Why should an OCIO that did not add value during the last 10 years get a continual fee increase? Worse yet, why should one that is adding value in a protracted bear market suffer continual fee cuts? Performance-based fees solve these contradictions.
Current Fee Structure Today, most outsourced chief investment officers (OCIO) charge a percent of assets under management (AUM). The average is around .05%, or 5 basis points. The dollar fee charged therefore fluctuates with the market value of the AUM.
This flat-fee structure appears to create an alignment of interests. After all, the better the performance, the higher the fee. But do not forget that old Wall Street saying, “Don’t confuse brilliance with a bull market.” Over the last 10 years many OCIOs have enjoyed ever higher fees without adding value.
The Problem Imagine if a plan sponsor hired an OCIO in December 2014 with pricing and performance calculations starting in 2015. The OCIO immediately changes the asset allocation and hires/fires active managers to achieve the desired portfolio starting January 1, 2015. The long-term objective is 7.25%, net of fees.
As of December 31, 2019, the 5-year average annual return was 7.56% net of fees. The OCIO’s fee has theoretically increased by 43.96% over the same period, but only beat the return objective by a paltry 0.31%. A sense of proportionality is missing.
Beyond the exorbitant fee increase compared to the excess return, the OCIO may have destroyed value while barely beating the client’s return objective. I will briefly describe this reality and then provide three performance-based solutions.
There are five duties every OCIO performs that can create or destroy value. The duties are strategic asset allocation, tactical asset allocation, rebalancing, manager hiring and manager firing. The OCIO may have performed poorly in one or more of these duties such that their total value-add was negative; but a bull market masked the OCIO’s performance. Further, superior/inferior active manager performance may have shown bright or been the lightning rod for blame.
It may be that the portfolio allocation and active managers in place at the end of 2014 performed better than 7.56%. To learn the truth the plan sponsor must track how that prior asset allocation and the fired managers performed over the last 5 years. It may be that the portfolio would have returned 9.16%. If so, the OCIO helped destroy 150 basis points per year, but still got a 43.96% fee increase.
There are three components of return when an OCIO has discretion over a portfolio- market beta, aggregate manager alpha & OCIO alpha. OCIO fees based on AUM lumps these together and obscures return attribution. What the markets and managers contribute is quite explicit. But the OCIO’s value-add is unknown. The OCIO controls the performance reports and they usually put their best foot forward to establish the narrative. Further, they do not show the value-add for their 5 duties. These are lies of omission. For example, an OCIO replaces Manager A with Manager Z. Only by comparing the post-termination performance can the OCIO’s manager selection skill be known. A similar counter-factual analysis is needed for asset allocation and rebalancing. But they do not provide the needed data in their reports.
3 Simple Solutions For plan sponsors to truly reward OCIO performance, regardless of whether the markets are going up or down, they must change from a flat percent of AUM fee structure. Here are 3 methods that any plan sponsor can adopt to better align interests and reward good stewardship. Further, they will no longer overpay for poor OCIO performance.
Universe Rankings Whether you are a public pension, corporate pension, foundation, endowment or multi-employer pension plan, there is a representative universe of similar plans. How your performance ranks can be an objective measure for paying an OCIO.
There are 3 questions that must be answered to implement this structure. 1) What is the most appropriate universe? 2) Over what time period should we observe and compare? 3) What are the OCIO fee rates based on ranking?
Most likely your OCIO is already providing a universe and your plan’s ranking. Ensure that the universe is appropriate, transparent and verifiable. Once you are satisfied with the universe, stick with it unless something disqualifies its further use. Be sure to get independent verification from the universe provider.
Much like actuarial smoothing, you will need to choose a ranking period that eliminates short-term swings in the markets and allows the OCIO’s abilities to materialize. 1-year is probably too short and 10-years too long. 5-years is probably the “Goldilocks” length- not too short or too long.
Since no one would hire an OCIO that promises below median performance, the fee paid today would be for above median performance and increase with better rankings. Below median performance would result in a lower fee. Assuming a 5 bps starting fee, here is a visual of how this might look:
Performance Versus Permanent Benchmark Virtually every performance report provided by an OCIO or non-discretionary investment consultant provides a comparison of total plan performance versus a “Plan Benchmark” or “Policy Index.” And the plan benchmark or policy index mimics the plan’s strategic asset allocation. When the OCIO changes the plan’s strategic asset allocation, the benchmark also changes.
This practice of Benchmark Linking is problematic because an ever-changing benchmark means you have no benchmark. If the benchmark simply tracks the strategic asset allocation, any differences are then due to aggregate manager alpha, tactical asset allocation and rebalancing. You never learn how a new asset allocation compares to the previous asset allocation.
This second performance-based fee structure is dependent upon having a permanent, comprehensive, representative and diversified benchmark. The performance of this permanent benchmark is then compared to total plan performance, net of fees. Like the previous method, there are 3 questions that must be answered to implement this structure. 1) What is the most appropriate permanent benchmark? 2) Over what time period should we observe and compare? 3) What are the OCIO fee rates based on average excess return in basis points?
The key question is choosing the appropriate permanent benchmark. One tried and true barometer is the 60/40- 60% S&P 500 and 40% Aggregate Bond, rebalanced quarterly. It has long served institutional investors as a reliable and diversified index. You may choose to augment this with allocations to international equity, high yield bonds, real estate, etc. Discuss this question with your OCIO or hire an independent expert to choose this permanent benchmark.
The permanent benchmark could also be the long-term return objective. But the problem is that this could create prolonged periods of feast or famine for the OCIO, depending on the markets, and does not necessarily reward the OCIO’s value-add. Assuming a 5 bps starting fee, here is a visual of how this might look:
Performance in each of 5 OCIO Duties As noted above, there are 5 duties every OCIO performs. Remember, OCIO performance reports do not show the value-add in any of these duties. The third way is to measure the OCIO’s value-add in each of these duties and be paid a percentage of the incremental dollar gains.
Continuous evaluation of these duties with an annual summary would serve as the basis for determining the fee. The more value they add, the more they are paid. If an OCIO is competent, consistent and confident, they should want this method.
For this method an independent monitor capable of scoring each of the 5 duties is necessary for objective and unbiased reporting. Further, the monitor would need to go back in time to determine the previous decisions made by the OCIO and then update accordingly.
This is the purest performance-based fee as it ignores changes to AUM due to market returns. The primary question for a plan sponsor is what percent of value-add would be the fee. The two factors affecting this answer are the size of the plan and whether there is a base fee.
The larger the plan, the smaller the percentage. The percentage would also be affected on whether to also have a minimum fee. Having a minimum fee would be a trade-off for a lower percentage. Ultimately, this would be a negotiation between the OCIO and plan sponsor with the monitor being the moderator.
To assist with the negotiation of this fee arrangement, it would be helpful to analyze past years and determine “what if” scenarios to simulate future possibilities vis a vis the other methods.
Please visit OCIOMonitor.com or contact me at admin@OCIOmonitor.com if you have questions or would like help implementing and/or overseeing any of these models.