UPDATE: The Biggest Public Pension Investment Policy Shift
You've Probably Never Heard Of
FISCALWATCH MEMO June 13, 2005
By Nicole Gelinas and E.J. McMahon

Update: Gov. Pataki vetoed the revised bill on July 19.

Note: One week after this FiscalWatch Memo was first posted, the State Senate inexplicably "recalled" from the Assembly the bill highlighted below, which would have fundamentally changed the law governing how the state comptroller invests public pension funds. That same day (June 20), the Assembly introduced a new bill (A.8970) that simply increases the comptroller's "basket" of investments permissible under current law, from 15 percent to 25 percent. The new bill was passed by both the Assembly and Senate on June 24, the last day of the legislative session, and sent to the Governor's desk for veto or approval.

With no fanfare or debate—not even a public hearing—the State Legislature appears close to passing a significant change in the law governing how the comptroller invests New York's $120 billion Common Retirement Fund for state and local employees.

The bill, which was the top priority on the legislative agenda of state Comptroller Alan Hevesi, passed the Senate by a 58-0 margin on May 2. As the session entered its final two weeks, the Assembly print (A.7597) had been reported from the Government Employees Committee to Ways and Means—one step away from a floor vote.

The proposed change in investment guidelines for the nation's second largest public pension fund doubtless seems arcane to legislators. But it has far-reaching implications—including the potential of more complex financial risks for New York taxpayers, who already have been straining under the burden of $1.1 billion in added state and local pension expenses in the last four years.

It would also invest more power and discretion than ever in the hands of one official—the state comptroller, who is sole trustee of the state and local retirement fund. New York is one of only a handful of states with such an arrangement; most of the nation's public pension funds (including the retirement funds of New York City and the New York State Teacher's Retirement System) are overseen by multi-member boards of trustees.[1]

At the very least, the proposal raises significant questions that deserve more careful consideration and a public airing by the Legislature.

What is the purpose of the bill?

The bill, sponsored by Sen. Joseph Robach (R-Rochester) and Assemblyman Peter Abbate (D-Brooklyn), would amend New York's Retirement and Social Security law to allow the comptroller to invest the pension assets in accordance with a "prudent investor" standard, rather than the current legal list of "permitted investments."

For decades, state law has directed the comptroller to invest only in asset classes detailed on that list. According to the current list, the assets can't exceed 70 percent stocks (up to 10 percent of that in international stocks) and 5 percent real estate. Much of the rest is in high-quality corporate bonds, with one loophole: The comptroller can invest up to 15 percent of the fund in an "other" category, if such investments are "prudent."

The comptroller's goal should be to "achieve the highest return obtainable within the limits of a prudent benefit and risk analysis" for the benefit of current and future retirees, according to the sponsor's memorandum in support of the bill. "The current statutory framework undermines the achievement of that goal."

Practically speaking, under the new framework, the comptroller could invest in most anything he deemed fit to achieve the stated goal—including new investments in commodities and foreign bonds as well as more cash in lightly regulated investments, such as private-equity funds and hedge funds. The sponsor's memo states: "The tradeoff between risk and return [would be] identified as the … central concern" of the comptroller—not the individual prospects of any single investment.

Why the change?

The sponsor's memo asserts that the current approach is "outdated" and prevents the pension-fund managers from investing in an optimal manner. It notes that all corporate pension funds, as well as most public plans, including California's $250 billion CalPERS and CalSTRS funds, have switched to a prudent-investor standard.

The sponsor's memo further asserts that the change would be good for New York, because it would allow the fund to achieve not only higher returns on some investments, but a lower level of year-to-year volatility for the entire portfolio.

Volatility in New York's pension fund has ranged from a high 28.8 percent return to a low negative 10.2 percent just over the past five years. Why? New York invests heavily in equities to achieve its desired 8 percent annual return—and equities are volatile. This makes it difficult for elected officials to know if the fund is regularly collecting enough money from local governments and taxpayers to make good on future benefits.

The expectation of lower volatility under the prudent-investor standard is based on the following theory: The comptroller would be free to pick new "alternative" assets for the fund, like certain hedge funds, based not only on their individual potential for returns, but also based on how those assets are expected to work well together in the entire portfolio.

That is: When the US stock market is down, some "alternative" investments should retain their value or actually go up. Some hedge funds, called market-neutral funds, claim they can achieve "absolute returns" year after year with little volatility no matter how well or poorly the market does, because their strategies are not based on the overall market.

Is this sound investment strategy?

It would be—if the New York state pension fund were purely a financial creature, and not a half-political beast, as well. Adding quirky assets to diversify a portfolio in a quest for the highest possible return for a reasonable level of risk is sound financial management in the private sector.

For corporate pension funds and rich investors, the freedom to invest "prudently" is a no-brainer—because the company or person taking on the investment risk in anticipation of a higher return is the same who will get the reward if the risk pays off. Sophisticated investors can direct their advisers to take on a clear risk (and pay a high management fee to an "alternative" investment manager) for the chance of a clear reward.

Diversifying investments into hedge funds and private equity adds one more level of risk assessment: Will one asset really move up when the rest of the portfolio moves down? This makes sense for sophisticated investors: The benefits are good if the risk assessment is correct.

But the theory may weaken when it comes to New York's public pension fund.

As the sponsor's memo notes, the new focus of the pension fund would be the tradeoff between risk and reward. But the true "investors" in New York's fund—the taxpayers—are not able to understand or control the new risks they might be forced to undertake in an aggressive quest for diversification.

Public-sector workers don't take on any investment risk inherent in their own pension fund—taxpayers do. If the comptroller invests poorly, taxpayers must pump new cash into the fund, because the Constitution guarantees a promised level of benefits to current and future retirees.

And if the recent past is any guide, any potential reward from potentially higher returns will be shared with public-sector workers, in the form of enhanced pension benefits. The dynamic is an object lesson in the perils of fiscal and political asymmetry.

When the pension fund does well, elected officials often hike future benefits for public workers; that's what Gov. Pataki and the Legislature did in 2000[2]. But when investments don't do well, those promised benefits cannot be reduced; the taxpayers still must pay.

Moreover, the potentially high return of each "alternative" investment is high only because those investments, by themselves, carry more risk. The hope that hedge-fund and other "alternative" investments don't move in tandem with the market is also risky in its own way—because it's difficult to predict how they will move during a crisis. So courting an above-average return on each and all of these investments, year after year, is in itself risky.

For example, as The New York Times recently reported:

Some hedge fund executives said they were disappointed at how closely the performance of certain hedge funds, especially those investing stocks, mirrored the results of the broader markets. Many investors, particularly pension funds, have been drawn to hedge funds because they were seeking better returns than more conventional investments.[3]

What are the risks?

Hedge funds, and other "alternative" investments, are opaque. Only the best hedge-fund managers can accomplish what they say they will accomplish. How do you find out which hedge-fund managers are the best? Wait until an unexpected event roils the financial world.

The comptroller must survey an array of alternative investments and determine whether to believe the financial advisers who say that this particular fund or another will diversify the portfolio. The proposed change would theoretically allow him to stake a good chunk of the state's pension fund on these decisions.

The best "alternative" assets will be the hedge funds and other assets that present, and pursue, the most creative investment strategies. If it was easy, everyone would be doing it, and the "best" funds would track the stock market. But, an inconvenient corollary: The worst ones will also present the most creative strategies for the comptroller to try. The comptroller can't really know until it's too late.

Another risk: Currently, the comptroller picks and pays financial institutions and advisers to manage each aspect of the whole public-pension portfolio. One manager is chosen for expertise in, say, value stocks, while another might handle municipal-bond investments.

But for a "prudently" diversified strategy to work, someone who oversees all of the investments in the entire $120 billion pension fund must amass and analyze complex data to ensure that when the stock-market investments go down, some of the alternative investments do go up, or at least retain their value. (Of course, someone does that already—but it will become more important.)

The comptroller can intuitively determine if it's reasonable for the fund to invest in a particular class of stocks. But can he really understand the data that predicts how those stocks will move in relation to a supposedly market-neutral hedge fund? He would be entirely dependent on his advisers.

The next risk is: How to keep track of these opaque investments? Politicians—and taxpayers—should know the value of the entire pension fund at all times with reasonable accuracy, to determine if the fund can cover future payments to retirees.

It's easy to know what one million shares of ExxonMobil stock are worth each day. But "alternative" investment managers don't price their assets as often—and only they know if that pricing is accurate.

An illiquid investment held by a sophisticated investor, such as a large private-equity stake, is only worth what another sophisticated investor wants to pay for it after a crisis. Even Wall Street's private bankers—the bankers of the very rich—are wary of the lack of easy price information at hedge funds and private-equity investments.

What do all these "alternative" investments cost?

A $2 billion investment across hedge funds would likely carry a minimum $20 million annual flat fee, plus an additional fee of 20 percent of each hedge fund's own gains each year.

A sophisticated private investor can decide if such fees are fair. But in the public sector, taxpayers get no benefit from the consistently high returns that supposedly justify the high fees—and only a tenuous possible benefit from aggressive diversification.

Moreover, as the state fund must more carefully manage the interaction among different sorts of alternative investment classes, the entire pension fund must pay more, and more expensive, sophisticated advisers in-house—hiking administrative costs for taxpayers.

Sophisticated investing in the quest for diversification is expensive.

Why must the pension fund seek the highest return within a newly "prudent" range of risk in the first place?

The pension fund has averaged nearly 12 percent a year for 20 years—well above its 8-percent target[4]. Yes, volatility is a problem, but the volatility is a problem because the fund must already aggressively seek high returns to pay its promised benefits.

And what if the argument for increased diversification under the "prudent investor" standard is just a red herring to distract from a quest to achieve plain old higher returns, by whatever means necessary?

Public pension funds everywhere are coming under pressure. Future liabilities for the retiring baby-boomer generation loom, and some public-pension fund managers are terrified that they won't be able to consistently achieve the high returns of the past 20 years through regular old investing.[5]

This is another risk that will be added to the pension fund if the law is changed: Only the comptroller would know for sure if he picked one speculative asset due to a promised high return, or due to vague future "diversification" benefits.

The tradeoff between risk and reward and making pension fund investment decisions is a worthy subject of debate—one that demands the sort of public hearing the Legislature all-too-seldom holds on major bills. Such a hearing would also create the opportunity to air broader issues that affect taxpayers and public-sector workers alike, such as: Should the structure of some pension benefits be changed, so that public-sector workers can choose to take on a higher risk for a higher reward—under a defined-contribution system with individual accounts not guaranteed by taxpayers?

###

Notes

  1. This does not include the increase in pension contributions required by the New York City retirement systems, or by the New York State Teachers Retirement system, which are not affected by the bill.
  2. Governor Pataki Signs Historic Pension Legislation," Press release, 7/11/2000. http://www.state.ny.us/governor/press/year00/july11_2_00.htm.
  3. "A Relief: Some Gains for Hedges," New York Times, Wednesday, June 8, 2005. From http://www.nytimes.com/2005/06/08/business/08place.html.
  4. Comprehensive Annual Financial Report, Office of the State Comptroller, 9/2004, p46. http://www.osc.state.ny.us/retire/aboutus/annrep04/CAFR-04.pdf.
  5. Consider this anecdote from the Wall Street Journal, "Pension Funds Bet on Currency Markets," 4/27/05:
    "The Houston Firefighters' Relief & Retirement Fund faced a dilemma familiar to pension funds across the country. With benefit costs rising, the fund was being forced to pay out more money than it was taking in. To ease this problem, the Houston Firefighters' Relief & Retirement Fund's chief investment officer, Christopher Gonzales, made a move last year he hadn't seriously considered before: He decided that the $2 billion fund would bet on the currency markets. "We needed extra income," Mr. Gonzales explains."
    No doubt some who advise New York's own pension fund are far more sophisticated than the hapless Mr. Gonzales—and one hopes that New York's comptrollers, current and future, would never make a wild investment just for the chance of extra income.

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