Monday, November 6, 2017

Big Bonuses at CalSTRS and CalPERS?

The Associated Press reports, California teacher pension executives get big bonuses:
Two top executives at California's teacher pension system are getting big bonuses worth more than $200,000 each following strong investment earnings.

The California State Teachers' Retirement System approved the bonuses without discussion Friday for Chief Executive Officer Jack Ehnes and Chief Investment Officer Christopher Ailman.

The bonuses amount to 53.5 percent of the base salary for each executive. Ehnes will get just under $225,000 on top of his base salary of $420,000. Ailman's bonus is $273,000 on top of his $510,000 base pay.

CalSTRS is the nation's second largest public pension fund with more than $215 billion in assets. Its investments earned 13.4 percent last fiscal year, beating a 7 percent target.

Bonuses are based on a formula in each executive's employment contract, which considers investment performance and personal performance. Ehnes is also evaluated on long-range strategic planning.

Ehnes is eligible for a bonus of up to 80 percent of his base pay while Ailman's maximum bonus would double his salary.

CalSTRS distributes retirement benefits for 900,000 teachers, retirees and their family members.

Pension executives are working to fill a nearly $100 billion gap between projected liabilities and assets. The Legislature in 2014 approved a funding plan that increases contributions from the state, school districts and teachers to fully fund the system by 2046.

The California Public Employee Retirement System, the state's other big retirement fund, also awarded bonuses to top executives this year following its own strong investment performance. Chief Investment Officer Ted Eliopoulos was awarded a bonus of $314,000, while CEO Marcie Frost got $80,000.
I read this article and thought to myself, big deal, compared to their large Canadian peers, CalSTRS, CalPERS and all large US public pensions grossly underpay their investment staff.

Of course, to be fair, there are a lot of reasons for this huge discrepancy in compensation, which I alluded to last week in my comment on whether Canada has all the answers:
Unfortunately, I don't see the US moving to the Canadian pension model anytime soon but if it did partially or fully privatize Social Security to adopt a similar CPP-CPPIB approach, it needs to ensure a few things first:
  • Get the mission statement right: What is the purpose of this new retirement system and how will the mission statement govern all activities at this new fund?
  • Get the governance right: Make sure the board overseeing this new pension plan is experienced, informed on all aspects (not just investments but HR, IT, etc.) and most importantly, independent. This board can then hire a CEO who will hire his or her senior team to carry out the day-to-day operations of this new pension. Most importantly, there can be no government interference whatsoever, and they need to get the compensation right to hire qualified staff able to bring assets internally and manage money at a fraction of the cost of outsourcing to external managers.
  • Get the risk-sharing right: If you look at the best pension plans in Canada, they have all adopted a shared-risk model which means higher contributions, partial or full removal of inflation-adjustments when the plan experiences a deficit or both. Investment returns alone will not be able to restore a plan's fully-funded status no matter how good the investment managers are. 
Now, there are a lot of other things that US plans need to get right, like lower their discount rate to estimate future liabilities which is still unreasonably high for many plans.

The biggest impediment for US plans to adopt the Canadian model is governance. I just don't see US public pensions doling out Canadian-style compensation packages to their public pension fund managers. It's never going to happen and there are powerful vested interests (unions, funds, etc) who want to maintain the status quo even if the long-term results are mediocre at best, especially compared to Canada's large, well-governed DB plans.

And by long-term results, I don't just mean performance, I mean funded status which Hugh O'Reilly and Jim Keohane emphasized in a joint op-ed they wrote last year. Long-term results matter but what ultimately matters most is a plan's funded status.

Now, it should be noted that Canada's large pensions have certain degrees of freedoms that their US counterparts don't have. They are piling on the leverage nowadays to take advantage of their pristine balance sheets which are a direct result of good governance, excellent risk management and to be truthful, a long bull market and investment policies that allow them to leverage their portfolio to improve overall risk-adjusted returns.

I also don't want to leave the impression that Canada's large pensions are perfect on the governance front and they can't learn anything from their US counterparts. This is pure nonsense.

Back in 2007, I did a study for the Treasury Board and can tell you in detail where Canada's large pensions can learn from the CalSTRS and CalPERS of this world. Things like better and more transparent benchmarks for private markets and better communication like public board meetings which are then on YouTube for everyone to see.
In terms of funded status, CalSTRS’ funded status fell to 64% as deficit grew to $21 billion following rate reduction at the end of March but that has improved somewhat since then as rates have risen and it posted a 13.4% gain as of the end of June (its fiscal year).

In a vote back in February, CalSTRS's board voted to lower the system's expected rate of return to 7.25% from 7.5%, starting July 1. It is part of a two-year plan to lower the rate of return to 7%.

CalPERS posted an 11.2% gain for its 2016-2017 fiscal year which also ends at the end of June and back in April, it lowered its assumed rate of return to 7.375% from 7.5%, which is why many California cities are now crying foul, warning next year's pension bill is not sustainable.

The biggest difference between US public pensions and Canadian ones is the latter use much lower discount rates (around 5% to 6.5%) to discount their future liabilities and they're still fully-funded or close to it.

Last week, David Crane, lecturer at Stanford University and president of Govern For California, wrote a comment, A Tale Of Two Public Pension Plans, comparing CalPERS to Ontario Teachers' Pesion Plan and rightly noting:
  1. Before the crisis C chose to employ a much higher discount rate — 50 percent higher! — that allowed it to hide the true size of pension obligations and to inadequately pre-fund those obligations, as explained here. C continues to employ a much higher rate than O.
  2. O requires employees to equally share pension costs with citizens and after the crisis made changes to un-accrued future benefits for retirees whereas C imposes most of the pension cost burden on citizens and made no changes to un-accrued future benefits.
But the issue of lowering the discount rate inevitably turns political in the US because unions and governments don't want to see their contribution rate increase. Also, in regards to CalSTRS, there are some who question whether it should use its growing reserve account to pay down its debt.

More importantly, however, the lack of a shared-risk model has really hampered US public pensions because it means US taxpayers are ultimately on the hook when plans experience severe deficits and aren't able to make their payments.

In Canada, the primary reason why our big public pensions are fully-funded or close to it is that their plans are jointly sponsored (unions and governments) and they equally share the risk of these plans when they experience a deficit.

In practice, what this means is when plans are in the red, contribution rates go up, benefits are lowered (typically by partially or fully removing cost-of living adjustments) or both until fully-funded status is restored.

Now, back to the "big bonuses" doled out at CalSTRS and CalPERS, you need to take this tuff with a grain of salt, and wait until CalSTRS's comprehensive annual report is available here and the same for CalPERS here.

From my quick glance at CalPERS's press release on FY 2016-2017 results and that of CalSTRS's press release on its FY 16-17 results, I can tell you there was solid performance all around (click on images of asset class returns for CalPERS and CalSTRS):



In fact, CalPERS's Private Equity performed quite well, gaining 13.9% in FY 2016-17 but underperformed its benchmark by 640 basis points while CalSTRS Private Equity gained 17.2%, outperforming its benchmark by 460 basis points. Obviously, there is a PE benchmark issue at CalPERS. No worries, Mark Wiseman and BlackRock will come to the rescue!

But information from these press releases isn't enough for me to discuss compensation and bonuses in detail. I need to compare 5-year returns at each fund relative to the benchmark and really drill down into the benchmarks used for each portfolio across public and private markets.

Still, it's clear CalSTRS is outperforming CalPERS and it's not only because of private equity. CalSTRS has more international equity exposure and different liabilities (taking on more risk to meet these liabilities so it's normal its returns are higher in a bull market).

The key difference will be when markets turn south because only then will we see who protects downside risks better.

Below, Ted Eliopoulos, CalPERS Chief Investment Officer, comments on the positive fiscal year returns and what it means as a long-term investor.

Also, once again, take the time to watch  HOOPP's Jim Keohane and OPTrust's Hugh O'Reilly discuss key differences between Canada's large public pensions and those in the US at last week's Brookings Institution event.

You can watch all the panel discussions here but I want you to focus on Hugh and Jim's comments because they explain key differences in governance behind the success of Canada's large public pensions. This is a great discussion which also covers compensation, listen carefully.

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