Thursday, November 10, 2011

Not Ready for Prime Time - Proposal for Central Investment Board for City Pension Funds

The Proposal

On October 27, 2011 the mayor and the comptroller issued a joint press release. The release announced an agreement in principal to reform investment governance and management of the five city pension funds. Any joint policy initiative by two political rivals is usually a significant event. Six union trustees joined in the announcement.

In the past I have commented on the lunacy and high risk investment decisions which specifically the NYCERS trustees have engaged in since 2000. NYCERS is the largest of the five city pension funds. The NYCERS trustees are established by statute and include the mayor’s representative and the comptroller, the public advocate, the five borough presidents, and three major city unions. There are definitely changes that the pension funds need to make. This proposal, however, misses the mark completely. The tools are already there but no one wants to use them.

As a rationale, the mayor's press release stated:

The proposal is intended to insulate management of pension assets from any political office, further professionalize it and make it more consistent with industry best practices. The proposal aims to increase investment returns, lower the City’s pension costs, protect and strengthen pensions for current and future retirees, enhance accountability and guard against the possibility of fraud and corruption.

Current Investment Authority

The mayor seems to be unaware that the city pension trustees already have the authority and resources to depoliticize the investment process, professionalize the investment staff, and implement "best practices". For the last ten years the mayor has not used that authority. It is significant that he chose Martha Stark be his representative at the pension boards for his first seven years in office.

The five city pension systems currently delegate, on a annual basis, their investment authority to the comptroller (Section 13-702 of the NYC Admin Code). This creates a centralized investment system managed by the comptroller. The comptroller usually hires a CIO who reports to him. The comptroller also has a permanent investment staff within his Bureau of Asset Management (BAM). The five pension systems subsidize the comptroller's operating budget to cover the costs of running these investment operations.

Section 13-702 also permits the trustees of any of the city pension funds to rescind their delegation of the comptroller at anytime. If the trustees are unhappy with interference of political forces in the investment process or the lack of investment performance, they can assume direct responsibility of their own investment process. They can hire necessary support staff. In addition, each of the five city pension already has its own outside investment consultant which the trustees have hired. These consultants could easily provide the expertise needed by the trustees to operate their own investment function.

Loss of Power for the Comptroller

The proposed investment board would clearly accomplish one thing. It will reduce the status of the comptroller in the investment process and impact his ability to raise campaign contributions. From a purely political point of view, political actors never willingly surrender power. There is a funny smell in the air here. It may not be a coincidence that federal authorities are investigating the comptroller's campaign fund raising activities.

Performance

With regards to investment performance no one with any certainty can say that the new investment board will be able to improve performance by 1% or more over the current arrangement. It is just as likely that the new board would produce a 1% drop in performance. This is the standard type of delusional comments you find in marketing propaganda.

Structure of New Board

Who will sit on the new board? It will be particularly difficult determining who will be members of the new board and what the voting structure will be. I can not imagine any trustee not wanting to be on the investment board. So much for a more simple and effective board. It is clear that the Public Advocate and the five borough presidents will want to remain involved. I am sure that the same will be true for all unions currently involved.

There will also be pressure from unions currently not on the boards. I know for a fact the Correction Force and Sanitation Force unions would love to have a seat at the table.

As seen in subsequent news articles, the mayor failed to check with at least seven of the NYCERS trustees, a majority of the NYCERS board. These trustees have made it clear that they have serious questions about the proposal.

Each of the five city pension funds has a distinct financial profile which impacts investment decisions . For example, as of June 30, 2010, the FDNY pension fund was 56% funded and NYCERS was 80% funded, a significant difference. They have different cash flow demands. The funds will continue to be separate accounting entities and trusts. The trustees of each fund are the prime legal fiduciaries of the funds. It will not be possible to remove their responsibility for the investment process of their associated fund assets.

The NYCERS fund, specifically, has other significant participating employers besides the city. In the past OTB was a major participant. There are some really complex issues embedded in these pension systems.

There is no mention in the proposal how this new investment board will be funded. There was no mention of the current civil service of the the existing staff at BAM. Who would approve the investment board's annual operating budget and the fees paid to outside managers? Assets of any of the pension funds can only be disbursed upon the public approval of the associated board of trustees.

Staff for the New Board

There is always a presumption that the compensation for investment staff should be free of government compensation limits. This opinion is tied into what type of investing you want to do. I have expressed my opinion that public pension funds should follow a lower risk/lower cost strategy. This strategy would allow the pension board effectively manage their assets with staff paid within the city pay structure. The 2008 financial crisis taught us all how irresponsible and incompetent highly paid investment professionals can be.

The mayor wants the pension funds to emulate Harvard and Yale. Pension funds are very different from endowment funds in that pension funds must make mandatory annual payouts no matter what the pension fund earns on it investments. Without mandatory payouts, endowments can tolerate higher risk profiles than pension funds. This is where higher compensation might become an issue. But then again, higher risk is not a guarantee of higher return.

The Chief Investment Officer

The proposal envisions a permanent CIO described below:

A Chief Investment Officer will lead the new investment management entity. The Chief Investment Officer will report to the new pension investment board – not to any individual elected official – and will be appointed to a fixed term that will not coincide with citywide election cycles

It will be no easier for the investment board to hire a new CIO than it is for the comptroller . The CIO will clearly be an at-will employee. There will definitely be a certain level of politics associated with the investment board. An truly independent CIO is not logical when the trustees are the fiduciaries of the five pension funds.

The Comptroller's Duties as Custodian and Disbursement Agent

By statute the comptroller is the custodian and the cash disbursement agent for the five pension funds. While the custodian function has been contracted out for many years, the disbursement function means that the comptroller is responsible for the cash management operations for the five pension funds. This separation of control is a very sound arrangement. It is a good accounting practice and guards against fraud. It should not be changed. It should, however, be reinforced. The accounting control of investment management fees is a disaster.

Recap

The more I think about this proposal, the more I am convinced that it is a public relations effort with no connection to reality.

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