Adding Fees to Total Plan Benchmarks is a Bad, Bad, Bad, Bad Idea! Here's Why.

Heed Charles Kettering's words, "Good news weakens me." False good news of "above benchmark" performance weakens investors' governance allowing poor strategies to continue without course correction. The problem especially pervades public pension plans.

Neurologically speaking, they are eliminating pain receptors while supplementing with a dopamine drip.

While researching for my recent piece about SWIB's performance and benchmarking, I discovered they also are using net of fee benchmarks by adding external manager fees. See page 60 of this report to read for yourself SWIB's many benchmarking practices.

This is being done in broad daylight with the apparent approval by SWIB's board of trustees. In fact, they have a Benchmarking Committee and employ a benchmarking consultant. Is this consultant there to give the imprimatur of objectivity? Understand this consultant has the conflict to slow benchmarks thus creating job security for themselves and SWIB employees.

I have documented the many ways consultants and OCIOs slow performance benchmarks. These practices have also been validated by researchers and academics using various statistical metrics.

Let me explain the rationale for not including fees and then explore the problems of doing so.

Fees are a Choice

I have written several articles about public pension plans failing to beat the traditional 60/40 (S&P 500 / BB Aggregate) over long periods. For example, for the 25 years ending June 30, 2024, CalPERS has lagged the 60/40 by about 50 bps per year. How many billions have the politicians and bureaucrats in Sacramento sent to Money Heaven?

The 60/40 can be managed for virtually free, depending on whether securities lending is allowed. Fees, therefore, have become practically optional. Ipso facto, the default should then be no fees in total plan benchmarks.

Allocating to active management and expensive alternatives are choices. The ex-ante belief is that the asset class returns and manager alpha (since alts cannot be indexed,) will more than offset the higher fees. Otherwise, why do it?

Adding fees to a total plan benchmark is practically admitting such allocations have not been successful and thus need a helping thumb on the scale to appear profitable.

Adding Fees Invites Abuse

Goodhart's Law states, "When a measure becomes a target, it ceases to be a good measure." The reason is it becomes manipulated to create the appearance of success.

Adding fees to a total plan benchmark creates another opportunity to put an even larger thumb on the scale. For example, who says they must use the actual fees incurred? They could use inflated industry averages or use retail fees while demonstrating they are using lower fee managers.

The players that benefit from adding fees include CIOs, internal staff and outside consultants. They all benefit financially from creating the illusion of outperformance and thus creates an internal conspiracy that is guided by the invisible hand of self-interest. As George Carlin famously said, "You don't need a formal conspiracy if interests align."

Creates Price Insensitive Investing

No matter how high the fees associated with a certain manager or asset class, it will just be offset in the benchmark. This lowers the incentive to be cost conscious when allocating or hiring managers.

This is especially pernicious in public pension plans. The reason is such fees are often "recycled" into contributions to politicians that have influence over such plans. This could mean the most expensive, and most politically generous, managers are hired.

False Good News Stifles Improvement & Protects the Status Quo

Napoleon Bonaparte said, “Never awake me when you have good news to announce, because with good news nothing presses; but when you have bad news, arouse me immediately, for then there is not an instant to be lost.”

Beating your benchmark connotes all is well so the status quo remains. But being behind lights a fire to seek and make improvements. Considering bureaucratic inertia and increased compensation for being "above benchmark," their preferred choice is obvious.