Sunday, February 7, 2010

Who's Minding the Store: Paying $143M to lose $7.8B.

Review of NYCERS Investments for FY-2009: $7.8B loss and $143M fees

On December 31, 2009, NYCERS submitted its FY-2009 financial report (CAFR) to the national government finance association (GFOA) in Chicago.

The bottom line on NYCERS income statement showed a loss of $7.8B. That is a 19.6% loss in assets ($31.9B down from $39.7B).

For this disaster, NYCERS paid $143M in investment fees and expenses. The city and other participating employers must replace the $143M with 8% interest in FY-2010. As a reference, NYCERS paid $45M in investment expenses in FY-2003. This cost explosion is a recent development.

You can see a breakdown on the specific investment classes on a chart that I recently posted. It outlines each class’s performance and expenses for FY-2009.

As listed in the chart there are 23 asset classes. This strategy is much too fragmented and expensive for any pension plan and far too risky for a pension plan that has an annual benefit payout obligation equal to 11% of assets ($3.3B benefits, $31.9B assets).

On the rational side of this strategy, there are six of the classes with assets of $17.1B and annual expenses of $4.6M.

On the truly out of control side of this strategy, there are two classes with assets of $2.7B and annual costs of $99.7M.

It is clear to me 1) that the six classes are totally sufficient for NYCERS investment needs, 2) that NYCERS would save well over $120M per year in fees using only the six classes, and 3) that the six classes would produce a higher rate of return than the 23 class scheme.

Unfortunately, even if sanity would return to the trustees, the Comptroller's office has signed contracts that require NYCERS to submit to this legal rape and pillage. The best NYCERS could do is to stop the bleeding and drop whatever contracts that have an opt-out clause.

The trustees also need to change the investment consultant function. They need to hire a totally independent advisor with no income coming from investment managers. The consultant must commit significantly more resources to assist the trustees. The consultant must have a permanent presence at the NYCERS site so that he/she can perform comprehensive analysis of manager’s performance and be available to all trustees on daily basis.

This consulting function would most likely cost about $10M a year. It is, however, far better to have the consultant earn his/her profit from NYCERS rather than from the managers that he/she is suppose to audit and monitor.

The following are comments about specific asset classes

US Stocks

The work horse of the NYCERS portfolio is the indexed domestic stock class. Its value on June 30, 2009 was $10.0B, 31% of the total portfolio. Last year was a disaster with a -26.44% loss in this class. This class, however, always has the saving grace of having almost no cost. The 2009 fees were only 0.3 basis point of assets managed. Yes, that is less than one basis point. The annual return over the last 15 years is 6.98%.

Comment on reported returns: The Comptroller, on a quarterly basis, reports rates of return for individual managers. He/she provides no data or calculations to support the accuracy of these rates of returns.

In contrast, NYCERS actively managed domestic stock class had a -25.11% return before fees were paid. The 2009 fees were 24.0 basis points. The annual return, however, over the last 15 year is 6.26%, gross of fees. This class is a waste of time and very expensive. Pension funds should not be involved with this asset class. This is a touchy subject because of industry wide implications of this position.

A particularly questionable asset class is the domestic stocks - minority managers class. This class had a return of -27.66%. This performance is worse than other active managers. The 2009 fees for this class were 68.8 basis points. Any attempt to provide opportunities to minority managers legally should not cause any increased expense to NYCERS. This asset class borders on gross negligence by the trustees. The NYC Law Department has failed to properly advise their clients of their fiduciary obligations.

Minority managers also appear in the bond and international stock classes. The comments made above are also relevant in these two other classes

International Stocks

Actively managed international stocks had a return of -32.2% last year, gross of fees. The 2009 fees were 32.6 basis points. This class has had extensive turnover the last three years reflecting the risk in this area. It also has the same performance flaw as the actively managed domestic stock class. International stock exposure should be handled on a country structured indexed basis.

NYCERS indexed international stock manager had a return of -30.68% last year, gross of fees. The 2009 fees were 1.7 basis points. This class needs to be broken down to a country grouping. As an example, Japan has a heavy weight in this index and has pulled down the index’s performance.

The emerging market stock class had a return of -31.41% in 2009, gross of fees. The fees were 36.9 basis points. This class should also be shifted into the index class. If a country doesn’t have a reasonable index, NYCERS should not be invested in that country.

US Bonds

NYCERS has a long standing effective domestic bond program. Listed below are the four traditional classes with their 2009 returns and fees:

  1. investment grade corporate bonds, return = 2.44%, fees = 2.6 basis points

  2. government bonds, return = 7.04%, fees = 7.4 basis points

  3. mortgage backed bonds, return = 6.26%, fees = 7.0 basis points

  4. dollar denominated foreign bonds, return = -5.62%, fees = 7.7 basis points

  5. .

The dollar denominated foreign bond class performed poorly in 2009 but has a good performance history and its fees are comparable to that of domestic corporate bond class.

The high risk domestic bond class had a -1.28% return last year, gross of fees. The fees were 27.9 basis points. The annual return for the last ten years has been 4.88% while the corporate bond return has been 5.58% and has fees in the range of 7.4 basis points. This high risk class just can not compete with high grade corporate bonds.

In 2008, NYCERS began investing in convertible bonds. This class is just inappropriate for a large pension fund which has both equity and fixed income investments. The return was -13.19% and the fees were 39.2 basis points. The high basis point number is a tip off to stupidity.

The actively managed inflation protected government bond (TIPS) class is too expensive when compared to the standard government bond class. The inflation protection is not sufficient to justify this class’s severely discounted rate of return. This also applies to the index TIPS class.

Unregistered Investments

At the end of the list of investment classes are two classes that have gotten completely out of control. They are private equity and real estate partnerships. Both classes are illiquid and have no published market value.

The fees for private equity were $81.7M and for real estate were $15.3M. The consulting fees for these two classes were $2.7M

This is 70% of the total annual investment expenses for the entire portfolio but the asset classes have a book value of only $2.7B or 8.8% of the portfolio. The private equity class has 116 partnerships. NYCERS did not report fees paid for 26 of them. The real estate class has 30 partnerships. NYCERS did not report fees for 8 of them. This is a sign of NYCERS's lack of financial control over the payment of fees to all managers. What is particularly questionable about these two classes is that $25M of the $99.7M is classified as organizational costs. That means NYCERS is not reporting who or why this money was paid. There is a high potential for fraud when controls are not present.

While NYCERS does not report rates of return on either of these classes, the real estate class dropped in value from $1.2B to $.886B in FY-2009.


In hind sight, it is always easy to criticize. The trustees’ investment decisions over the last ten years, however, have been purposely aggressive. This was done in the hope of keeping employer contributions lower than they would have been if the trustees had followed a more conservative strategy. It is perverse that, overall, the conservative strategy would have been less expensive for the employers. This is the price of incompetence.

While there is a growing funding problem at NYCERS (it is much worse at the other four city systems) caused partly by benefit enhancements that were enacted in 2000, the main source of this problem is the underfunding by participating employers and the investment failures by the NYCERS trustees.

I will not even comment on the campaign contribution issue.

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