Dear Board Members,
When your committee meets to discuss the PBI program, I would request you consider a few issues (see attachment [Comments by Richard DeColibus, below]). It is an error to use Wall Street standards to determine whether the PBI program is effective, or even if we should have an investment department at all. The current economic crisis is specifically and directly the result of unregulated Wall Street greed. To give one example, Thomas L. Friedman, of the New York Times, reports a Mexican strawberry picker making $14,000 a year in California, and who spoke no English, was granted a mortgage to buy a $720,000 house. The subprime mortgage culture of unrestrained greed for profits, and disregard for any kind of intelligent decision-making, is not the culture we wish to emulate. Your job is to regulate.
What has infected STRS is internal empire building. The investment department has become an entity unto itself, one manifestation of which is the expectation of huge bonuses regardless of external events. The fiduciary responsibility of each and every STRS Board member is to monitor and, when necessary, rein in those excesses. Who among you is willing to stand before a group of teachers (whom you have the responsibility to represent) and justify $70,000 bonuses to individuals whose sole responsibility is wise investment of STRS assets in light of the fact we have now lost $30 billion?
[Rich DeColibus is an STRS retiree and former president (16 years) of the Cleveland Teachers Union.]
Comments by Richard DeColibus
STRS Ohio Performance-Based Incentive (PBI) Program
• The $6 million paid to 87 Investment associates in September 2008 was for the period from
July 1, 2007–June 30, 2008 (also known as fiscal year 2008). During this period, active management by these associates and external managers beat the benchmark return by +.35%, resulting in an additional $215 million for the pension fund than if assets were passively indexed.
All true. Now step back and look at it again. Beating the benchmark return by about one-third of one percent is not exactly a masterful performance. It produces a large “savings” of $215 million but fails to recognize we have lost more than a hundred times as much ($25 Billion). The $215 million “saved” looks large but isn’t compared to the total being worked with (it is less than 1% of what we lost). Put another way, if we had lost $10, our “savings” on a proportional basis would have been 9¢.
Another problem is the benchmark. It is so complicated to calculate, unless you have extensive background in banking and investment, it is impossible to verify that the benchmark itself, which is the key to all calculations with respect to the PBI program, is valid or appropriate. My sense is the benchmark is accurate and legitimate, but that is a statement of faith, not knowledge.
Finally, look at the last five words in the paragraph. The presumption is there are only two choices: have an investment department or have your assets passively indexed. There are dozens of other options, none of which are considered.
• STRS Ohio Investment associates internally manage about 80% of STRS Ohio’s investment assets; third-party studies have shown that internal management is extremely cost-effective for STRS Ohio, saving $100 million in external fees in calendar year 2007 alone.
This would depend entirely on what investment vehicle is chosen to be compared. No doubt, STRS could choose a high-fee arrangement and incur this kind of cost. It could also choose much lower-fee vehicles. The claimed $100 million it “saved” is a result of deliberately picking the most costly and undesirable options available.
• The PBI Program for fiscal year 2008 was approved by the State Teachers Retirement Board more than 1½ years ago, in April 2007. Applicable PBI payments were discussed at the August 2008 board meeting, approved by the Retirement Board at its September 2008 meeting, and paid later that month. Given the extraordinary market downturn since then, the Retirement Board has accelerated its annual review of the PBI Program usually conducted in March, and has been conducting discussions this fall.
It is well to note it is stated very clearly in the PBI policy that the STRS Board has the right to modify or eliminate the program at any time for any reason.
• The PBI Program is very transparent to both STRS Ohio members and the Legislature.
— Permitted by state statute; (It is, in other words, not illegal).
— Reviewed by the Ohio Retirement Study Council (ORSC) and the Joint Committee on Agency Rule Review (JCARR); (This is good, no problem here).
— Included as a separate line item in the budget presentation made annually to the ORSC prior to adoption by the Retirement Board; (This is also good, very good in fact)
— Communicated to the membership through newsletters, postings on the STRS Ohio Web site, messages sent to subscribers to STRS Ohio’s e-mail news service, and handouts at speaking engagements; and (whoa…sure the facts are communicated, but are also so spun as to be very misleading. See paragraph 1.)
— Included in the monthly posting of the STRS Ohio budget on the STRS Ohio Web site (both budgeted amount and actual expenditure). (This is OK).
• Including a PBI as part of an overall compensation program for Investment associates is an appropriate and commonly accepted practice in both the public and private sectors. As noted in a study of STRS Ohio’s program conducted by Aon/McLagan in March 2005, “STRS’ incentive plan for Investment Associates can be considered ‘mainstream’ relative to competitive practice.”
I dispute this. Name me another public sector agency that routinely awards its workers an average bonus of $70,000 each when said agency is in the midst of a horrible financial disaster. Wall Street, it is true, operates on the presumption everyone should get a bonus every year no matter what. We not Wall Street, nor is this PBI type of program “commonly accepted” in the public sector.
• The PBI Program is only available to eligible Investment associates; no other STRS Ohio staff members participate.
• References to a $25 billion loss reflect the period from mid-October 2007 through mid-October 2008, which covers portions of two fiscal years. Losses recorded in fiscal year 2008 are reflected in the September 2008 payments; investment results for fiscal year 2009 will be reflected in any applicable September 2009 payments.
This is true, but it is also irrelevant. In fact, STRS has seen a constant slide downward in asset value, and it continues to this day. Quibbling about in which fiscal year money was lost is of interest only to auditors and bookkeepers; it does not lessen the loss, nor excuse those who are responsible for managing our assets. How much did we lose on Enron? Was anyone ever held accountable? How much did we lose because of computer trading? How much did we lose buying Fannie Mae? At what point in time will we be back to $80 Billion in assets?
Investment Department Staffing and Compensation
80% of STRS Ohio’s investments are handled in-house by associates in the Investment Department. Currently, there are 115 associates in the department, of which 87 received PBI Program payments for fiscal year 2008.
Why didn’t the other 28 (115-87) associates get bonuses? Was it because of performance, or was it because they haven’t been employed long enough to be eligible for the bonus program? Let me ask the same question another way: Did anyone who was eligible for a bonus not get one because of poor performance?
Third-party studies have shown that internal management is extremely cost-effective for STRS Ohio, as shown in the chart below:
Savings Due to Lower Cost of Internal Management Compared to External Management Fees
Calendar Year 2007 $100 million
Calendar Year 2006 $88.4 million
Calendar Year 2005 $90 million
Calendar Year 2004 $74 million
The magnitude of these numbers depends entirely upon what assumptions are made, as noted before.
The Performance-Based Incentive (PBI) Program enables eligible Investment associates to receive an additional percentage of their base salary through a PBI payment, depending on both total investment fund performance and their individual goals over the previous fiscal year. STRS Ohio has had some form of PBI Program for Investment associates since the mid-1980s. Under the current program, total compensation for STRS Ohio Investment associates (base salary plus maximum PBI) places them in the bottom quartile (25%) of total compensation levels in the private market (i.e., 75% of private sector investment professionals can earn more). Maximum PBI payments can only be paid when positive absolute returns are achieved and the total fund return exceeds the benchmark return by 40 basis points.
Fact one: The average salary of STRS Investment associates is $150,210 and the highest is more than double that. They are not underpaid.
Fact two: Add to that a bonus of $70,000 each, and the average Investment associate is making $220,000 a year. Who else in the public sector makes that kind of money? Even superintendents don’t make that kind of money. The governor doesn’t make that kind of money. No one who ever paid into STRS ever made that kind of money.
Fact three: Since the Investment associates are in PERS, and not STRS, for retirement purposes, every penny of their bonus will count toward their Final Average Salary (FAS) and their retirement.
Fact four: Look at the last sentence in this paragraph. This is classic spin and misdirection. The important word is the first one: “Maximum”. Most of the bonuses were at the 60-98% level, and that’s what produced the $70,000 average bonus. The top ten bonus recipients all got bonuses between 93% and 98%. Sure, they didn’t get the maximum, but they did rather nicely, considering we lost $25 billion. We did not have “positive absolute returns”, nor did the “total fund return exceed the benchmark by 40 basis points” So, they didn’t get the maximum (100%) allowed, they got about 60-98% when we were losing $25 Billion. A basis point, by the way, is one-hundredth of one percent.
PBI Payments Reward Outperformance
When markets decline, the value of STRS Ohio investment assets decline. Conversely, when markets go up, the value of investment assets goes up. STRS Ohio’s goal throughout is to minimize losses and maximize returns beyond the markets’ performance. For example, in fiscal year 2008, STRS Ohio’s total fund return of –5.44% beat, or outperformed, the composite benchmark return of –5.79 by +.35%. The net value added after deducting all direct investment costs (including PBI payments) was 24 basis points or about $215 million for the year. In other words, active management by STRS Ohio Investment associates and external managers resulted in the total fund return loss being less than it would have been if the assets were passively indexed — and the pension plan benefited.
This is true if, and only if, your only alternative is a passively indexed fund. There are dozens of other ways to invest assets, a fact conveniently ignored. The validity of this paragraph depends entirely upon the assumption there are no other options available, and that is patently untrue. For example, if we had seen the coming market slide and moved into bonds, even T-notes would have been a smarter investment and we would not have lost $25 Billion. In fact, we would have made money. But, we failed to anticipate it, a $25 Billion error.
Here is a five-year history of “net value added” to the pension fund, as well as PBIs paid:
[Click image to enlarge]
The validity of these “savings” is addressed previously. The figures are presented as facts, while the reality is STRS is starting with a preconceived point of view and then adjusting the numbers to retroactively make the data fit its contention that we should have an investment department. Simply change the starting assumptions and you can move the decimal point of these “savings” anyway you wish.
PBI Process for Fiscal Year 2008
March 2007 — Retirement Board adopted the PBI Program for fiscal year 2008 (July 1, 2007–June 30, 2008).
August 2008 — The Retirement Board discussed the payment of $6 million to 87 Investment associates based on a total fund return of –5.44% that beat, or outperformed, the composite benchmark return of –5.79% by +.35%.
September 2008 — The Retirement Board approved a motion to pay this amount and payments were made to eligible Investment associates later in the month.
All true, which is exactly the problem.
Under the PBI Program criteria, no Investment associate earned a maximum payment for fiscal year 2008 performance. In addition, all PBI payments earned were reduced by 20% as the total fund had a negative absolute return. As a result, the payment of $6 million was $3.4 million less than the budgeted amount of $9.4 million and $2.2 million less than the amount paid for fiscal year 2007 performance.
Note the word “maximum” again. Let me rephrase this paragraph: “Even though we lost $25 Billion, we still paid out 64% of the budgeted bonus amount for good investment performance by our associates.” In my opinion, beating the market index (however they figure that number) by one-third of one percent is not a bragging point, and certainly does not justify a $70,000 bonus.
Point of clarification: The investment returns after June 30, 2008, are NOT factored into the fiscal year 2008 payment of $6 million, but will be used in calculating any applicable payments for fiscal year 2009 performance. While STRS Ohio’s total investment assets have dropped by $25 billion from mid-October 2007 to mid-October 2008, this period crosses over two fiscal years. There was a $6.5 billion reduction in the value of total assets from
July 1, 2007–June 30, 2008. Since July 1, 2008, through mid-October 2008, there has been an additional reduction of $18.5 billion.
I fail to see why the $25 Billion loss (now $30 Billion and climbing) spanning more than one fiscal year means anything except we lost $30 Billion.
Oversight of the STRS management is the responsibility of the STRS Board. It goes without saying this should include a healthy dose of skepticism and a willingness to intelligently question big buck decisions. Whether we need an investment department or not is one question. Whether this PBI policy needs revisiting is, in my mind, beyond question.