The most recent headlines from the world of public pensions are about “pay to play” and “placement agents.” Before that was Bernie Madoff, market timing, Enron and Orange County. The list goes way back. Public pensions are run by boards of trustees. (Sometimes there is only one member of the board.) What has not really been talked about is the role trustees played in these scandals.
Bernie Madoff, Ponzi schemes, dark pools and breach of trust
Suppose you and three other investors each invest one million dollars in a hedge fund. After a year, the fund managers tell each of you that your money has doubled to two million dollars. So, the fund should have eight million dollars of assets. However, because the managers either invested poorly or embezzled from the fund, it actually has only four million dollars. You ask to withdraw the two million of principal and income they say you have. Because the fund has four million dollars, it can pay you, but it is paying you with other people’s money, not your own. If a second person asks to withdraw two million dollars, the fund can pay that, too. But if a third investor asks for his two million dollars, the scheme collapses because there is no money left. The managers of the fund make money either by embezzlement or by charging investors inflated fees on investments that are not there. This kind of thing is known as a Ponzi scheme because of a particularly famous one, run by Charles Ponzi in the 1920s. Ponzi schemes are illegal.
In the United States, mutual funds are required to give investors lists of the securities their money is invested in. However, not all kinds of funds are required to reveal their investments. One that does not is known as a “dark pool” in the jargon of investments. In effect, the manager of a dark pool says, “I’m not going to tell you what I am doing with your money. Just trust me.” Hopefully, the vast majority of dark pools are legitimate. Nevertheless, running a Ponzi scheme is clearly easier with a dark pool.
Bernie Madoff’s version of a Ponzi scheme was different in the details, but the basic concept was the same. He told investors they had more money than they really did, and he covered it up by paying them with other people’s money. Prosecutors estimate investors, including public pension plans, lost over $60 billion, making Madoff’s the largest known Ponzi scheme in history. Madoff’s version was also a dark pool.
Individuals can invest their own money however they want. Trustees of public pension plans are investing other people’s money. The law requires them to be prudent. Among other things, this means they must be diligent and careful. Investing in a dark pool is not being careful or diligent; it is being lazy. At best it is poor management, and, in my opinion, it is a breach of the legal duties of a trustee. Bernie Madoff is not the only one to blame for the losses.
Pay to play, placement agents and bribes
Suppose you are an investment management firm under consideration for a contract with a public pension plan. You get a call from a trustee of the plan asking you to make a contribution to somebody’s election campaign. Maybe the trustee is the state treasurer and is asking for a contribution to his own campaign. In most states, such campaign contributions would not be illegal. Unfortunately, too many investment management firms make the contribution.
Perhaps there is no request. An investment firm can look at campaign contribution lists. They can see investment companies from the East Coast making campaign contributions to the treasurer of a western state. Or they can see the spouses of employees of a West Coast company making campaign contributions to a governor in the Midwest. Too many investment firms believe they must do the same if they want business with public pension plans in those places.
In some cases the investment firm pays commissions to “placement agents” or “introducing agents” if they are awarded the contract. There is nothing automatically wrong with paying a commission to salespeople, whether employees or contractors. However, if the salespeople are also advisers to the pension plan, or trustees of the pension plan or related to a trustee of the pension plan, then the commission is really a bribe or a kickback. In the jargon of the investment world, these payments are called “pay to play.”
Sometimes pay to play is illegal. The Carlyle Group has paid $20 million to settle charges by the New York Attorney General. Elliot Broidy has admitted paying over $1 million to people associated with the New York state pension plan, and he has pled guilty to felony charges. Terrance Gasper is in jail for accepting bribes in return for investment business while he was at the Ohio Bureau of Workers’ Compensation.
Often, pay to play is legal. The California Public Employees’ Retirement System and the California State Teachers’ Retirement System, each of which has well over $1 hundred billion, both tried to impose policies banning campaign contributions to those in a position to influence their investment decisions. The policies were challenged in court and overturned. Most states have little effective control on pay to play.
The Securities and Exchange Commission (SEC) has proposed a ban on placement agents. This will not stop pay to play; it will only change the superficial details of how the bribes and kickbacks are paid.
If you think pay to play isn’t happening in your state, you better look at the campaign contribution lists. Pay to play is a widespread problem.
Market timing and breach of trust
In some contexts, “market timing” means forecasting whether the stock market, or some other market, will go up or down, then buying or selling stocks accordingly. Although difficult to do well, this is a legitimate exercise.
A few years ago a different practice came to light that was also called market timing. Ordinarily, when you buy or sell shares of a mutual fund, the price of the fund shares will be based on the next closing price of all the securities it holds. However, in certain circumstances, the price of the fund shares was based on the last closing price of the underlying securities. In this context, market timing is not based on whether you think the market will go up or down; it is based on whether you know the market has already gone up or down. If you knew how to do this kind of market timing, you were almost certain to make extra money. This extra money came out of the pockets of all the other investors in the mutual fund.
If this kind of market timer is just an ordinary investor in a mutual fund, we might call this savvy investing, a sharp practice or unethical behavior, depending on our own standard of behavior. However, in some cases those mutual funds were being used by pension plans, and the market timers were pension plan trustees. Pension plan trustees are require by law to behave in the best interests of the participants of the plan. Instead, they were picking the pockets of their pension plan participants.
Contribution rates, mismanagement, self-interest
Money doesn’t grow on trees. Over time, the following must be true: Total contributions to a pension plan plus net investment earnings of a pension plan equals total pensions paid. In order to calculate what contribution should be made this year, trustees must estimate what future investment earnings will be. They do this by making an assumption about what rate or return they will get on the investments in the future. The higher the assumed rate of return, the lower the current contribution.
Public pension trustees have an incentive to keep contributions low. High contribution rates mean higher taxes. Trustees that are elected officials have an obvious incentive to keep the tax rate low for current voters. Trustees that are appointed by elected officials often have the same incentive. Trustees that are participants in the pension plans have an additional incentive. Low contribution rates make state, school districts or municipalities more likely to agree to increased pension benefits.
Most trustees justify a higher return assumption and low contribution rates by arguing that a pension plan is a long-term investor. There is good reason to believe that riskier investments will probably have higher returns over long periods of time than safer investments. (This is known as the risk versus return trade-off.) Because a pension plan is a long-term investor, it can ignore short-term market fluctuations and invest a large portion of its assets in riskier investments. In turn, this justifies using a high rate of return to calculate contributions.
There are two problems with this argument. The first is that it motivates trustees to take more and more risk with the investments. The more risk they take, the higher the return they get to assume when calculating contributions, and the lower the current contribution rate.
The second problem is that it leaves future taxpayers holding the bag. Current taxpayers enjoy low contributions because of the high assumed rate of return. If the investments do earn a high rate of return, future taxpayers will also enjoy low contribution rates. But if the investments do not earn a high rate of return, future taxpayers must cover the loss. (For some public pension plans, future plan participants must also cover some of the loss.) In effect, future taxpayers are providing the pension plan a guarantee that the stock market will have high return.
This is excessively unfair to future taxpayers. They receive no benefit for providing this guarantee. By comparison, an insurance company would charge a lot of money for such a guarantee. In order to be fair to future taxpayers, trustees should assume their investments will get a lower rate of return than what they think the investments will probably earn. With a lower assumed rate of return, current taxpayers must pay a higher contribution. This means that future taxpayers will probably pay a lower contribution. (To see why, look back at the “money doesn’t grow on trees” equation.) If the investments do poorly, future taxpayers will still have to cover the loss. But at least they are compensated for this risk, because they probably will get to pay a lower contribution.
These are complex, theoretical arguments. Nevertheless, they have a great practical importance. The incentives were different in the private sector, but for many years private-sector pension funds took too much investment risk and had too small contributions. Most private-sector pension plans now have been replaced with 401(k) savings plans. In the public sector, taxpayers are now having to cover losses from the bear market of 2008 and 2009. In response, politicians in many places are proposing that public pension plans be replaced with the public-sector equivalent of 401(k) savings plans.
The laws pertaining to public-sector plans and the strength of public-sector unions make this difficult but not impossible. Governments may even resort to using bankruptcy courts to help accomplish the change. Some people argue that states or even municipalities cannot really go bankrupt. I wonder if they have any idea how much they are betting that they are right.
There are many more examples. The following kinds of public pension plan programs all probably have at least a few examples of fraud or mismanagement: socially motivated investing such as Sudan divestiture, economically targeted investing, emerging manager programs, bundled defined contribution plans (including college savings plans), infrastructure investment, investing in employer stock and corporate governance initiatives. The opportunities for fraud and mismanagement are wide and deep.
The underlying problem
The common feature of all these scandals is the trustees not doing their jobs right. Public pension plans can be huge. Most state plans have assets exceeding $10 billion. Trustees who deal with ethical problems by asking only “is it legal?” should not be trusted with this amount of money. Trustees who do not thoroughly understand the contribution calculation and the associated intergenerational issues are not knowledgeable enough to make good decisions about how to fund a huge pension plan. Trustees who cannot thoroughly explain the pros and cons of using index funds have no business hiring investment managers.
I am sorry to say that not even half of the public pension plan trustees I have had contact with are qualified. I do not believe this will change as long as boards have elected officials on them, including those elected by employee groups. I do not believe this will change as long as the main qualification of an appointed trustee is that he or she is a successful campaign fundraiser. I do not believe this will change as long as there is no effective way of removing trustees who do not maintain a high ethical standard and a high level of competency.
Without high-quality trustees, public pension plans will eventually be mismanaged and pilfered to death. Both public-sector employees and taxpayers will pay the cost.