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Cowell’s Alternative, Part 1: High Fees, Secrecy Surround Pension Investments

Courtesy of the North Carolina Department of State Treasurer

Over the past five years, North Carolina Treasurer Janet Cowell has been undertaking what she calls "an experiment" with the state's public pension system. It involves moving some $20 billion of retiree money away from traditional stocks and bonds and into complex investments broadly referred to as alternatives.

Over the next two days we will be examining North Carolina's experiment with alternative investments. The returns, the risks and claims of conflicts of interest and campaign cash.

Opponents of alternative investments say they are nothing more than a sham, which siphons money from retirees and ships it off to Wall Street. Before we get to the arguments, we need to start with some background.

For decades, plain vanilla stocks and bonds were the workhorses of North Carolina’s pension system. They helped turn it into a $90 billion behemoth, one of the largest in the country.

"The pension fund is solid. It’s one of the best in the country," says Schorr Johnson, the Treasurer's spokesman. And North Carolina will not face the pension problems found in states like Illinois or cities like Detroit, Johnson says, "if we continue our conservative investment management."

That conservative strategy is changing.


To understand why, we need to go back to January of 2009 when Janet Cowell became North Carolina’s treasurer. World financial markets were on the brink of collapse. And North Carolina’s pension was taking a big hit. As Cowell told Charlotte Talks earlier this year, "My first press conference as state treasurer was to announce the $20 billion loss as the stock market plummeted, which is a great way to start a new job."

The news was bad. But it could have been worse. Cowell said North Carolina’s pension had invested in bonds much more heavily than other pensions, which helped offset some of the losses.

Still Cowell, a Democrat, was left looking at a $20 billion hole in the state’s pension system. Over time, it could threaten the pension’s ability to pay retirees, which could require North Carolina taxpayers to bail out the system. Cowell needed something that could fill that hole, and fast.

Wall Street firms said they had just the thing: Alternative Investments.

Credit Courtesy of the State Employees Association of North Carolina
Ardis Watkins, Legislative Director for the State Employees Association of North Carolina

And, Wall Street needed something too; millions in additional fees they’d earn for managing those new investments, says Ardis Watkins, the legislative director for the State Employees Association of North Carolina. "There’s $3 trillion nationwide in public pension assets. Wall Street has their sights set on them because it’s the last huge pool of money."


Here’s how Alternative investments work.

Rather than investing in those plain-vanilla stocks and bonds, you invest pension money in hedge funds, private equity, buy up distressed real estate, distressed corporate debt, venture capital, commodities and loan money to companies and industries that couldn’t get financing on the open market.

It’s clear Treasurer Cowell liked what Wall Street was selling. She declined to be interviewed for this series. But as she said on WFAE's Charlotte Talks earlier this year, she started moving pension money around.

"Because of the low interest rates, we’re diversifying. So we’re trying to put more money into real estate. We’ve done credit investments, private equity investments, as well as the stock market. So really just trying to have a global and diversified portfolio," Cowell said.

That slow diversification has actually happened rather quickly. When Treasurer Cowell took office, the state pension system had just 5 percent of its money in alternatives. Today, according to current asset allocation percentages issued by the treasurer’s office, it’s more than 22 percent. That number can go higher. Last year the General Assembly signed off on that number shooting up to 34 percent.  


Credit Courtesy of the North Carolina Department of State Treasurer
Fees paid by Nkorth Carolina during the 2012-2013 fiscal year

Alternatives are complex investments to manage. And they come with two major strings attached. The first, extremely high fees.

In a 2010 interview with WRAL TV, Treasurer Cowell said those fees better be worth it. "If we’re paying higher fees for investments they better be performing and giving us a higher rate of return, otherwise it’s a failed experiment," she said.

The second string attached to alternative investments?

Where and how these fund managers invest would be designated a trade secret – and kept from public examination - indefinitely. Treasurer Spokesman Schorr Johnson says not only is that legal, it's the cost of doing business in order for the pension to grow. "We want to get the best deals, and we want to make the best investments. Those things they can designate, and they make the designation, as confidential and proprietary."

That’s an argument Ardis Watkins of the State Employees Association is tired of hearing. "They like to say two things over at the treasurer’s office, they like to say, 'well, it’s the industry standard.' 'We give you what most people will give you when you ask for the records.' And, you know what, in most cases, that’s true.  Because the industry standard was created by the industry."


Her group wanted to know more. So it launched a public records request campaign that resulted in thousands of pages of emails and other documents.

Credit Edward Siedle/Twitter
Edward Siedle, President of Benchmark Financial Services

And they paid Edward Siedle $65,000 to do a deep dig into the North Carolina Pension system. Siedle is the President of Benchmark Financial Services, a former investigator with the Securities and Exchange Commission and is an expert in forensic investigations of pension systems. "I've investigated over a trillion dollars in pension assets," says Siedle.

His report is scathing. At times outright accusing Treasurer Cowell of breaking multiple state laws, including trading public pension funds to money managers in exchange for campaign donations. "Alternative investments lack any meaningful transparency," says Siedle, "And as a result, investments made in the shadows can involve various conflicts of interest, self dealings and violations of the law."

That’s something we will examine in part two of this series.

But the heart of Siedle’s findings are this - taken from his report.

The profound lack of transparency related to these risky so-called  “alternative” investments provides investment managers ample opportunities to charge excessive fees, carry out transactions on behalf of the pension on unfavorable terms, misuse assets, or even steal them outright.

In questioning excessive fees, Siedle is in good company. Earlier this year the SEC completed an investigation of the fees some 400 private equity funds charged their clients. Private equity is considered an alternative investment. 

America’s top financial cops found more than 50 percent of the funds charged unjustified fees to clients that in some cases may amount to fraud. As to the misuse or theft of assets, we asked Siedle to elaborate.

"We literally don’t know where this money is. If anyone can tell you with certainty then I would say get them to guarantee dollar for dollar that money is there. Get them to tell you that money is there. Because I can’t tell you it’s there. "

And while he can’t tell you where the money is, Siedle is pretty sure he knows how much in fees the state pension is paying out. "According to the figures that the treasurer has disclosed to the public, the fees in North Carolina have skyrocketed 1,000 percent over the last 10 years."

To get that number Siedle sifted through thetreasurer’s annual reports. The most recent of which is for the 2012-2013 fiscal year.

The annual report is the only place you’ll find information on how much the state pension system pays outside firms to manage their money.

In 2013, $322 million of fees went to alternative investment fund managers. Even though they controlled around 20 percent of the pension they reaped 77 percent of all of the fees the pension system paid for an entire year. "The fees that are disclosed are the tip of the iceberg fees," says Siedle, "And the fees that aren’t disclosed are significantly greater."

Take what’s known as a "fund of funds," for example. It’s a complicated arrangement where one fund manager subcontracts the investing to others.

Here’s a hypothetical example of how that works. hypothetical because the actual fees are a designated trade secret. So here we’re using the low end industry standard.

Say the pension invests $100 with a firm.

The firm takes 1 percent of that principle outright as its fee – and ships the rest, $99, off to three others firms to invest.

Those subcontracted firms also take 1 percent of what they’re given as an outright fee.   

So before any of that $100 is invested, it’s already paid out almost $2 in fees. It may not sound like much but that’s $2 every year. And that adds up fast – plus remember we’re not talking $100 here – we’re really talking hundreds of millions of dollars.

And at each step the firms also take a percentage of any profits they make.

Schorr Johnson of the treasurer’s office acknowledges these additional fees, paid to subcontractors, aren’t reported by the state. "The pension fund publishes all fees that are paid directly by the pension fund. But the fees in fund of funds are not directly paid by the pension fund so they are not something that we currently publish in our fee schedule."

Siedle believes these hidden fees may be twice what the state is reporting.

The treasurer’s office sees Siedle’s overall findings as deeply flawed.

"The report itself is simply wrong," says Johnson, "and the treasurer’s office put out a 25 to 30 page document with lots of footnotes detailing exactly why it is wrong."

That document (found here and here) says all pension funds are accounted for, though they gave few details. Time and again it said the pension system is sound and performing well.

The treasurer’s office also attacked the messenger by effectively accusing Siedle of plagiarizing himself. 

An appendix to their response shows 10 passages in the North Carolina report that are almost word for word copies of Siedle’s investigation of the Rhode Island pension system which is also moving heavily into alternative investments.  

And, the treasurer's response points out the fees the pension pays amount to just half of one percent of the overall value of the fund. A total of $416 million.

Those fees would be tolerable if, as Treasurer Cowell put it, they lead to higher returns. The latest numbers show they’re not.


Credit Courtesy of the North Carolina Department of State Treasurer
North Carolina investment returns. The "1 YR" represents full year earnings for the 2013-2014 fiscal year.

Last week the treasurer released the fiscal year returns for the pension system. Overall the pension returned 15.88 percent for the year. But last year was a particularly strong bull says Richard Warr, professor of finance at North Carolina State. "Everybody made money last year. The question is what should it have made?"

According to Wilshire TUCS, one of the leading surveys of public pension returns, North Carolina’s pension brought in 1.5 percent less than its peers.

That translates roughly to $1.2 billion in lost revenue.

Alternatives returned 17.4%, which is nothing to sneeze at.

But the treasurer’s own benchmark shows alternative investments under performed by 1.5% as well.

And over the last 10 years, according to the treasurer’s own numbers, alternatives returned 6.7%, just .3% higher than bonds.

In a sign that others are souring on alternative investments, California Public Employees Retirement System, the nation’s largest public pension, is considering cutting its investments in alternatives by as much as 50 percent. That system were one of the first to invest in alternatives. And the Wall Street Journal reports that after going through 22 years of fees and returns, CalPERS is questioning if alternatives are worth it.

Next in our series we’ll examine the claims of conflict of interest and campaign cash tied to alternative investments.

Tom Bullock decided to trade the khaki clad masses and traffic of Washington DC for Charlotte in 2014. Before joining WFAE, Tom spent 15 years working for NPR. Over that time he served as everything from an intern to senior producer of NPR’s Election Unit. Tom also spent five years as the senior producer of NPR’s Foreign Desk where he produced and reported from Iraq, Afghanistan, Yemen, Haiti, Egypt, Libya, Lebanon among others. Tom is looking forward to finally convincing his young daughter, Charlotte, that her new hometown was not, in fact, named after her.