Bob Stein: Comments and a response to questions from Jim and Linda Conard to the STRS Board

Bob Stein to Kathie Bracy, January 12, 2010
Subject: Re: [Fwd: FW: Common Sense??]

The National Institute of Retirement Security has reports that would help members compose letters to the editor.

http://www.nirsonline.org/index.php?option=com_content&task=view&id=338&Itemid=116

The "Pension Economic Footprint" report may be particularly useful because it has state-by-state data sheets. This map is of interest:

http://www.nirsonline.org/index.php?option=com_content&task=view&id=184&Itemid=88

I complained to NIRS in a webinar today that they were too willing to accept the "taxpayer funded" argument that seems to be the basis for a lot of criticism of DB plans. I wanted them to acknowledge the fact that the contributions made by employers are part of the total compensation package and not a gift. Even though the contributions come out of the employers' budget they represent pay for services rendered. Had the funds not gone to fund pension benefits they would have been negotiated to be paid to the employees in salary or some other form. Contributions represent employee pay.

The NIRS representative agreed and said there was a report coming out in March that addresses this -- they expect that report to change the debate considerably.

However, even if the employer contributions were a gift, they would still represent more than a 5 to 1 economic return on investment for Ohio.

Bob

Bob Stein to Kathie Bracy, January 12, 2010

The use of incentives to avoid crowd following behavior in investments seems to be more useful than is generally considered. There are studies that show this to be true but not much in the way of specific guidance on formulas to indicate optimal incentive levels. The most clear information suggests that, given the relative value of performance enhancement provided by incentives, it is far wiser to err on the high side than the low side.

The attachment from the Conards is for reference.

[Jim Conard's letter: http://kathiebracy.blogspot.com/2010/01/jim-conard-to-strs-board-do-you-have-it.html]

Bob Stein to Jim and Linda Conard, January 7, 2010
Subject: RE: Common Sense??

Mr. And Mrs. Conard

Thanks for your continued attention to STRS.

The topics you mentioned are discussed at nearly every board meeting or meetings between board members and staff and have a significant impact on more policy than you appear to know. At the last board meeting the board cut simple investment incentives by 15% to 30%. We cut projected (by me using historical data) average incentives by more than 27% in addition to the incentive reductions made in the policy revisions last year. The total reduction is over 50%. I voted for it but I didn’t like it. There was a time when I would have agreed with much of what you contend. My studies have led me in another direction.

I’m sure you will be able to find plenty to be upset about in this email but I urge you to consider the comments carefully. Please remember that there is no reason for a board member who donates significant time and money to assure a retirement to the teachers of the state to risk upsetting even one retiree or member needlessly. These comments are only a trivial summary of my studies on these topics. I can send you references for any of this if you promise to read them.

While your email looks very similar to some from past exchanges, there are some things that need to be clarified:

1. A defined benefit pension fund is different from school systems and most other organizations with which teachers are familiar. Schools, hospitals, libraries, and even defined contribution pension plans (like 401Ks and IRAs) start with a budget and see how much of their mission they can accomplish with that budget. The budget is fixed by taxes or whatever grants or annual contributions are received. The principal method to increase progress toward the mission comes from reallocating the budget. When annual contributions are reduced then the progress toward the mission is cut back in a very short time. All risk is born by the mission on a year-to-year basis. The money stops and the mission ends. This is the world in which your arguments of “common sense” apply.

The mission of a defined benefit pension plan is to provide a lifetime pension benefit based on a specific formula. All risk is born by the pension plan across generations. STRS contributions and the benefits are both fairly fixed. The administrative operating budget is similar enough to other organizations pursuing comparable activities that it is very close to a fixed cost and not actuarially significant to our mission. STRS administrative expenses compare favorably with Medicare and other large benefit organizations. The number of current and future retirees is so large relative to the size of staff that trying to reduce staff payroll below market levels is likely to be impractical from a business standpoint, counterproductive from benefits and service standpoints, and not effective from a budget control standpoint. We are looking at the long-term mission here. For example, I would rather that the executive director would hire a replacement for his secretary that left – leaving the position open saves some money but secretarial time is cheaper than his time and he has other things to do that are critical to the mission, particularly now. The majority of the savings that have not been made, and some that have, are similar to saving money by not buying toothbrushes or not changing the oil in your car – it only looks good for a while.

2. Nationally, payroll contributions to pension funds account for between 10% and 20% of benefits, with investment returns accounting for the remaining 80% to 90%, depending on lifespan etc. Our benefits department tells new retirees that teacher contributions are exhausted after the first three years of retirement – the balance of their retirement is funded by investment profits made during their careers. While pensions were not reduced when investment returns went sour, the only way to maintain or increase benefits going forward is to maintain and improve long-term investment returns. I do not believe the “contingency plan” is a permanent fix because there is no way to continue to raise payroll contributions enough to cover benefits if we can’t get investment returns.

We can and do save money by seeking the lowest bidder for custodial financial services. One certified custodian is pretty much the same as another. However, for investment services we save huge amounts of money by maintaining an internal investment department. The board gets a 200+ page report from an independent agency annually to keep track of investment performance and costs. Our investment department performs slightly better and at slightly less risk than the comparator group with a savings of about $110 million per year. About 80% of the STRS portfolio is managed internally. We are working on responsibly bringing a higher percentage of our portfolio in-house in order to save more. However, recklessly slashing at the investment department is identical to not feeding the goose that lays the golden eggs.

When it comes to investments and investment policy, most any strategy that involves doing what seems obvious is the surest way to lose money. What makes you feel good almost always lightens your wallet. Investments in most financial markets are, for the most part, a zero sum proposition – whatever one group wins in purchasing power another looses. The 8% to 10% APY “free lunch” expected from the stock market is largely discounted against purchasing power losses related to inflation and currency fluctuations. You have probably noticed this in your own budget.

The way a large portfolio wins purchasing power is by first hiring the best possible staff. Performance incentives are used to assure that the staff doesn’t follow the investment crowd too much. They encourage team cooperation and original thinking, which tends to be profitable in this group, and removes the “everybody else lost money” excuse from the equation. Performance incentives also help the fund to be able to reward (as well as recruit and retain) investment staff members that prove useful in extracting money from the markets better than the staffs working for other firms.

You don’t need the absolute best staff people but slightly above most is only OK. Above the vast majority is worth nearly anything you have to pay to get them especially if they work together well as a team. Performance incentives are an investment in providing future pension benefits and not a gift. The National Council on Teacher Retirement states that performance incentives increase investment income to pension funds. Of that increase, NCTR estimates that more than 99% of it is retained by the funds and 1% is paid to staff as performance incentives. The investment managers only get the bonus money if they gain 99 times as much for the fund. That could be considered a 9900% annual return on investment. In studying related topics for most of my investment life and intensively during October and November, in addition to the NCTR conferences, I saw other studies done for hedge funds and for mutual funds that show similar results – not entirely applicable because some of their managers are responsible for raising capital in addition to managing money but the results were very similar. Properly managed performance incentives are the best investment a pension fund or any large portfolio can make. Profit-making investment companies pay incentives because this is true. That said, the way to go if you really want to reduce relative costs in this area is to:

A. Find highly skilled people and pay them a slightly higher than market-level base pay. This is not just about “filling the job”. The senior staff will probably be able to fill the job at nearly any price we set. The quality may have to be compromised or the work load modified. That will be far more expensive in various kinds of performance than anything we could save on the compensation package. There are no training wheels for this.

B. Increase properly managed performance incentives to many multiples of the base pay and assure that the incented behavior is consistent with investment policy.

C. Adopt an investment policy that allows this skilled staff enough freedom to exercise their skills and that is well integrated with the compensation program.

Because of political deference given to “common sense” complaints such as those you offered and because the legislature, media, and board have historically consisted of mostly lawyers, teachers, and businesspeople who are experienced in budget-driven economics rather than investment management we have done none of the above. I believe that this is one of the primary reasons that STRS has not maintained purchasing-power-level returns over its history and is also one of the major sources of its current difficulties.

Staff adjustments are just as necessary in a well designed investment staff structure as in any other employment plan but attempting to punish investment staff en mass for shortcomings in the tools they were allowed to use by board policy is worse than useless. This is what we and some other pension boards have been doing and it is both wrong and fiscally dangerous.

I am unlikely to respond personally in this detail again. I have research that I want to complete before the board meetings this month.

Thanks
Bob Stein

PS. I’ve not studied the topic directly but it would seem that it is worth considering a performance incentive plan for the Executive Director. This might be a way to reduce crowd following behavior and increase circumspect risk taking in that position. I would be interested in any research you might find on that topic. Almost all universities maintain their theses and doctoral dissertations on line. Thanks for your help if you should choose to give it.

RWS