High performance fees
Dutch pension funds pay asset managers substantial performance fees to asset management firms as additional rewards for achieving returns that outperform a specific threshold or benchmark. Performance fees are typically paid for active investment strategies and investments in alternative asset classes, such as hedge funds and private equity. In 2015, performance fees paid by Dutch pension funds totalled EUR 1.5 billion. They fund these from the additional returns from such investments.
Performance fees vary from one asset class to another, with high fees typically being paid for private equity and hedge fund investments. Between 2012 and 2015, pension funds paid on average of 0.69% of assets under management in performance fees for private equity and 0.87% for hedge funds (see Table). By contrast, performance fees paid for the traditional asset classes averaged only a few basis points. The table also shows that Dutch pension funds achieved total returns of 9.72% on average over the same period. At 1.40%, excess returns were the highest in the case of private equity. Excess returns are total returns less all investment costs (which include performance fees) and the returns on a benchmark.
Total returns, excess returns and performance fees (averages for 2012-2015)
|Total returns (net*)||
* Net means net of all investment costs, which include performance fees
** Excess returns means net total returns less returns on a benchmark selected and reported by the pension fund
*** As a percentage of assets invested in the applicable asset class
Size and expertise matter
An analysis of 218 Dutch pension funds for the period between 2012 and 2015 shows that large and specialised pension funds apply performance fees more often. In addition, large pension funds pay significantly less for the same performance by asset managers, in particular in the case of hedge funds. Pension funds specialising in private equity enjoy the same benefit.
So it would seem that large and more specialised pension funds are able to negotiate better contracts with their asset managers than smaller ones, under which they granting a smaller portion of excess returns to their asset managers. This may be because their size or expertise gives them a better negotiating position, which suggests that pension funds investing in alternative asset classes should specialise and be of sufficient size. The study also indicates that larger and more specialised pension funds achieve slightly higher returns on equity, real estate, private equity and hedge fund investments. Naturally, many more factors besides the effectiveness of performance fees determine a pension fund's optimal size.
Performance fees are less relevant
Pension funds pay performance fees for active asset management to incentivise outperforming a specific benchmark. If the asset manager fails to outperform no performance fee is paid. Other pension funds pursue passive investment strategies, which means they do not pay asset management firms any performance fees. An important finding is that, on average, no difference in returns can be observed between the group of pension funds that pay performance fees and the group that does not. This applies to most asset classes, also after risk adjustment. Individual pension funds may of course have outcomes that differ from the average. Investments in alternative asset classes may offer benefits in terms of additional portfolio diversification. Active asset management is important for price discovery in financial markets.