Retreat from Indexing or How to Make Wall Street Rich

In March, 2000 the NYCERS pension fund was worth $44.4B. Half of that, $22.3B (50+% of assets), was invested in US equity Russell-3000 index strategy run by two firms, Merrill Lynch and Barclay Global. Prior to 2000 there had been only one manager, Bankers Trust/Deutsche Bank fund. It cost NYCERS $438,000 in fees to run $22.3B. As early as 1980 NYCERS had been a pioneer in using indexing for its US equity assets. In particular, the Russell-3000 index strategy is profitable, comprehensive, and low cost. Perfect for a mature pension fund like NYCERS.

As of March, 2013 the NYCERS pension fund was worth $46.3B. But the Russell 3000 index fund has been cut and a lot redundant index funds have been added. The total US equity index assets is now $14.3B but with annual fees equal to $2.3M. You can see the details: below:

• Russell 3000 $6.325B, 20102 annual fees equal to $456,000
• S&P 500 ---- $3.978B, 20102 annual fees equal to $103,000
• S&P 500 ---- $0.340B, 20102 annual fees equal to $327,000
• Russell 2000 $0.198B, 20102 annual fees equal to $ 39,000
• S&P 400 ---- $2.462B, 20102 annual fees equal to $ 82,000
• Russell 1000 $1.033B, 20102 annual fees equal to $1,294,000

It's like like the trustees have lost their way. All of the added indexes are subsets of the Russell-3000. There is no value gained by this proliferation of funds. Only the managers are gaining with added fees. This fall off in the index strategy, however, is the root cause of the explosion in management fees. The trustees cut this strategy to free up assets for other less valuable strategies, like private equity.

NY Times - Pensions - Detroit

On July 20, 2013 Mary Williams Walsh wrote the following highlighted article in the NY Times concerning the newly discovered deficit in the two Detroit municipal pension plans and the city's pending bankruptcy action. Ms. Walsh has written many pension articles in the past. Like most commentators on public pension plan issues, however, she never addresses the whole picture. Not that what she reports is necessarily incorrect but that it is incomplete.

For the record, the one issue I never hear reported is the miserable investment performance of public pension plans and how much this contributes to pension underfunding. There are also many questionable investment decisions that the NY Times never reports. It's a great newspaper but it's not always on the cutting edge.

In this article Ms. Walsh points out a sudden increase in Detroit's reported pension underfunding and lays a large amount of blame at the door of widespread actuarial practices which have lead to long term shortfalls on employers' contributions to most public pension systems around the country.

This is a valid and accurate statement but it is not a secret. Everyone in the public pension community knows that the plan actuaries have not been providing good numbers for a long time. Their chief sin has been the use of investment targets that are far to high. This has systematically lead to underfunding of the plans. It has also lead to reckless investment strategies adopted by plan trustees trying to hit the unrealistic targets. It also created the excuse to hire investment firms with outrageous fee structures.

Generally actuaries are very bright mathematicians but like all of us they are usually short on courage. No one wants to lose his/her job. That is what would happen if an actuary came in with the real numbers. So, they do what most of us would do. They bend and twist to keep the parties with power happy.

Below is an extract from Ms. Walsh's article that describes this problem. Towards the end of the extract Ms. Walsh mentions a "Blue Ribbon Panel" set up by the Society of Actuaries which was formed to look into how to address the reputational risks that "bad" numbers were creating. One of the panel members that she idnetifies is Robert North, the NYCERS and NYCTRS actuary. North has a questionable history on his own interest rate assumptions for the city pension funds. I listed below the interest rate changes he has recommended while working for NYCERS. Walsh doesn't seem to be aware of the inconsistency in having North on this panel.

This made me do a little homework. I checked the Society of Actuaries web site and listed all the panel names below. One of the names that Walsh did not identify was Mike Musuraca. For many years Musuraca worked for DC-37, a municipal union with a recent history of corruption while he was working there. He represented DC-37 on the NYCERS Board of Trustees for investment issues. In 2009 he went work for a private equity firm, Blue Wolf Capital, but not before he voted to hire Blue Wolf as private equity firm for NYCERS. Here is a little more background on Blue Wolf Blue Wolf.

When someone like Walsh has these issues in front of her and she doesn't address them, you wonder whether she serious about the problem.

Extract from NY Times article, July 20, 2013

But that is not what happens. To calculate a city’s pension liabilities, an actuary instead projects all the contributions the city will probably have to make to the pension fund over time. Many assumptions go into this projection, including an assumption that returns on the investments made by the pension fund will cover most of the plan’s costs. The greater the average annual investment returns, the less the city will presumably have to contribute. Pension plan trustees set the rate of return, usually between 7 percent and 8 percent.

...

A few years ago, with the debate still raging and cities staggering through the recession, one top professional body, the Society of Actuaries, gathered expert opinion and realized that public pension plans had come to pose the single largest reputational risk to the profession. A Public Plans Reputational Risk Task Force was convened. It held some meetings, but last year, the matter was shifted to a new body, something called the Blue Ribbon Panel, which was composed not of actuaries but public policy figures from a number of disciplines. Panelists include Richard Ravitch, a former lieutenant governor of New York; Bradley Belt, a former executive director of the Pension Benefit Guaranty Corporation; and Robert North, the actuary who shepherds New York City’s five big public pension plans.

The commplete list of members of the Blue Ribbon Panel

Chair: Bob Stein, FSA, MAAA, Retired, Ernst & Young
Co-Vice Chair: Andrew Biggs, American Enterprise Institute
Co-Vice Chair: Douglas Elliott, Brookings Institution
Bradley Belt, Palisades Capital Management, former executive director of the Pension Benefit Guaranty Corporation
David Crane, Stanford University, former advisor to Gov. Arnold Schwarzenegger, CA
Malcolm Hamilton, FSA, FCIA, Retired, Mercer, senior Fellow, C. D. Howe Institute
Laurence Msall, The Civic Federation (Illinois)
Mike Musuraca, Blue Wolf Capital Partners, former trustee of the NYC Employees Retirement Systems-NYCERS and formerly of American Federation of State, County and Municipal Employees
Bob North, FSA, EA, MAAA, FCA, FSPA, New York City Office of the Actuary
Richard Ravitch, Co-chair, State Budget Crisis Task Force, formerly Lt. Governor of New York
Larry Zimpleman, FSA, MAAA, Principal Financial Group

Assumed Interest Rate History under Robert North (1990 to 2013)

1. 7/1/1995 9.0% to 8.75%
2. 7/1/1999 8.75% to 8.0%
3. 7/1/2011 8.0% to 7.0% (net of fees)

I don't have the documentation describing the origin of the 9% rate and my memory is a bit weak that far back. It is quite possible, however, that North also make the recommendation for 9%.

FY-2013 Was a Good Year. Thank God for the S&P 500 Index.

According to the Comptroller's quarterly reports NYCERS started FY-2012 at $41.6B and it's going to end the year, June 30, 2013, at approximately $47.4B. How did NYCERS do so well? Simple, the S&P 500 Index went from 1362.16 to 1606.28. And for the record that performance is almost free to any investor.

A Message to the New Trustees in 2014

On January 1, 2014 all of the elected officials on the five city pension funds will be new people. Actually the NYCERS trustees will be doing a little musical chairs. The union reps will generally remain unchanged.

The Bill de Blasio will, I assume, will be appointing a new chairperson for the NYCERS Board of Trustees. This can be any person the mayor chooses. It is an unpaid position. It would be intriguing if he choose a former executive director. At least it wouldn't cost the city any money.

In spite of public perception the new Comptroller will only be one of the eleven trustees at NYCERS and acts only as investment agent for the full board. (See Note below)

All of the new trustees, not only the Comptroller, should focus on their prime responsibility as trustees, protecting and building the assets of the system. It is clear to me that the departing trustees failed in that duty.

The following is a list of the money spent by NYCERS for investment services since 1997. It totals $1.4B over 16 years. This covers only one of the five city pension funds. The five system total is in the $3.0B range

1. $17,3M (1997)
2. $26.1M (1998)
3. $27.4M (1999)
4. $32.5M (2000)
5. $41.3M (2001)
6. $37.6M (2002)
7. $29.3M (2003)
8. $35.1M (2004)
9. $53.9M (2005)
10. $69.4M (2006)
11. $98.1M (2007)
12. $115.3M (2008)
13. $138.2M (2009)
14. $175.3M (2010)
15. $145.1M (2011)
16. $129.5M (2012)
17. $183.3M (2013)

1997 was the year that NYCERS began paying all of its investments expenses from the assets of the fund.

1997 was also the year that Alan Hevesi hijacked the contacting and payment process for investment managers. The trustees, including the mayor's representative, were truly stupid in letting him do this, as future events have shown. At the time I objected to this statutory violation but the Law Department said it was ok.

As background, 1987 was the first year that NYCERS started paying any investment expenses. At that time Ed Koch and Jay Goldin got into a pissing contest at the old Board of Estimate over approving contracts for equity managers for the pension funds. So Jay Goldin went to the trustees to get the contracts paid from the assets of the funds. Prior to 1987 these expenses were paid directly out of the city budget. For some reason the bond managers continued to be paid directly from the city budget until 1997.

I have never before put this complete list together. The patterns are fascinating. For the fiscal years from 1997 to 2002 the fees under Hevesi climbed from $17M to $37M. From 2003 to 2010 under Thompson the fees jumped from $29M to $175M. From 2011 to 2012 under Liu the fees dropped from $145M to $129M. The drop is encouraging but the fees are still way out of control. 2013 saw a reverse in this drop with a jump to $183M.

As a point of reference in FY-1999 NYCERS assets grew from $37.5B to $41.0B with fees of $27M. In FY-2009 NYCERS assets dropped from $38.9B to $30.9B with fees of $138M. It appears that there is most probably no benefit gained from higher investment fees and in fact quite the opposite.

How does this crap keep going on for years and years?

Note:
Comment from the last (2002) NYS Insurance Department Report of Examination:

The highest governing body at NYCERS is its board of trustees. The trustees are fiduciaries for NYCERS, its members and its retirees. The trustees delegate NYCERS investment functions to the New York City Comptroller, pursuant to Section 13-702 of the New York City Administrative Code. The investment powers transferred to the Comptroller are subject to written delegations which may not exceed one year. Although this authority is renewed annually, the System is not required to use the Comptroller for investment services. The investment services provided to NYCERS by the Comptroller are provided through the Bureau of Asset Management (BAM), a division of the Comptroller’s office. The delegated powers authorize the Comptroller of the City of New York to make any investment which NYCERS trustees are authorized to make. Also, the Comptroller is authorized to hold, sell, assign, transfer, or dispose of any of the properties, securities or investments in which any of the funds of the System have been invested.

Section 136.2 of Department Regulation No. 85 states in part: (b) “Administrative head shall mean,…the board of trustees of a retirement system, in their individual and collective capacities”

Section 136.6 of Department Regulation No. 85 states in part:
“(a) The administrative heads are fiduciaries and as such shall act solely in the interests of the members and beneficiaries of the systems they administer. They shall perform their responsibilities in a manner consistent with those of a reasonably prudent person exercising care, skill and caution.
(b) The assets of a system shall at all times be under the control of the administrative head.
(c) No investment or loan transaction shall be made by a system unless the same has been approved by the administrative head. The administrative head may delegate its powers of investment to a committee or agent of the administrative head within well-defined established guidelines. Such committee or agent shall render timely written reports of its activities to the administrative head under a schedule to be established by the administrative head and shall render special reports whenever requested by the administrative head.
(d) In respect to the delegation of investment powers, the administrative head shall periodically review: (1) the present holdings in the investment account; (2) any marked changes in the account during the preceding period; (3) the reasons for such changes and the results achieved thereby; (4) the investment activity in the account including the rate of turnover; and (5) any other factors the administrative head considers pertinent to an analysis of the financial performance and planning, consistent with its obligation as a fiduciary.”

As outlined in Department Regulation No. 85, the trustees are the fiduciaries of the System and as such must act solely in the interests of its members and beneficiaries. No board collectively, no trustee individually, nor any administrative head, can delegate their fiduciary obligations to others. They must perform their responsibilities in a manner consistent with those of a reasonably prudent person exercising care, skill and caution. The Regulation requires that the assets, at all times, be under the control of the trustees and that investments and loan transactions be approved by the trustees. Department Regulation No. 85 allows the trustees to delegate its investment powers within well–defined established guidelines and with the rendering of timely written reports of its activities to the trustees under a schedule established by the trustees. At a minimum, the Department believes that appropriate implementation of such guidelines requires a comprehensive Investment Policy Statement.

Pay a Lot : Get a Little in Return -- Who Would Have Guessed

Thr following link is a press release from a research group in Maryland. The intro is:

ROCKVILLE, MD — A new study shows that state pension systems that pay the most for Wall Street money management get some of the worst investment returns. The study, conducted by the Maryland Public Policy Institute and the Maryland Tax Education Foundation, reviewed investment returns and fee ratios for 35 state pension systems and found startling results.

The gory details are in this six page study .

You Can't Trust NYCERS.

Denial of a Request to Correct an Error

I just received a copy of a letter Karen Mazza sent to a lawyer trying to help a former Transit Authority worker who qualified for a NYCERS disability retirement in 1990. Mazza is the director of the Legal Division at NYCERS and is paid $175,000 per year.

This letter is a response to a request by the lawyer asking NYCERS to correct an error that NYCERS had made in 1990 in processing the member’s disability applications. (as per S.13-182 of the NYC Admin. Code). NYCERS had failed to process his Tier-3 S.507 disability application. The agency only processed his Tier-3 S.506 application and granted him this smaller disability benefit.

This processing error had come to light in 2013 in conjunction with NYCERS’s recent discovery of its errors, over a 30 year period, in processing Workers Compensation offsets for certain disability benefits and its harsh campaign to correct those errors. This member is one of the effected retirees. See Note #1 below.

While this letter appears to be innocuous and straight forward on its face, it is not. In the third paragraph of her letter Mazza states in connection with the member’s Tier-4 S.605 disability application:

“Since the Medical Board had already determined that his incident was not an accident he was not eligible to be considered under S.507 of the RSSL for accident disability”

This is a false statement.

The Medical Board in response to the member’s S.605 application determined only that the member was not disabled. Mazza provided no evidence to support her statement. The wording from the final medical report dated June 5, 1990 is as follows:

“The Medical Board, after reviewing all the documentation in the incident involved, the findings by Mr. XXX’s own physicians and the diagnostic tests performed , found insufficient objective medical evidence to substantiate Mr. XXX’s claim of disability and recommendation was made that he was referred to Dr. XXX, neurologist for neurological exam.

Dr. XXX examined Mr. XXX on 4/12/90 and reviewed the history and noted the complaints of the applicant. As a result of his neurologic examination, Dr. XXX came to the conclusion that there was no objective evidence of neurologic disorder in Mr. XXX at that time.

The Medical Board, after careful consideration of all the facets of this case and the report of Dr. XXX, reaffirm its previous decision and recommends denial of the application for accident disability retirement.”

When the Medical Board finds that an applicant is not disabled, its job is done. Procedurally and logically, it does not address the issues of whether the "on the job" incident caused the disability or whether the incident is an accident. An “accident” has a legal definition created by a court decision.

In addition, while the Medical Board’s finding on disability is definitive, the Medical Board’s findings on causation and accident, when necessary, are only advisory. The NYCERS Board of Trustees is, by statute, the final arbiter of these two issues. See also Note #2 below.

In contrast to the S.605 benefit, the disability decision for the S.506 & S.507 disability benefits is determined by the member’s eligibility for primary social security disability benefits. This member was so eligible.

Like S.605, the S.507 benefit requires that the NYCERS Board of Trustees determine that an on the job incident caused the disability and that the incident was an accident. The trustees refer to a Medical Board recommendation when making their decision but are not bound by it. The member may or may not be able to clear that hurdle but he is entitled to try.

The S.506 benefit only requires 5 years of service in addition to the social security disability benefit. The member had 8 years of service. This is the benefit he was given by NYCERS and it began in 1986 when the social security award began.

After NYCERS denied his S.605 application, the member requested that his application be processed under Article 14 (Tier 3). NYCERS processed his S.506 application but not his S.507 application. Needless to say the S.507 benefit is significantly greater than the S.506 benefit.

I suspect that the medical division incorrectly assumed that the member’s S.605 denial was based on either the causation or the accident issues. The agency was under very tight budgetary constraints in 1990.

Benefit Difference Between S.506 and S.507

The benefit under S.506 is 33% times a three year average compensation minus two offsets, 50% of the social security benefit and 100% of any workers compensation award, plus the Tier-3 annual cost of living adjustment.

The S.507 benefit is the same as S.506 benefit except that the percentage is 60%, much higher than the 33% in S.506.

In 1991 NYCERS using a $35,426 three year average compensation computed the member’s S.506 benefit to be equal to $11,808. It was then reduced by $2,790 (50% of his social security benefit). The reduced benefit was $9,018/year. At the time NYCERS did not apply any workers compensation offset. This was a mistake. The benefit after the offset for the workers compensation award ($7,800/year) was $1,218/year, a very small amount.

If NYCERS had processed the member’s S.507 application and the trustees had found that the member had been disabled by an on the job accident, his annual benefit would have been $21,255. With the two offsets it would then have been $10,665. If he had been granted the S.507, then he actually has been underpaid since 1986.

Conclusion

Now NYCERS refuses to correct this error using lies to justify its denial. The retiree does not have the resources to mount a legal challenge. He has no recourse but wait for over 15 years while NYCERS extracts its money. What ever happened to the union representatives on the Board of Trustees. They had no trouble getting a disability benefit for the son of a DC-37 union official, Mark Shaplo who plead guilty to fixing a 1996 contract ratification vote.

What is the lesson learned here? You can not trust NYCERS. The senior management has a record of incompetence and corruption and it is the members and retirees who suffer.  

Note #1: Workers Compensation Offset

In December, 2012 NYCERS notified the member that the agency had discovered that it had failed to apply the workers compensation offset to his benefit in 1991. The WC award was $150/week, $7,800 a year starting in 1989.

As a result NYCERS claimed that the retiree was overpaid by $186,199 from March, 1989 to December, 2012. NYCERS provided no detailed spreadsheet outlining the overpayments. NYCERS also did not detail the repayment amounts or the repayment schedule. A quick calculation of the WC payment of $7,800/year for the period is equal to only $108,000.

NYCERS suspended the retiree’s pension as of January, 2013. It did not state specifically when the agency would restore his pension. The agency stated only that at some undetermined date in the future he would be reinstated when the debt was paid off.

There are also significant COLA payments attached to this benefit which impact the overpayment - repayment schedule.

While it is obvious NYCERS needs to take action to recoup an overpayment, this situation was caused by a NYCERS error and NYCERS should show some consideration to effected retirees.

Note #2: More Deception

While admitting in paragraph two of her letter that the Medical Board found the member not disabled, Mazza strangely adds the following sentence possibly hoping to confuse the reader into thinking that The Medical Board had decided that the incident had not caused the disability:

“They went on to find that he was on restricted duty at the time and the incident did not aggravate the non-line of duty injury”

This is not a finding that the incident did not cause the disability because there was no disability as far as the Medical Board was concerned. According to procedure there was also no mention about whether the incident was an accident in the Medical Board report. For the record restricted duty is no different than full duty with respect to being on the job.

There is also a bogus reference to the fact that the member was represented by counsel throughout the entire process. NYCERS did nor deny the member's S.507 application. They failed to process it. This is an issue about NYCERS making a mistake and fixing it as required by Section 13-182 of the NYC Admin. Code. Ask any disabled retiree with a workers compensation offset.

It always amazes me that I hired Mazza and gave her a second chance when she falsified her time sheets. I guess we all make mistakes. Too bad I can’t fix this one.

Tier 6: Benefits vs Costs

I've created a spreadsheet modeling the pension benefit for a typical long term city worker under Tier 6. Comments about problems with public pension plans rarely go into specific details relating benefits with costs. It is always helpful to examine the details to get a true picture of problem.

Let us assume a city employee starts working for the city (and joins NYCERS) at age 22 with a salary of $25,000. If the member gets on average a 2.5% pay increase each year (probably too optimistic) and works to age 55 or age 63, his/her annual pension benefit under Tier 6 will be:

• Age 63: $51,768 based on a five year avg. salary of $65,527, 42 years of service, and $60,127 required employee contributions.
• Age 55: $17,619 based on a five year avg. salary of $53,782, 34 years of service, and $42,428 required employee contributions.

What is very interesting about these benefits is how the city's cost for theses benefits fluctuate based on what NYCERS actually earns on its investments.

Currently NYCERS is using a 7% assumed interest rate (AIR) for its assets. (See Chapter 3 of the Laws of 2013 .) This is the rate of return that NYCERS projects that it will earn each year on its assets. NYCERS also currently uses 7% annuity factors to calculate the present value of pension benefits at the point of retirement. Again, this is a rate of return assumption over the lifetime of the retiree.

The city's costs for these two benefits under the 7% assumption are:

• The age 63 benefit has a present value of $495,566 which requires the city to contribute $52,809 over 42 years or 2.9% of salary each year. This amount along with the $60,127 contributed by the member will generate a sum equal to $496,983 at retirement.
• The age 55 benefit has a present value of $193,213 which requires the city to contribute $17,099 over 34 years or 1.3% of salary each year. This amount along with the $42,428 contributed by the member will generate a sum equal to $193,966 at retirement.

If, however, NYCERS earns on average only 5% on its assets, the cost to the city changes significantly. This would also require NYCERS to use a 5% annuity factor at retirement to calculate the benefit's present value. As a historical note NYCERS used 4% annuity factors up until the late 1980's when it switched to 7% factors to blunt the cost of eliminating gender discrimination ordered by federal courts. The change in costs for a 5% rate of return are listed below:

• The age 63 benefit has a present value of $587,356 which requires the city to contribute $152,964 over 42 years or 8.4% of salary each year. This amount along with the $60,127 contributed by the member will generate a sum equal to $586,272 at retirement.
• The age 55 benefit has a present value of $235,984 which requires the city to contribute $61,820 over 34 years or 4.7% of salary each year. This amount along with the $42,428 contributed by the member will generate a sum equal to $235,870 at retirement.

It is incredibly clear from these figures ($52,809 vs $152,964) that the NYCERS trustees must be consistently successful with their investment decisions. There needs to be a hard and open review each year on whether the trustees made the 7% target or failed to get the job done. It can not be hidden in executive sessions behind closed doors. There must be a public record of investment failures. You only have to look at Detroit. It is the workers and retirees who are at risk of being destroyed. The trustees are long gone working for hedge & private equity funds.

At the very least, the NYS Department of Financial Services should be critiquing the investment performance of all seven public pension funds in New York State. The last report only covers up to 2002, which is over 11 years ago. It is strange that DFS will be starting a new audit at NYCERS in FY-2014 and they still haven't produced any report since 2002.