Investment Fee Guidelines for External Management of Defined Benefit Plans

Defined benefit plans, such as pension and other post-employment benefits, seek to achieve the highest risk-adjusted net return, which includes the cost of investment management. Plans can use a combination of approaches to minimize fees for fixed income/public equity management, including:

1. Achieving economies of scale with a particular investment manager.
2. Pursuing low-cost passive index investment strategies.
3. Using competitive selection processes that make fee negotiation an important factor in the procurement decision. [1]

In addition to the traditional mix of public equities and fixed income, defined benefit plans now make increasing use of alternative investments such as hedge funds, private equity, and real estate. Given this added complexity, procedures to identify, quantify, and analyze compensation for investment managers are needed to help a fund obtain the highest net investment returns possible.

People: Guidelines should address the roles and responsibilities of internal and external participants involved in the investment management fee negotiations.

1. Staff responsibilities should include fee negotiation, and these responsibilities should include reporting on the status of negotiations before any investment documents are executed and should include reporting on fees in accordance with plan trustee policy. 
2. Staff and consultants should negotiate the lowest reasonable competitive fees using measures and techniques such as:
   1. Determining what fees similar investors are paying and making these peer comparisons part of the negotiation process.
   2. Including a "most favored nation" clause [3] in the agreement – doing so ensures that the type and level of fees are in line with what is being made available to other, similar investors.
   3. Making use of the consultant's knowledge of the marketplace to minimize fees for contracted services.

Process: Establish guidelines that identify the actions the defined benefits plan should take in negotiating investment fees.[4] The importance of competitive fees should be ranked among the other factors being analyzed when selecting investment managers, including:

1. Demonstrated manager track records, proven investment talent, repeatable investment processes, competitive and strategic investment advantages, and other qualitative factors.[5]
2. The fees, investment process, and historical performance of active managers, which can be expected to have higher fee structures than those of passive managers. This information will allow the fund to compare an active manager's net performance against an index return over an entire market cycle.[6]
3. The appropriateness of the fees (for either an active or passive manager), given the expectation of future investment returns/performance. Future returns are uncertain, while fees often can be determined in advance. When one manager charges greater fees than another for a comparable investment strategy, analyze the manager's track record and additional services offered to determine whether the additional cost is justifiable and necessary.

When investing in alternatives, ensure that the defined benefit plan is not paying unwarranted fees by implementing the following additional strategies:

1. Favor performance fees that compensate the manager for alpha rather than beta, [7] and the fee should include a hard hurdle.[8] Alternative investment managers also commonly use "carried interest" (an incentive that rewards the manager for enhancing performance), which is expressed as a percentage of net profits over a specified minimum return.
2. Retain a qualified attorney to review all alternative investment partnership agreements and related documents before making a commitment. Consider all forms of manager compensation because alternative investments can have long contract lives and may be difficult to terminate until the natural conclusion of the partnership. If necessary, have the attorney help negotiate the agreements.
3. Ask the investment manager to consider all the accounts it handles for the defined pension plan when determining fees.

Performance: A defined benefit plan should incorporate the following strategies regarding anticipated investment performance:

1. Establish instructions for how each manager should manage each portfolio, using a specific investment strategy within certain risk parameters. This investment mandate should define:
   1. any constraints on the strategy and which benchmark the strategy will be measured against;
   2. how the assets will be valued (third-party valuations are preferred, though this is typically not available with alternative investments); and
   3. how all fees will be calculated and paid.
2. Smaller defined benefit plans that don't have access to higher-returning alternative investments should consider entering into cooperative arrangements with other plans. First, however, the plan should perform an analysis to ensure that lower fees would not compromise the expected investment returns. Options for cooperative agreements include:
   1. Group purchasing arrangements (rather than entering into direct partnerships with alternative investment managers) which can allow plans to achieve pricing concessions based on their meaningful economies of scale and their long-term investment horizon.
   2. Cooperative pools which allow defined benefit plans to "piggyback" on other institutional investors, maximizing economies of scale and increasing negotiating leverage.
   3. Collaborative procurement strategies and other tactics which can increase a plan's bargaining and purchasing power.

Price: Ensure that the defined benefit plan is paying a reasonable, competitive fee by implementing the following strategies:

1. When using a separate account structure (professional investors managing an investment portfolio solely for the plan), establish fee break points as the portfolio amount increases.[9]
2. When investing in commingled and mutual funds (investment vehicles that pool assets of multiple investors), require the manager to identify and to quantify all fees.
3. Identify all fees and focus on aligning the interests of the plan with those of the investment manager through a performance fee structure, potentially including fulcrum fees, hurdle rates, fee caps, and clawback provisions.[10], [11]
4. Any fees that aren't directly related to the management of the portfolio should be considered for elimination.[12]
5. Seek access to the lowest-cost share class and require that any fees related to services provided to retail investors be refunded to the plan.
6. Ask if the investment manager offers a performance fee structure and, if so, analyze the provisions to assess whether it meets the defined benefit plan's needs.