, a move to outsource defined benefit pension obligations and to defined contribution plans.n