Pennsylvania's underfunded State Employees' Retirement System has shifted billions in investments towards indexed funds and less-expensive private managers, but still needs to do a better job negotiating fees and making public all payments collected by more than 200 private firms that manage its $27 billion portfolio, the state's elected Auditor General Eugene DePascuale said in an audit report released Thursday.

DePasquale praised SERS' partial abandonment of high-fee "active" investment strategies in favor of cheaper "passive" investments based on the S&P 500 and other market indexes, which market observers say are tough for active managers to beat over time.

"Since October 2016, SERS terminated 18 active strategies with $3.9 billion of assets and moved the funds into passive strategies," reducing fees by $17 million, DePasquale noted.

SERS, like the state teachers' pension fund (PSERS), remains heavily invested in private equity and other high-fee "alternative" assets, compared to other big pension funds, DePascquale noted.

Overall, "SERS has lowered its [direct] investment manager expenses from $345 million in calendar year ended December 31, 2007, to $167 million in calendar year ended December 31, 2016." But, he also noted, "the current accounting and disclosure practices do not address how to report the expenses for complex alternative investments like private equity."

Noting that private equity — one of the most expensive asset classes, given the  high direct fees fund charged, and not even counting the shared profit many firms collect without public disclosure — also has tended to deliver higher profits than most asset classes during the recent stock market run-up.

DePasquale doesn't attempt to show whether the state's switch from active towards passive investing has improved or hurt SERS' overall investment performance.

Among his criticisms and comments:

– Anyone with the support of the Governor or General Assembly leaders can become a SERS trustee, despite a lack of investment competence and without any commitment to learning more. SERS might not need a board of experts,  given its professional staff and consultants, DePasquale acknowledges. But "there are no statutory prerequisites [minimum level of investment or financial knowledge] for becoming a Board trustee." He wants the General Assembly to set board member training standards.

– Pennsylvania's governors enjoy "unusually strong control over the selection of (SERS) Board members" and none are elected by paying members or pensioners.

– "The Board places too much reliance on the individual trustees to self-report potential conflicts of interest," he wrote. "The SERS Board's composition, vague ethics policy, and nonexistent attendance policy jeopardize its level of independence and reliability."

-"SERS extended one consultant contract for three years without pursuing other competitive offers." The contract, for real estate investing advice, was extended in 2014 and 2015, a period of turnover in SERS' investment management staff. SERS might have gotten better advice or paid lower fees if it had done more to attract competing consultants, the report concludes. It doesn't attempt to assess how successful SERS' real estate investments have been compared to other investors'.

– SERS "did not document its external investment manager fee negotiations or justification for the reasonableness of the fee structure. Due to this lack of documentation, auditors were unable to determine if SERS' negotiation procedures were
sufficient to obtain the lowest fees possible." The audit found SERS had negotiated lower fees for stock and bond managers, but had accepted several private-equity and hedge fund money manager fee schemes, which are more expensive, at the same levels the managers offered.

– "SERS appears to be more open in regards to reporting investment expenses and performance measures than most of
its peer state systems. However, SERS should strive to take a leadership role by improving the clarity of its reporting. Additionally, the procedures used to monitor external private investment managers should be formalized in writing… SERS can improve its reporting by including all fund-level investment expenses and gross-of-fee performance and net-of-fee performance to more accurately reflect the cost of SERS' investment strategies."

In a generally cordial response, SERS Executive Director David Dubin said DePasquale's recommendations on board reform and stronger governance were directed to the General Assembly, so the  system won't comment on those. He added that SERS has been strengthening board training standards, though it doesn't have the power to discipline board members who don't comply.

Durbin also promised to review DePasquale's recommendations for stricter fee negotiations policies and disclosures. But he challenged DePascuale's recommendations suggesting the system strengthen its internal audit and pension-forfeiture for criminal pensioner policies, saying those in place conformed with the law.