CalSTRS Reports Saving More Than $1.2 Billion in Portfolio Costs Since 2017

The California State Teachers’ Retirement System reports that its Collaborative Model, an investment strategy that seeks to reduce costs, control risks and increase expected returns, cut operational costs by $437 million in 2021.

CalSTRS, the U.S.’s second largest public pension fund by net assets, has emphasized decreasing the cost of operating its portfolio to maximize returns and control risks.

The costs of operating the portfolio include external asset management fees and internal operating costs, and these costs are highly correlated to the net asset value of the total portfolio.

According to the pension fund’s cost report, “costs can fluctuate significantly each year depending on the life cycle of the underlying investment and/or the investment pace of the strategy. CalSTRS is a long-term investor and as such, return and cost data is more meaningful when compared over long time periods.”

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In 2021, CalSTRS spent roughly $3 billion on overall costs, 38% of which was carried interest, 44% of which was external costs and 17% of which was internal costs. Total portfolio costs increased by 20% in 2021—as the portfolio returned 29%—while carried interest paid out to general partners at external private asset managers increased by 69% during the year, as exits in private investments were up in 2021.

During a presentation of the 2021 Annual Investment Cost Report on November 3 at CalSTRS’ board meeting, Shifat Hasan, director of investment performance and compliance at the fund, shared that “the total costs of 2021 were a little over 88 basis points.” Over the year, portfolio costs, in basis points, relative to the net asset value decreased, while the total costs in absolute dollar terms increased.

A large factor contributing to a pension’s total costs is how heavily it is allocated to private assets. Private markets and active strategies generally carry higher fees than public markets and passive strategies. In 2021, CalSTRS’ 32% allocation to private assets stayed relatively flat to slightly decreasing, having a negligible impact on costs.

The spread between gross returns and net returns in private equity were highest at 302 basis points. As a result, “the biggest and largest opportunity [for cost savings] is within private assets, specifically, private equity,” Hasan said.

CalSTRS’ collaborative model, which focuses on managing more assets internally and leverages CalSTRS’ external partnerships to achieve similar benefits, has saved the fund more than $1.2 billion in costs since 2017, according to the plan’s own reporting.

The model’s most significant savings come in carried interest, often up to 20% of profits are paid to externally managed private assets, but not for those managed in house. Carried interest is therefore an important cost to suppress, as private market costs, including carried interest, accounted for more than 90% of the fund’s expenses in 2021, while these assets made up only 32% of the portfolio.

According to the fund’s cost report, “the collaborative model reduced portfolio costs by 9% [in 2021]. Most of the savings was due to an increase in the allocation to co-investments. The number of co-investments grew from 135 to 188 over the year. This allocation to investments with lower fee structures accounted for almost 8% of the savings.”

Mike Dunigan, associate portfolio manager at CalSTRS, said at the board meeting that, “the collaborative model has two components where we achieve savings. The first part is really an economics of scale portion. We have operating expenses that are more fixed portions of our portfolio costs; those aren’t going to appreciate at the same rate as net asset value growth, so we get about 1% from that portion.”

“The bulk of [the savings] came from allocating more towards private assets, and while doing so, [the pension fund has] continued to shift towards co-investments where possible,” Dunigan said.

In 2021, external management costs were approximately $1.3 billion, compared to that of $516 million for internal management costs.

Depicting the gap in cost structure, internally managed investments accounted for 67% of the portfolio’s total net asset value yet only accounted for 28% of the total portfolio costs last year.

The costs roughly equate to a 163 basis-points-per-dollar cost ratio for externally managed private assets, compared to 112 basis points per dollar of assets for internally managed private assets. Similarly, externally managed public assets cost 48 basis points per dollar, while internally managed public assets cost 3 basis points per dollar.

According to Hasan, in 2021, the pension reported its highest capture ratio ever at 94.1%. “[This] means that we kept 94 cents of every dollar of returns,” she said.

Ashby Monk, executive director at the Stanford University research initiative on long-term investing, said the collaborative model is “a means of doing innovative things with peers in illiquid and alternative assets as means of reducing costs. [This] collaboration makes innovation easier and cheaper.”

Dunigan said, “boiled down to 2021, the model saved $437 million. $290 million of that came from management fees, and $146 million came from carried interest. Over time, we are increasing the rate we are saving, and this is coming from a ramp-up in private assets.”

The cost-saving mechanisms added an excess return of 16 basis points to the overall pension’s portfolio in 2021.

Monk’s conclusion on the CalSTRS collaborative model is that “it’s not really just insourcing … it’s innovation!”

Related Stories:

CalSTRS Loses 1.3% in Fiscal Year 2022

CalSTRS Votes on Record Number of Shareholder Proposals

CalSTRS Increases Co-Investments and Private Equity Allotments

Tags: Ashby Monk, CalSTRS, Collaborative Model, cost savings, Mike Dunigan, Shifat Hasan

LDI strategies allow for passive equity to be replaced by holding ‘cash’ and synthetic equity instruments. But with better funding statuses, are pensions’ derivative positions less necessary?

Art by OYOW

The current interest rate environment, while tough for assessed values across asset classes, is actually a great thing for pension mathematics. Higher interest rates mean improved funding for pension funds, as the risk-free return rises.

Often derivatives are used by pensions to free up cash that plans may invest into growth assets in an attempt at improving the returns and funding ratio of a plan.

Due to higher funding statuses, market turbulence and higher interest rates, Gary Veerman, head of LDI solutions at Capital Group, says leaders should be evaluating their derivative strategies usage.

“If you’re 100-125% funded, do you really need the leverage that you have operated with over the past 10 years?” Veerman asks rhetorically. “It’s a scenario where what you have done has worked, but should there be a re-evaluation? Do we need the same structure in place going forward to achieve the ultimate objective of paying benefits payments? Is there more intention in risk transfer activity? If you’re 125% funded, you might consider effectively offloading those liabilities.”

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According to Richard Bruyère, managing partner and co-founder at Paris-based strategy consultant INDEFI, the use of derivatives in liability-driven investing has allowed pension funds to “do more with less.”

“Most pensions were historically underfunded, which meant to recover their funding ratios to 100%, they had to invest in growth assets: equities or private markets,” Bruyère says. “Instead of holding 1:1 cash to liabilities, they matched liabilities with cash and derivative exposure, releasing more capital to growth assets to assist with the funding ratio. Pension plans use off balance sheet commitments and derivatives to match those liabilities to invest in growth assets.”

On the effects higher interest rates have on pensions, Bruyère says, “In general, there’s a form of indexation to inflation to pensions, which means the plans will have to fork out more money to participants. An indirect impact is that inflation means higher rates, and as a result, net present value of liabilities are reduced …[and] future liabilities will be lower.”

Bruyère said, “pension funds today are in a better position than they were before, the need to over-invest and stretch the balance sheet is not as critical.”

“We typically see across our client base three potential derivative instruments used,” says Rick Ratkowski, a director of investment strategies at NISA Investment Advisors. “One would be U.S. Treasury futures, the second would be total return swaps and the third alternative would be to use U.S Treasury repurchase agreements to get interest rate exposure. There are traditional, cleared interest rate swaps available in the U.S., but those are less frequently used by our clients because, historically, the swap-spread basis was not a good fit for client liabilities because pensions generally think about their liability as a treasury rate plus a credit spread.”

Pension derivatives took center stage when the British economy saw its gilt yield spike, currency devalue, and markets gyrate when then-Chancellor of the Exchequer Kwasi Kwarteng unveiled tax cuts deemed overly excessive in his ‘mini-budget’ in September. LDI derivative implementation, however, is far different in the U.K.

“Liabilities are ultimately valued in the U.K. based on gilt-type exposure with some inflation component, and in the U.S., liabilities are typically valued with high-quality, investment grade, corporate bonds,” Veerman says.

Veerman also notes that derivative usage by pensions overall in the U.S is lower in comparison to the U.K.

“The U.S. corporate pension market is about $3 trillion, and the U.S. treasury market is about $24 trillion, multiple times greater than the overall size of the pension universe,” Veerman says. “Where in the U.K., the pension market is about £1.5 trillion, and the overall treasury gilt market is about £2.3 trillion. The U.S. treasury market is about ten times the size of the gilt market. Then you add on the fact that we’re not using derivatives and treasuries as that foundational hedging vehicle, and I think that sort of paints the picture of not only how different the marketplace is in terms of potential liquidity, but also for the ability for buyers to come in.”

According to Ratkowski, the movement of interest rates and the duration sensitivity of liabilities to changes in interest rates are key factors contributing to why pensions take part in LDI and the strategies usage of derivatives. “The reason a plan wants to hedge their liabilities is a byproduct of what happens to a liability when interest rates fall, or interest rates rise,” says Ratkowski.

“Ultimately, a plan sponsor may choose to [hedge liabilities] because they want to control how they receive excess return in their pension,” Ratwkoski says. “Do you want additional return on the pension assets because interest rates moved a particular direction, or do you want to focus on spending your risk budget where you get paid a risk premium? Plans enter [a] hedging program so they can manage pension funded status volatility for changes in interest rate risk. Derivatives give pensions a way to match both the interest rate risk and the yield curve exposure, while, if desired, still keep a modest amount in return-seeking assets .”

“Everybody knew what LDI scheming , and everybody knew the risks of the positioning involved,” Bruyère says of the gilt crisis. “I don’t think [hidden pension leverage is] massive. It’s a matter of stress testing and risk management. Overall, this is not the space where you will find hidden risks; they’re in other areas.”

Ratkowski says the current rate hiking cycle provides minimal risks to the pension universe overall and to derivative positionings.

“In the U.S., in particular, pensions generally keep a very large amount of collateral on hand, either with the overlay manager or with other assets outside the overlay manager,” Ratkowski says. “That could be treasuries, cash and potentially corporate bonds if needed, etc.”

As a result of the recent hikes, pensions have maintained, and in some cases, even improved their funding statuses.