Sunday, February 14, 2010

Bob North and the 8% Dilemma

This spring Bob North, the NYCERS and NYCTRS actuary, must make a very important decision. He must recommend a new assumed actuarial rate of return for the city pension systems. This recommendation has to be enacted into law and is usually effective for the next 5 years. Last year the old 8% rate expired (2004-2009). Bob chose to kick the can down the road and recommended that the old rate be renewed for one more year (C.211/L.2009, see:NYS Laws).

This sounds like a very obscure issue but it is not. This rate of return has a huge impact on the city pension costs over the next 5 years. Any reduction in the rate will greatly increase the city’s cost. Over the last ten years the pension systems have only had a 2.17% rate of return, significantly short of their 8% target. This is a big part of the pension crisis in the city.

It is bad enough that the 8% assumption leads to underfunding of the pension systems but it is creates a rationale for risky investment decisions hoping for high returns to compensate for the underfunding. You can see what a vicious cycle this is.

Because of the budget crisis there will be intense pressure on Bob North not to reduce the actuarial rate. He most likely will buckle under the pressure. This is not responsible but at least, it is understandable. The trustees, however, must abandon their current risky policies and adopt a prudent investment strategy that recognizes a lower, more realistic rate of return. The trustees must not make the situation worse.

City workers have skin in this game. Over the last ten years NYCERS members have contributed $3.3B to NYCERS from their own paychecks. In that same time period the city and the other participating employers have contributed $8B. Most of that amount was paid in the last 4 years ($6.5B: 2006 – 2009).



In 1990, NYCERS and NYCTRS appointed Bob North as the actuary for the two pension funds. BY statute, this also made him the actuary for the police, fire, and Board of Ed. pension funds. At the same time the city created a new stand alone agency for the actuary. Previously the actuary’s operations were part of NYCERS. There was no legal basis for creating this agency but the Law Department can be counted on to be creative when asked.

This was done partly to make Bob feel good about running his own agency. This really didn’t matter much until 1996. In that year however, Albany granted NYCERS and NYCTRS their own independent budgets. The law was changed for several reasons, one of which was that the city was slowly strangling the budgets of both retirement systems.

Prudently, both retirement systems should have pulled the actuary’s operations back into their agencies in order to exercise proper control of their appointed actuary. The trustees did not do this and left the actuary under the budgetary control of the mayor. Since 1990 the mayor has controlled the actuary’s salary and he still does.

Of course, the NYC Law Department never advised the retirement system trustees that as of July, 1996 they should, as fiduciaries, place the actuary within the boards’ budgetary control. The Law Department has never given the trustees comprehensive advice about their fiduciary responsibilities. That potential advice would have had to include a clear warning about the on-going conflicts of interest that exists whenever the mayor’s lawyer is giving advice to the NYCERS Board of Trustees.

On January 28, 2010 the mayor proposed cutting the actuary’s budget for FY-2011 by $222K ($4.9M down from $5.1M) and his headcount by 5 (32 down from 37). In addition, if the state goes forward with the governor’s budget recommendations, the mayor has proposed cutting another 5 positions from the actuary’s headcount and an additional $406k from the actuary’s budget.

This is a clear reason why the actuary’s operations should be directly funded by the retirement systems. In addition, the actuary should be totally transparent with respect to any work that he does for any outside agencies. He should be more active with investment issues. He should also be more responsive to 1) the operational needs of the pension systems and 2) requests for fiscal notes of proposed legislation from all responsible parties, not just the city.

FYI: This is the most current estimates of the city’s ongoing pension costs. The chart below does not include the Transit Authority, the Housing Authority, HHC, and other participating employers. These figures are based on the 8% assumption. Even with 8%, you can see that the situation is deteriorating. If the rate of return is reduced, the amounts will increase even further.

YearAs of June 2009As of Jan. 2010
FY-2014 NR$7.9B

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.