STRS Ohio Systematically Overstates Its Returns By: Rudy Fichtenbaum

In this post I will discuss how STRS Ohio systematically overstates its returns. The incentive for overstating returns is clear: higher returns mean bigger bonuses for the investment staff.

Exactly how STRS calculates its returns is something of a mystery, which speaks to the broader problem of a lack of transparency. STRS returns are verified by Adviser Compliance Associates, LLC (ACA). Specifically, in a 2020 GIPS Verification and Performance Examination Report issued August 10, 2020, ACA verified that STRS “complied with all the composite construction requirements of the Global Investment Performance Standards (GIPS)….” 

The notes in the ACA report say that STRS returns are calculated using the Modified Dietz method. Most of us probably know that a simple rate of return is just the change in value divided by the value at the starting point. The problem with using this simple method is that STRS is always adding to its funds during the year as member and employer contributions are paid, and also subtracting from those funds as benefits are paid; those cash flows must be taken into account in calculating the rate of return. This is what the Modified Dietz Method accomplishes. 

According to the report, total fund gross return consists of a weighted average of gross returns for all assets, except externally managed real estate and alternative investments. Externally managed real estate and alternative investments are allegedly reported net of fees even though they are included in STRS’s computation of gross assets. STRS then compares those “gross returns” (a mix of gross returns and allegedly net returns) to a benchmark, which is itself a net return.

Measuring performance relative to benchmarks which are net returns by comparing them to gross returns is clearly misleading. Gross returns should always be higher than net returns, and this virtually guarantees that the STRS investment staff will receive bonuses. In fact, ACA reports that in 2020 STRS’s net performance was 3.01% and that the benchmark was 3.07%, so “the fund underperformed its benchmark”, but bonuses were still paid.

Moreover, ACA reports that “costs are reported annually by CEM Benchmarking.” But we know, based on my last post, that CEM excluded certain carried interest and performance fees; STRS pays these to the general partners of private investment funds that manage alternative investments for hedge funds, real estate, infrastructure, natural resources, and private equity. STRS’s true costs are thereby underestimated. Hence, I use the term allegedly when I refer to returns that STRS claims are net of fees. 

At the end of the day, all that matters is net investment income and net rate of return. So, let’s look at STRS’s real net rate of return. To calculate this, we use the same method used by Cheiron, the consultant that provides STRS with their Actuarial Valuation Report. Cheiron’s returns are the ones that really matter because they are used in calculating the funded ratio. Restoration of the COLA is tied to the funded ratio. Their method for calculating a rate of return takes net investment income and divides it by the average of the beginning and end of year assets plus ½ of the net cash flow. The following table shows the difference between GIPS (Global Investment Performance Standards) returns used to determine bonuses and the Cheiron returns that influence the funded ratio.

Between 1991 and 2020, the compound annual GIPS return was 8.17% compared to 7.32% per Cheiron. If for each year you multiply the difference in annual returns and by the end of year net fiduciary position (the assets STRS has to pay members) that adds up to $13.4 billion. That’s a loss of $446.7 million per year. In the last 5 years the loss was $808 million, or about $161.6 million per year. Contrast those losses with the cost of restoring the COLA, about $210 million per year.

If you elect me to the STRS Board, I will be your advocate and do my best to get you the truth about what is going on at STRS. In addition, I will fight to change the culture at STRS to ensure that it puts members’ interests first. That means reducing expenses, fighting to increase employer contributions and restoring the COLA.

Rudy H. Fichtenbaum is an American economist. He is a professor emeritus at Wright State University, and in 2012, was elected the president of the American Association of University Professors.