One of the consistent themes we have talked about here over the last few years is the concept that Return On Investment (ROI) assumptions for all the state pension systems is too high. What we mean by this is we do not think that any investment style will allow 8% plus returns over a long period of time. Currently the Teacher Retirement System is assuming an 8% ROI over the next 33 years, down from 8.5% previously. GASB (Governmental Accounting Standards Board) thinks it should be 5.1% and Moodys thinks 5.5% for comparison.
One good way of examining investment style is what TRS calls “Investment Allocation” which shows the breakdown in investments for a given year. By examining this Investment Allocation over time we can see how the direction of investments made by the various pension systems varies as they attempt (I would say “struggle”) to achieve their high ROI assumptions.
The pension trustees are ultimately responsible for achieving the investment assumption though they hire mangers to achieve those goals rather than actually making the investment decisions themselves. This of course also allows them a convenient scapegoat for ROI failures. “We hired the best and they didn’t do their job” etc. etc. But in the end the trustees are the ones who have fiduciary responsibility and should be kept or fired based upon the success or failure of the ROI. Right now it looks like they should all be fired.
By law 6 of the 13 trustees must be teachers either active or retired, one is the state superintendent of education and the other 6 are appointed by the governor.
High ROI assumptions require risky investment strategy – how prudent men become imprudent.
For decades trustees for pension funds have strictly interpreted the “prudent man rule” i.e. an investment manager/trustee should invest in the safest investments possible and above all remember “speculative or risky investments must be avoided” in order to maintain assets for the benefits of the members. The “prudent man rule” has not changed since 1959. It resulted in a typical 2/3 bonds and 1/3 equity investment style.
Then about 1970 the teacher unions represented in IL by the IEA (Illinois Education Association) began to have undue influence on state politicians resulting first in the constitutional pension guarantee and subsequently 43 years of ever increasing pensions and benefits for teachers via TRS. The only way you can justify the higher pension payouts is to assume a higher ROI, and the higher risk associated with that higher rate, and if for some reason it doesn’t work out Oh well, the mistake is paid for 100% by taxpayers not teachers. Heads we win, tails we win too.
So to justify this new ill-prudent policy they came up with the “Prudent Investor Rule”:
The logic is this: an asset may be too risky to put all your money in (thus failing the Prudent Man Rule) but may still be very diversifying and therefore beneficial in a small proportion of the total portfolio.
But who is to say what is “too risky” or who can define “small proportion”? Ultimately the trustees are responsible and that is why they are the fiduciaries and have the legal liability that goes with fiduciary responsibility. Of course elitists like trustees and politicians are smart and always find ways to protect themselves with processes and words. The current word in prudent man rule is “benchmarking”. If you can get every other pension fund, who by definition are the current universe of “prudent men”, to agree what is “prudent” including options, futures, options on futures and derivatives then you have covered your butt. You can, thanks to the approval of your peers, “prudently” do options, futures, options on futures and derivatives transactions that every stock broker and investment advisor would consider to be wild and crazy for the average investor.
Of course you don’t invest in those risky assets directly that would be too risky, legally speaking. So you invest in hedge funds or special investment vehicles that do it for you while offering another layer of legal Kevlar. Everybody is protected except the taxpayer.
So that is how wild and crazy investments become prudent investments. Just make stuff up and have lawyers who are politicians pass laws that make it so.
All benchmarking does is protect the guilty and assures the simultaneous collapse of all pension funds when the next financial collapse occurs because they all invest the same way just to avoid legal liability.
How does TRS’s 2000 investment allocation compare with 2012?
The up-scaling of investment risk is obvious from the following chart which shows investment allocation in 2000 vs. 2012.
As can easily be seen safe Fixed Income (bonds and cash) has dropped by about 60% while private equity (remember Mitt Romney’s Evil Empire?) has tripled and Total Return plus Absolute Return have gone from zero to 15%. The final two items are those that usually involve some sort of options, futures, options on futures and derivatives transactions. Warren Buffet once famously called derivatives “financial weapons of mass destruction.” Clearly the trustees and TRS itself are stretching investment risk to reach what most people would consider to be unattainable ROI. And they almost certainly not make it.