Rich DeColibus to STRS Board: Alligators and PBIs

From Rich DeColibus, December 4, 2008
Subject: Alligators in the Sewers

"The one and only goal of STRS's investment department is preservation of capital. Nothing which interferes with this tenet should be allowed to impact STRS operations. "Preservation of capital" isn't a trite phrase, it's the only rationale for the existence of STRS."

"Having lost $30 billion over the last year essentially means we have lost asset value at the rate of $951 per second for a year...not a good thing." [That's $57,060 per minute or $3,423,600 per hour or $82,166,400 per DAY, folks!]

Dear Board Members,

Every once in a while you hear the news story about a huge alligator found in some city's sewers (usually NYC). The presumption is someone bought a cute little alligator, but then it grew. It wasn't cute anymore, and it became dangerous. After all, to an alligator, the hand that feeds it is just as yummy as the food it holds.

It is time to reflect on your PBI program, and maybe send it to keep the alligators company. It may have started well, but it has become counterproductive. You are always free to dispute my logic, but I do ask you to step back and look at the overall picture. Of course, human nature wants to hang onto anything one has already spent a good deal of time and energy defending, and it will be an emotional challenge to reverse course. However, even Superbowl championship football teams have to punt once in a while. A punt is not an admission of defeat, it is a recognition of reality and a determination to do better next time.

I will give my brother the credit for the overriding principle that energized me to write this. As in the Hippocratic Oath, the words "First, do no harm" come to mind. The principle is this: The one and only goal of STRS's investment department is preservation of capital. Nothing which interferes with this tenet should be allowed to impact STRS operations. "Preservation of capital" isn't a trite phrase, it's the only rationale for the existence of STRS.

I have met many teachers in my life, as have most of you. I have yet to meet one who went into the profession to get rich. Teachers go into teaching because they love children or are fascinated by some field of human endeavor, and they want the rest of the world to enjoy it as much as they do. The satisfaction involved in being successful is considered sufficient gratification, and no amount of monetary compensation will make a teacher happy if he cannot see students progress.

What has this got to do with the PBI program? If you look a bit deeper, what I am trying to ask is simply this: what motivates individuals? Certainly money does, but money isn't the sole reason why human beings do what they do. Money is a perfectly legitimate incentive, but -- and this is the relevant point -- it must be structured in such a way that the behavior it motivates parallels the primary goal of STRS: preservation of capital. Therein lies the problem.

The PBI program is technically adequate. It is based on the principle money is a powerful motivator, which it is. It is not, however, the only motivator, nor, I submit, the most effective motivator. The most effective motivator is a feeling of accomplishment and satisfaction of a job well done, as well as recognition by others that you have exhibited superior performance. This is not feel-good, touchy-feely stuff; this is the grist of what it is to be human.

Allow me to demonstrate how the PBI program works against preservation of capital. I do not claim this is accurate in detail, but it is accurate in general application. We shall create four categories of investment: low-risk bonds, and similar investment vehicles, paying 3% a year, market index investments which return 5% a year, risky investments which return 7% in good years, and high-risk investments which return 9% in good years. The PBI is based on beating the market index so there are no bonuses for the first two categories. Let's see what happens to $100 (or a $100 million) over six years, using the historical standard of five good years to one bad year, and an average yearly bonus of $70,000 as per the most recent PBI payments.
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As an investment associate, what would you do? Does the thought of preserving capital or the thought of a $70,000 check in your hand drive your decisions? Now, let's come to year six, when things are not so good.
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Take a look at the beginning $100 and the year six values. Investment associates are neither evil nor malicious, but your PBI program practically demands they invest not for the preservation of capital, but for that $70,000 check. Who can blame them? Y'all approved this PBI. You approved it because you were told it was a good program, a solid common business practice. This kind of Wall Street thinking was the same as the kind of thinking that insisted subprime mortgages were swell investments because, as we all know, the price of homes will always go up.

The question marks for the bonuses in year six are there because, if our particular investments lose money at a slower rate than the STRS composite market index, the investment associates will still get the same basic bonus as in the good years. Indeed, if the rate of loss is significantly less bad than the rate at which the market tanks, they can get a better bonus than in the good years, which is exactly what happened this year. This, pardon the colloquialism, is nuts. Take another look at some other STRS statistics:
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No amount of rationalization can justify this. I am not advocating any specific investment strategy, nor any specific PBI adjustment. Personally, I prefer sending it to where the overgrown alligators go. In any case, I am suggesting the current PBI program works directly against STRS's primary obligation: preservation of capital. It encourages investment associates to prefer relatively high yield, high risk investments because it maximizes their bonuses, and there's no down side for them if their individual and collective investment strategy fails, as it spectacularly did this past year.

This is a diagnosis of the disease; the cure is up to you. Having lost $30 billion over the last year essentially means we have lost asset value at the rate of $951 per second [or $57,060 per minute, $3,423,600 per hour or $82,166,400 per DAY] for a year...not a good thing.

Rich DeColibus
[STRS retiree, former president of the Cleveland Teachers Union]