How Do You Lose $174M in a Rising Market?

On October 31, 2016 the Comptroller's Office released the city's Comprehensive Annual Financial Report (CAFR) for FY-2016. This report, in particular, contains the basic financial information for the city's five pension funds.

Based on this report, NYCERS lost $174.2M in asset value during FY-2016 and had a closing balance of $55.59B. Even worse,during the same period the five city pension funds plus the TDA & VSF funds, in total, lost $1.323B in assets.

At a September NYCERS investment board meeting the Comptroller's representative, Scott Evans, presented a performance report to trustees that stated that the fund had earned a return of 1.76% for the year.

What he did not say was that NYCERS had lost $174.2M of assets during the year and obviously he did not explain how that had happened. In a year that the index/core rate of return was 3.9%, NYCERS assets fell by -0.32%.

This is absolutely unacceptable. In three of the last six years NYCERS lost assets. All six years were up markets. See the table below.

The Index/Core Performance for FY-2016

During FY-2016 the S&P500 Index increased in value from 2063.11 to 2098.86, a 1.7% increase for the year. Not good but above water.

The NYCERS bond core target was 7.16% for FY-2016. According to the September performance report NYCERS managed a 6.64% return in this asset class. That was C+ grade but not a loss of capital.

With a 60/40 stock asset allocation the fund should have produced a 3.904% increase in assets with a closing balance of $57.85B.

So how did NYCERS lose $174.2M in capital, a -0.32% loss?

Over the last 17 years NYCERS has managed to leave over $25B on the table because of investment decisions made by Comptrollers and trustees. There is no personal penalty for trustees if they fail to do their job. Hell, they don't even get fired. They just go to work for investment mangers.

NYCERS Investment Fees for FY-2016

NYCERS paid $212.9M in investment fees during FY-2016. That is 38 basis points on the closing balance of $55.59B. NYCERS should never pay more than 10 basis points in fees, even for beating the index/core strategy. 10 basis points is $55.6M, a savings of $157M.

Of course beating the index/core strategy is not possible for a pension fund over a long period of time. Investment returns over a long period of time always reverts to the mean, if you are lucky. Trying to beat the mean will cause a pension fund to fall short of average market returns over extended periods of time.

Six Year Review

Look at the last two rows in the table below. In only one year did NYCERS outperform the Index/Core rate of return. Just adding up the shortages for the six years listed below adds up to $4.2B. If you compounded the shortages for the six years, the loss is over $10B. When you compound the shortages over the last 17 years, the calculation produces a $25B loss.

Why do the trustees always make these bad decisions? Follow the money. Who is getting the extra $157M in fees. Who is making and receiving campaign contributions?

The following table is a recap of NYCERS income statements from FY-2011 to FY-2016:

Income Statement History

Year	FY-2016	FY-2015	FY-2014	FY-2013	FY-2012	FY-2011
Employee contributions	$485.5M	$467.1M	$447.7M	$437.8M	$403.6M	$413.7M
Employer contributions	$3.366B	$3.160B	$3.114B	$3.047B	$3.017B	$2.387B
Interest income(bonds)	$692.8M	$635.8M	$658.7M	$624.7M	$528.0M	$492.2M
Dividends(stocks)	$836.5M	$795.3M	$739.7M	$696.7M	$637.1M	$619.9M
Securities Lending	$29.7M	$26.5M	$8.8M	$27.8M	$25.0M	$23.4M
Income-In	$5.413B	$5.089B	$4.974B	$4.884B	$3.941B	$4.616B
Benefits/refunds	$4.403B	$4.236B	$3.990B	$3.851B	$3.689B	$3.569B
Transfers to the other pension funds	$7.4M	$7.1M	$7.2M	$5.3M	$5.0M	$4.4M
Skim to VSF's	-$41.2M	$41.9M	$202.1M	$12.3M	$12.4M	$12.4M
Investment Expenses	$213.0M	$231.8M	$184.6M	$183.3M	$129.5M	$145.1M
Administrative expenses	$56.7M	$54.6M	$50.4M	$48.7M	$51.4M	$46.4M
Income-Out	$4.638B	$4.571B	$4.283B	$4.101B	$3.888B	$3.770B
Net Income	$774.4M	$518.1M	$691.0M	$783.0M	$728.0M	$164.1M
Actual Cl. Bal.	$55.489B	$54.889B	$54.442B	$47.195B	$42.655B	$42.409B
Index/Core Cl.Bal.	$57.806B	$57.107B	$55.171B	$47.863B	$45.523B	$42.107B
Shortage	$2.317B	$2.217B	$0.749B	$0.668B	$2.868B	-$0.302B
Actual RR	-0.317%	-0.093%	13.850%	8.806%	-1.136%	19.391%
Index/Core RR	3.904%	3.981%	15.437%	10.373%	5.626%	18.537%

Rejection of Index Investing at the Common Investment Meeting - This is Fraud.

So, the Comptroller has convinced the five city pension boards to attend a combined investment meeting, “Common Investment Meeting - CIM”, every month. Interestingly, the Teachers Retirement System continues to hold additional separate investment meetings every month.

The CIM is similar to a lecture hall class with 200 students as opposed to an ordinary class with 15 students. There is a certain circus quality to the meeting. You can judge for yourself. The videos are on this link.

I recently watched the September 26, 2016 meeting run by Scott Evans. He is the head of the Comptroller’s Bureau of Asset Management (BAM) and is paid $350,000 per year. The five pension funds actually pay his salary through a non-governmental grant scheme to the Comptroller’s revenue budget but the pension funds have no control over his hiring.

Comments on Index Investing

At about one hour into the show Mr. Evans started to comment on a possible simple index stock/bond investment strategy for the city's pension funds as opposed to the “sophisticated” strategy that the funds have adopted and he supports.

While he was not clear about what he precisely meant by the index stock/bond strategy, I am assuming that he was referring to the index stock-R-3000/core+5 bond strategy that NYCERS was using to a large extent circa 2000.

As of June 30, 2000, NYCERS had assets worth $43B of which $21B was in a Russell-3000 stock index and $10B was in a core+5 (Treasuries, investment grade corporate bonds and agency/mortgage backed bonds bond strategy, all with terms 5 years or greater) strategy. Together the two components were 75% of the total portfolio.

Specifically Mr. Evans stated that the index strategy would produce acceptable results, simplify the investment process for the pension funds, allow the pension funds to shrink the staff at BAM and have shorter investment meetings. He, however, claimed that it would be more risky than the “sophisticated” strategy and he made some vague reference to possible draw downs problems but nothing else.

That is basically the end of his discussion on this topic. He provided no quantitative support for his position. He felt his comment was sufficient to dismiss the index concept. No trustee asked any questions in spite of the importance and value of index investing.

What he failed to mention, however, was the actual historical rates of return for the two strategies. He did not list the radical differences in external fees, internal costs and taxes between the two strategies. He made no mention of the liquidity, volatility, currency, political, and credit risks inherent in the “sophisticated” strategy. He also failed to mention the potential of the “sophisticated” strategy for improper political influence and corruption which has occurred in the state pension fund in Albany and other public pension funds around the country.

Some Actual Numbers

In an effort to provide some specifics let me give you some historical numbers. Over the last 20 years (1996-2016) NYCERS assets have increased at annual rate of 3.4% per year, from $27.98B to $54.55B. See below.

From 1996 to 2000, as I mentioned above, NYCERS followed an investment strategy that was roughly 75% in a index/core+5 strategy with the other 25% in more dubious assets. The annual rate of increase in the assets for those four years was 11.3%. As of June 30, 2000 there were almost no private equity investments (non-publicly traded assets) in the NYCERS portfolio.

Since 2000, the annual rate of increase in NYCERS assets, using the quarterly numbers, has been 1.51%. Since 2007, that rate has been 2.88%. Needless to say, 2000 was the advent of the “sophisticated” investment strategy. By 2008 NYCERS was hip deep in shit with only 56% in the index/core+5 strategy. You can see that the trustees are not totally crazy.

Since 2009, NYCERS assets have increased at a 9.5% annual rate but the S&P 500 stock index has increased at an even higher 12.5% annual rate. As of June 30, 2106 NYCERS had assets of $54.6B. That number, however, includes a $3.2B positive cash inflow from 2009 to 2015 and $9.9B in non-publicly traded assets. The quoted values of non-publicly traded assets are basically guesses of what they are worth and you know the real number is less than $9.9B.

Based on the NYCERS official financial statements, which are different from the Comptroller's quarterly reports, the opening balance on July 1, 1999 was $41.9B and the closing balance on June 30, 2016 was $55.49B. That is an average annual increase of 2.53% for the seventeen years. The rate of increase for the S&P500 index/core+5 bond strategy with a 60/40 stock/bond allocation over the same 16 years is 4.648%. That translates into a $81.0B closing balance for June 30, 2016. That is a $25.5B higher than what NYCERS actually had. The sum of each year's difference individually is over $16.2B but compounded over the 16 years it is $25.5B. This is a big step towards full funding for NYCERS but we should be very aware that even indexing does not hit the 7% assumed interest rate that actuaries dream about.

Bottom line, NYCERS almost certainly would be in far better shape over any span of time with the “unsophisticated” index/core investment strategy. Of course, Scott Evans would be working somewhere else.

Listed below are the June 30 NYCERS asset values since 1985 as reported by the Comptroller in the quarterly performance reports along with closing balances from the CAFR's and estimates of index returns from FY-2000 forward.

• Year - Quartely - CAFR CB - Indexing CB
• 1985 - $10.178B
• 1986 - $12.534B
• 1987 - $13.866B
• 1988 - $14.349B
• 1989 - $16.499B
• 1990 - $17.904B
• 1991 - $18.852B
• 1992 - $20.670B
• 1993 - $22.939B
• 1994 - $22.432B
• 1995 - $25.455B
• 1996 - $27.983B
• 1997 - $32.439B
• 1998 - $37.711B
• 1999 - $41.024B
• 2000 - $42.997B - $42.824B - $43.746B
• 2001 - $37.519B - $37.251B - $40.222B
• 2002 - $32.212B - $32.842B - $34.106B
• 2003 - $30.841B - $31.524B - $32.477B
• 2004 - $33,526B - $34.178B - $33.480B
• 2005 - $34.703B - $35.526B - $35.406B
• 2006 - $36.650B - $37.288B - $36.008B
• 2007 - $42.237B - $42.514B - $42.707B
• 2008 - $38.862B - $39.716B - $40.342B
• 2009 - $30.929B - $31.903B - $34.490B
• 2010 - $34.618B - $35.383B - $35.633B
• 2011 - $41.623B - $42.409B - $42.107B
• 2012 - $41,620B - $42.655B - $45.523B
• 2013 - $46.623B - $47.194B - $47.862B
• 2014 - $53.549B - $54.422B - $55.171B
• 2015 - $54.289B - $54.889B - $57.106B
• 2016 - $54.553B - $55.490B - $57.806B

A Message to the New NYCERS Chairperson

You have a huge problem. Your designated investment manager, the NYC Comptroller, is doing a terrible job with investing NYCERS assets, this Comptroller and the last three. NYCERS has an average annual rate of return over the last 15 years of 2.89%.

The Comptroller, however, has the backing of DC-37 which is the largest city union and also a NYCERS trustee. Between the three city unions on the NYCERS Board and the Comptroller these trustees control four votes, a majority of the total seven votes on the Board.

These votes control investment decisions, disability decisions, the NYCERS administrative budget and the budget subsidies from NYCERS to the Comptroller. The three unions are bound together because of disability votes at the Board. They need to back each other up to be able to get closely contested disability cases resolved in their favor.

Without the annual investment delegation from NYCERS Board of Trustees, the Comptroller has very little political influence. With the change in the City Charter in 1990 the mayor essentially controls the Comptroller’s administrative budget. This totally compromises his operating capabilities and his political influence.

If the Chair wishes to provide some relief to the mayor from the city’s huge pension burden, he will have to take away the Comptroller’s power over investment decisions.

This is a complicated task. Since 2005, DC-37 has run NYCERS as patronage mill for its flunkies. That starts with the executive director and spreads throughout the agency. This also includes regular employees who have criminal liabilities and are more than happy to do as they are told.

As the mayor’s appointee to the Board of Trustees, the Chair will need to take on both of these political entities. This will clearly be a hard fight. The investment issue cannot be resolved without addressing the investment delegation and the internal rot at NYCERS. The Chair will have to convince DC-37 that it is in its long term interest to reduce investment costs and raise returns. He will also have to commit to totally honest and sympathetic votes on disabilities that come before the Board of Trustees.

In return DC-37 and the other unions will have to not vote for the annual investment delegation to the Comptroller in June. It will also mean, however, that DC-37 will have to accept reform within NYCERS because the Comptroller will no longer have any incentive to allow NYCERS executive staff to run wild with the agency.

In eliminating the Comptroller from investment management operations the Board will have to hire a truly independent investment consultant and hire internal NYCERS staff to track investment activity. You can see why NYCERS also needs to be reformed. Current investment consultants under contract to NYCERS have structural conflict of interest issues involving the investment community. A large part of their revenue comes from the investment community.

While the Comptroller is the statutory custodian, he has contracted out almost all of its functions. The Comptroller has even turned over the the pension payroll operations to FISA, another city agency. There really isn't much left of the old Comptroller's Office. Ed Koch really did out maneuver Jay Golden.

The Trustees should set the target for total fee expenses at 10 basis points. That would have saved $130M in FY-2014 ($184M-$54M). The Trustees could then focus on a basic Russell-3000 US stock index fund & core investment grade bond Portfolio. Maybe the bonds could be indexed also. This will make running the portfolio and hiring staff much simpler.

Note: As of June 30, 2014 NYCERS had $11.8B in US equity index funds with annual fees of $500,000 for FY-2014 with an annual rate of return of approximately 24.5% gross of fees. But at 0.4 basis points the fees don't really effect returns. Yes, that is correct. NYCERS only paid a 0.4 basis point, not even half a basis point for that return. You can see why investment managers get nervous when you talk indexing.

The Trustees can then drop all the garbage asset classes listed below. This won’t be easy because of the crazy contracts the Comptroller’s office has signed in the past. I consider these contracts illegal because of the secrecy clauses.

Asset Classes to be Dropped:

NYCERS: Unproducive Investment Classes: Values and Fees for FY-2014

Asset Class	Fees Paid	Value as of June 30, 2014	Basis Points
Convertible bonds	$2.1M	$.5B	42
Bank loans	$3.1M	$1.0B	31
Emerging manager- US stocks	$4.4M	$1.0B	44
Emerging managers – Foreign stocks	$.3M	$.05B	60
Emerging managers – US bonds	not reported	$.1B	***
Private equity	$58.0M	$4.0B (guess)	145
Real estate	$20.87M	$2.3B (guess)	90
Infrastructure	not reported	$.02B	***
Hedge funds	$15.5M	$1.9B (guess)	82
Emerging market/active	$9.1M	$2.3B	39
Developed Market equity	$11.8M	$5.4B	22
Junk bonds	$6.9M	$2.1B	33
Opportunistic Fixed	$16.3M	$1.1B	148
Foreign bonds	$.4M	$.3B	13
Active US equity	$14.2M	$5.3B	26
TIP bonds	$1M	$1.5B	7
Subsidy to the Comptroller	$2.3M
Foreign taxes	$8.8M

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.