Finally, and most important, this month there is an election for one active, or contributing member seat on the STRS board—the outcome of which will be determined in early May. If the reform coalition candidate wins this seat, it’s likely control of the board will shift. Then the concerns of the state auditor and reform-minded members will be addressed regarding the need to restore transparency, lower investment fees paid to Wall Street, improve investment performance and move toward restoring benefits previously promised. If so, STRS Ohio’s participant-driven reforms may serve as a template for all of the nation’s public pensions. (On the other hand, if our request for public records is granted by the Ohio Supreme Court later this year—and court-ordered transparency ensues—there may be little need for board action because any mismanagement or wrongdoing will have been exposed to the public.)
But here’s the big picture: Since all public pensions in America have moved like a herd, pouring over $1 trillion into many of the same high-cost, high-risk secretive alternative investments, if any single state pension—such as Rhode Island, or Ohio STRS—restores full transparency and releases alternative investment information to the public revealing widespread industry abuses and violations of law, all participants in public pensions which have also invested in these funds, as well as taxpayers, will benefit. One obscure pension fund board vote in Ohio could ultimately force the transparency and accountability Wall Street has successfully resisted for decades.
The latest excessive fee suit targets “wildly excessive compensation,” an allegedly imprudent stable value offering, and the unmonitored use of “float” income.
More specifically, the participant-plaintiffs of Miami, Florida-based Lennar Corp. are raising issues with the recordkeeping/administrative fees (“wildly excessive compensation”) paid by the plan, the prudence of retaining Prudential’s stable value fund, and the use of float income by Prudential (the plan’s recordkeeper).
The lawsuit, filed in the U.S. District Court for the Southern District of Florida (Catenac v. Lennar Corp., S.D. Fla., No. 1:22-cv-23232, complaint 10/5/22), is directed at a plan with approximately $1.2 billion in assets and nearly 13,000 participants. The participant-plaintiffs are represented here by Morgan & Morgan PA.
Meanwhile, in Congress the Retirement Savings Modernization Act was just introduced to allow cryptocurrency and just about anything short of lottery tickets into America’s 401(k) accounts. The alternative asset industry — private equity, hedge funds, venture capital, real estate, and more — has been trying for years to offer their speculative products — and reap huge fees in the process — through personal retirement accounts as they are already able to do in some public pensions, such as Ohio’s.
There has been no legal barrier to these investments, and the Trump administration’s Department of Labor went so far as to specify that alternative investments could be part of 401(k)s, a decision affirmed by the Biden Administration. But companies administering 401(k) accounts are fiduciaries, and they’ve avoided alternative investments in fear of getting sued for breach of fiduciary duty for offering them to workers. For decades, prudence has prevailed and 401(k) retirement accounts have not allowed high-fee, illiquid funds as a 401(k) option.
The proposed bill simply states that alternative investments, despite the higher fees associated with them, are “covered” investments that do not establish fiduciary breach by their presence in a 401(k) plan. The cloak of congressionally created cover for alternative investments is needed because the current commonsense assumption is that the mere presence of these investments is strong evidence fiduciary duty has been breached.
Alarm bells should be ringing about the Ohio Police & Fire Pension following the release of a fiduciary audit of the fund, finished six years after the legal deadline.
Ignoring the law falls on the Ohio Retirement Study Council and their creator, the Ohio General Assembly. But the warnings on investment risk within the OP&F portfolio demand immediate, widespread attention.
The combined pension contribution for police is 31.75 percent of their salary and with firefighters the employer-employee combination is 36.25 percent.
Ohio Police & Fire is “clearly thinking outside the box,” according to Funston Advisory Services. “OP&F is among a very small number of major institutional investors to have adopted a risk parity investment approach across the plan’s entire investment structure,” Funston tells us. Ohio’s police and fire pension is also a pioneer in an investment strategy called “portable alpha.”
In each case, the characteristic that separates OP&F from the rest of the public pension pack is “meaningful use of portfolio leverage.” The Ohio safety forces pension is using one of the riskiest investment strategies in America. The 25 percent of leverage showing on the balance sheet is actually much higher because the alternative investments also include leverage.
The entire portfolio is managed by outside managers, 135 fund managers by our count, who pulled down “mind boggling” fees according to pension expert Richard Ennis. If Mr. Ennis’ name sounds familiar you probably remember he was the expert Ohio turned to for comprehensive analysis of the Coingate scandal at the Ohio Bureau of Workers Compensation. Mr. Ennis gave us an assessment of the OP&F performance over the last 10 years that indicates the pension matched the results of an index fund despite the high fees.
If you followed the saga of the route to passage of the Inflation Reduction Act, you already know that a last-minute maneuver by Arizona Sen. Kyrsten Sinema torpedoed a provision in the Senate compromise bill that would have finally closed the so-called “carried interest loophole.” That’s where savvy real-estate financiers and managers of private partnerships such as hedge funds and private equity deals are able to cut their income taxes as much as 40 percent by masquerading their compensation as a capital gain that enjoys much lower income tax rates.
Public pension funds, public employees and their associations need to put a stop to this, and they have both the moral high ground and the clout to do so. It’s high time for political and financial blowback. The PR firms orchestrating this nonsense will just keep it up until their profiteering clients get called out.
The reality is that if the fund managers had to pay standard tax rates on their income, it would have zero impact on pension systems’ returns. What are the managers going to do? Cook up fewer deals? Pull up stakes and move to a tax haven? Demand even higher fees on top of their already cushy income? They can huff and puff all they want, but pensioners would lose nothing if the loophole were plugged.
In the name of preserving carefully negotiated legislation, Senate Democrats’ leaders united their caucus to vote down amendments that would have added the party’s Medicare expansion plan and expanded child tax credit into the final spending bill now moving through Congress.
That unity, though, was not universally enforced: soon after those votes, seven Democratic senators joined with Republicans to cast a pivotal vote shielding their private equity donors from a new corporate minimum tax.
The seven Democrats who joined the GOP to give private equity firms that $35 billion gift were: Senators Kyrsten Sinema and Mark Kelly of Arizona, Raphael Warnock and Jon Ossoff of Georgia, Jacky Rosen and Catherine Cortez Masto of Nevada, and Maggie Hassan of New Hampshire.
Five of the seven Democrats are among the Senate’s top recipients of campaign donations from private equity donors, according to data from OpenSecrets. The group collectively raked in more than $1.4 million of campaign cash from the private equity industry, which has become a huge source of capital for the fossil fuel conglomerates that are creating the climate crisis.
The contrast between voting to protect private equity donors and voting against programs for the working class effectively screamed the quiet part out loud about whom senators typically respond to — and whom they don’t.
In this case, Democratic and Republican senators responded to the demands of an industry that has not only spent more than a quarter billion dollars on the last two federal elections, but that also employs an army of government-officials-turned-lobbyists to influence lawmakers in Washington. The world’s largest private equity firm is headed by one of the Republican Party’s largest donors, and now employs the son-in-law of Senate majority leader Chuck Schumer as a lobbyist.
CalPERS is so reliably bad at market timing that the giant fund serves as a counter indicators. Last fall, CalPERS increased its allocation to private equity from 8% of its total portfolio to 13%, which is an increase of over 50%. This is after this humble blog, regularly citing top independent experts, pointed out that the investment raison d’etre for private equity had vanished in the 2006-2008 time frame, not once, but many many times as various studies kept confirming that finding. Not only did private equity no longer earn enough to compensate for its much higher risks (leverage and illiquidity) but it was no longer beating straight up large cap equities.
Now there is a way out of this conundrum: to bring private equity in house. Private equity fees and costs are so egregious (an estimated 7% per annum) that even a bit of underperformance relative to private equity indexes will be more than offset by greatly lower fees. A simpler option would be public market replication of private equity.
But the dogged way funds like CalPERS stick to private equity points to rank corruption, of the sort that landed CalPERS former CEO Fred Buenrostro in Federal prison for four and a half years.
Another problem is cash flow management. Private equity funds do not take investor money at closing. Instead, investors get “capital calls” to pony up part of their commitment to the fund so the fund manager can buy a company. These capital calls require the dough to be sent as specified in the offering memorandum, usually in five to ten days. The consequences of missing a capital call are draconian. The fund manager can seize all the investments made so far and distribute them to the other limited partners.
In the financial crisis, CalPERS had too little cash on hand to meet private equity capital calls. It wound up dumping stocks at distressed prices to satisfy the private equity demands. So the risk outlined below is real.
A new era in the decade-long battle by retirees and whistleblowers to halt massive transfers of wealth out of retirement funds and into Wall Street firms could be at hand, thanks to the case of Katie Muth.
Muth, a Democratic Pennsylvania state senator, is one of fifteen trustees who oversees Pennsylvania’s largest public pension fund, the Pennsylvania Public School Employees’ Retirement System (PennPSERS). Not long after her February 2021 appointment to the board, Muth began questioning the fund’s investments in areas like private equity, hedge funds, and real estate.
Over the past thirty years, public pension funds have moved $1.4 trillion of retiree savings into such high-risk, high-fee “alternative investments,” enriching finance industry moguls like Stephen Schwarzman of the Blackstone Group and Robert Mercer of Renaissance Technologies while often shortchanging retired public employees and teachers.
But Muth says that when she asked the fund’s investment staff for more information about its high-risk investments, she was rebuffed — so in June 2021, she sued the fund for basic information about its investments.
First, the illiquid and long-term nature of the private equity asset class, significant dispersion in returns across funds, as well as bilateral and relationship-driven fundraising, creates scarcity in access to individual funds, giving private equity funds the bargaining power when splitting the returns. As the industry’s growth deaccelerates, the pendulum of bargaining power will start to shift to limited partners, but more permanently than what we saw during the GFC.
Second, we will see larger scrutiny of the cost structure and the industry’s value-add. Put simply, it is an expensive asset class, with the net returns to limited partners lacking consistency in beating public benchmarks (e.g. Harris et al. 2014).3 A central tension is large funds’ management fees, which typically run at 1.5% to 2% of committed capital already in the first five years of the fund life.4 This structure is lucrative for managers but underscores the disconnect between the private equity firm’s income stream and its fund performance, especially for large funds.
Third, such pressures would make new and smaller funds particularly vulnerable. The proliferation of new funds, especially generalists’ funds, in the past decade was partly explained by the strength of capital flow and investment managers’ desire to capture a more significant share of fund economics. These funds have a higher embedded cost structure. Larger funds, therefore, have more room to compress the fees and have a higher ability to experiment in the investment space. All this gives larger-scale firms a better chance to withstand adverse pressures, resulting in market consolidation.
These findings suggest that PSERS is not likely to achieve even a 6 percent average return over the next 10-15 years—much less its current assumed return of 7 percent. This suggests there is a high probability that the public pension plan’s unfunded liabilities could get worse, not better, in the near-to-mid term. This underperformance—relative to the plan’s own return rate assumptions—will make the system’s long-term solvency challenges even larger.
In a matter of fact, understated manner, the SEC document makes clear that its enforcement regime has not succeeded in getting private equity fund managers to stop or at least considerably reduce their abuses. Recall that in 2014, then enforcement chief Andrew Bowden gave a peculiarly titled speech, Spreading Sunshine in Private Equity. The SEC has just started its initial examinations of private equity firms. Bowden said that the SEC had found serious abuses in more than half of the firms examines, including what in other circles would be called embezzlement. Bowden also said if anything the misconduct was more prevalent at the biggest firms, which was the reverse of what it found in other areas it regulated, where the crooked operators were normally boiler-room level.
This promising start quickly fizzled out. Yes, the SEC did engage in a series of enforcements actions, targeting common abuses like charging “termination of monitoring fees” which had never been contemplated in the fund agreements, and hauling up big name firms like Apollo, KKR, and Blackstone. However, this amounted to enforcement theater. The SEC acted as if “one and done,” citing particular firms for an isolated abuse, when all the big players were certain to have engaged in many others, and then acting as if everyone would shape up, was either craven or willfully blind. Bowden immediately turned to giving speeches on how private equity firms were obviously upstanding and wanted to do right. He then gave a speech at Stanford at a private equity conference where went on far too long about how he wanted his son to work in private equity and an audience member immediately said he wanted to hire him. Bowden left the agency in three weeks.
This SEC letter, by contrast, makes clear that the agency has ample evidence in its files of continued abuses by private equity fund managers. It does not mention a particularly egregious general strategy: of admitting in the annual disclosure documents, the Form ADV, that the private equity fund managers are violating their contracts with investors. Admitting a contractual violation does not cure it, but the private equity barons appear to believe they can create their own alternative reality. And until Gensler showed up, that belief looked to be correct.
Seven hundred and forty-four million dollars. That is the amount of Wall Street fees paid by the Maryland state pension plan for investment advice in fiscal 2021.
Over the past 10 years, the fees totaled roughly $4.5 billion, or about 15 percent of the plan’s earnings. For that kind of money, you would think the state gets only the prime stock and bond picks from its advisers, but, during that time, Maryland, as with most other states, failed to beat the returns of a simple 60 percent stocks/40 percent bonds index. Many large institutional investors, including public pension plans, use this 60/40 index as a barometer to gauge their portfolios’ results. They structure their portfolios to avoid a 100 percent exposure to the sometimes volatile stock market. If their results are better than the index for a given year, they claim success. Many mutual funds attract smaller individual retail and 401(k) retirement accounts by copying the index and charging low fees for passive management.
This drainage damages the financial security of public workers in Maryland and other states, and it forces greater taxpayer contributions to the plans. The ongoing situation has a secondary effect as well: The massive wealth transfer — from public workers and average taxpayers — to a small coterie of Wall Street money managers fosters a new plutocracy, successful at obscuring the problem and blocking reform.
The obvious fix for public plans is to shift from expensive fee investments to low-fee indexing, a tactic endorsed by none other than Warren Buffett, the noted value investor and philanthropist. For large public plans, including Maryland’s, this shift, if implemented, would be gradual. Extricating the fund from its long-term contractual commitments and replacing them with passive investments is going to take time.