‘The Texas Model’: Texas Teachers Plans Transition to Direct Investing

Teacher Retirement System of Texas CIO Jerry Albright calls his plan for the pension system to make more direct private market investments “The Texas Model.”

The retirement system spends approximately $1.4 billion a year in fees to external managers and Albright aims to lower that. He envisions a potential reduction of $439 million in management fees and $1 billion in profit-sharing or carried interest fees that are shared with external managers over the next five years.

The $151 billion retirement plan began efforts to reduce its reliance on external managers around a decade ago. Today, around 20% of investments in the system’s $42 billion private markets portfolio are classified as direct investments—exclusive partnerships between Texas Teachers and external managers.

“The success we’ve had with our external asset managers has allowed us to gain deep expertise,” Albright told CIO. “We believe that now is the right time to utilize this expertise by managing more assets internally.”

The plan comes against the backdrop of expected diminished future returns, a problem pension plans across the world face.

The teachers’ plan for the 12-month year ending June 30, 2017, saw returns of 12.9% and since the plan was formed on July 1, 1991, an annualized average annual return of 8.7%

But pension plan officials are now recommending that the system’s board of trustees cut the expected annual return over the next 30 years to 7.25% from 8%. The board is split on how much the rate of return needs to be cut—some trustees favor a smaller cut to 7.5%—but there is no disputing the agreement among trustees that the rate of return must be lowered.

The issue is expected to be decided at the board’s July 26-27 meeting.

At the same meeting, it is expected that trustees will give the green light to Albright to embark on his plan expanding in-house management. Ultimately, the plan also calls for increasing the system’s investment staff by 120 within five years, bringing personnel up to 270.

“We are maxed out on staff,” Albright told the board at its meeting last month. “We have a lot of activity going on now, that’s why we need these additional people to handle the continued growth and bring assets in house to lower costs as well.”

Portions of the plan, including some of the staff additions, would need the permission of Texas lawmakers.

A key idea of Albright’s plan is that by taking more assets in-house, fees can be reduced to external managers, thereby reducing the impact of lower returns. Most major public plans have some type of internal management of assets, but like Texas Teachers, they are facing more lackluster returns, and are looking to increase internal management.

But the word direct investments can have different meanings to different pension plans.

In Albright’s “Texas Model,” direct investments always involve an external investment partner or manager. However, there aren’t other institutional investors investing alongside Texas Teachers—it’s a sole partnership between the pension plan and the outside manager.

Albright wants to increase the percentage of private market investments to 30% from the current 20% in the next five years.

This contrasts with the Canadian pension model, in which large Canadian pubic pension plans in many cases make direct investments themselves with outside investment partners.

“We’re not proposing that we move to the Canadian model,” Albright told CIO. “Instead, we are creating the Texas model. We do believe—and have made the business case—that bringing more asset management in house will help meet our goals of maintaining strong total returns and increasing alpha through better cost structures.”

Albright did not detail why Texas Teachers won’t consider the Canadian model now. One issue is that such a massive shift is considered be politically difficult to do in the immediate future given state legislators would need to approve it.

No major US pension plan has embraced the model to the extent the Canadian plans do.

The difficulty of implementing such a plan has to do with the willingness to pay for top investment staff with direct investment experience, compensation that can exceed $1 million for some staffers.

The investment staff of the nation’s largest defined benefit plan, the California Public Employees’ Retirement System (CalPERS) is working towards its own version of the Canadian model. That plan involves buy-and-hold direct investments and direct investments in companies in the latter states of the venture cycle. The plan, which still needs to be approved by the CalPERS board, could start as early as 2019. CalPERS would create its own direct investment subsidiary under the plan.

Albright said he doesn’t rule out that Texas Teachers in a span of five years or more could eventually begin direct investments without investment partners, but his more immediate goal over the next three years is to create more partnerships with external firms or funds of one.  

“I don’t know in the future that we wouldn’t go in that direction but for now it seems like the right balance,” he said of the current model to increase direct investments from 20% to 30%.

Albright’s plan also calls for more in-house management of Texas Teachers’ equity portfolio, as part of the cost-saving move.  Crrently 46% of the portfolio is managed in-house, Albright hopes to raise it to 50% or more in the next few years, though he won’t give an exact figure.

The pension plan internal equity management includes risk party and risk premia strategies.

Albright said he believes Texas Teachers will always hire some external equity managers,  particularly in specialized equity strategies in which external manages have strong expertise that cannot be easily duplicated.