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Wednesday, August 28, 2013

Why PSPRS is paying out bonuses

PSPRS released this memo by Administrator Jim Hacking on August 16, 2013 in response to this August 11, 2013 Arizona Republic story, Arizona pension system gave out bonuses, by Craig Harris.  While Mr. Hacking is certainly more qualified than me to defend the bonus structure of PSPRS, I believe that some more explanation is needed.

Mr. Hacking brings up two important points in his memo.  The first is that PSPRS is competing for talent with other non-profits and the private sector.  This 2011 chart from Pensions & Investments lists the 50 top paid chief investment officers (CIO) of US tax-exempt organizations.  The list includes colleges and universities, charitable foundations, and pension systems.  The list was topped by the CIO of Harvard University's endowment.  In 2011, she managed an endowment of $27.6 billion and was paid $4.75 million.  Number 50 managed the Rockefeller Foundation's $3.8 billion and was paid about $590,000.  The Republic article lists PSPRS CIO Ryan Parham's current base salary as $254,000, which will increase automatically to $268,000 on September 20, 2013,  He will also be eligible for a $75,000 retention bonus a year after that if he remains as PSPRS CIO.  The combined assets of PSPRS, CORP, and EORP, which are administered together as one investment pool, equaled approximately $6.7 billion on June 30, 2012.

The list of the 50 top paid CIO's contained only two who managed pension systems, one who earned about $1 million managing Texas' $100 billion teachers retirement system and another who earned $608,000 managing Georgia's $46 billion teachers retirement system.  I do not know the average salary for the CIO of a public pension CIO nor do I know how to assess the quality of one CIO versus another.  However, just looking at his overall compensation, it seems that Mr. Parham's salary is not out of line.  The Republic article focused on bonuses, which makes readers understandably angry when they consider the underfunded status of PSPRS.  However, this brings us to the second important point in Mr. Hacking's memo.

Mr. Hacking just briefly touches on this point by highlighting the gains made with the implementation of a new investment strategy.  This is actually a much more crucial point, which he may not be giving the proper emphasis due to his apolitical position as PSPRS Administrator.  Since I do not have that problem, I can provide a little more history.

Below is a breakdown of PSPRS' investments as of June 30, 2008, just prior to the start of the Great Recession:

US Government Securities                    13.50%
Corporate Bonds                                  12.20%
Total Fixed Income                               25.70%

Common Stock                                     67.79%
Alternative Investments                            6.51%

Contrast this with the investment breakdown as of June 30,2012:

US Equity                                              19.71%
Non-US Equity                                       14.45%
Total Equity (Common Stock)                 34.16%

Fixed Income                                           13.86%

Global Tactical Asset Allocation (GTAA)     9.68%
Credit Opportunities                                    8.83%
Real Assets                                                6.39%
Private Equity                                           10.45%
Absolute Return                                         3.56%
Real Estate                                                13.07%
Total Alternative Investments                      51.98%

As can be seen, there has been a dramatic change in the investment strategy of PSPRS.  This coincides with Mr. Parham's promotion into the CIO position.  He was listed as interim CIO in fiscal year 2007 and 2008 reports, and he is listed as permanent CIO in the fiscal year 2009 report.

The initial asset allocation appears not much different than that of an individual investor with a split between stocks and bonds.  This is a legacy of the past investment strategy.  If we go back to June 30, 2000 before the dot.com crash, PSPRS' allocation was 77.61% common stock and 19.15% bonds, a nearly complete commitment to stocks and bonds.  This had been a successful for many years until the two market crashes last decade showed the folly of this strategy.

Looking even deeper into the investments PSPRS held on June 30, 2008, we can see the top five equity investments were in financial companies: Citigroup, Bank of America, National City Corporation, Washington Mutual, and Wachovia, representing over $425 million in investments.  National City, Washington Mutual, and Wachovia were all taken over by other financial companies with huge losses to shareholders.  According to PSPRS' 2009 report, the losses on these three companies alone were approximately $110 million.

Obviously, a huge portfolio like PSPRS' is bound to have some losers amongst it, but the real problem here was the over-concentration of PSPRS' portfolio in equities. This was the same problem after the dot.com crash.  Some have tried to lay the blame for those losses on former PSPRS Administrator Jack Cross, while conveniently forgetting the huge returns he produced for years using the same equity-heavy strategy.  Now the current bonus controversy is being used against Mr. Parham, and to a lesser extent, against Mr. Hacking.

The only criticism that could be leveled against Mr. Parham was that he did not change the balance of PSPRS' portfolio before the last market crash.  I do not know how aware he or Mr. Hacking were of PSPRS' perilous state in 2007 or 2008 or what their plan for PSPRS was at that time, but to expect some special prescience about the imminent market crash is absurd.  I do not know if it was even possible to rebalance the portfolio in time.  I suspect a process like this takes months, if not years, to accomplish as it entails consultation with advisors and buying and selling investments in an orderly fashion.

In the end, Mr. Parham's job has been to clean up a mess that was there when he took over as CIO.  It appears from the outside that no one responsible for PSPRS realized what the real problem was.  The dot.com debacle was followed by the same pattern of equity investment, I guess, with the idea that the previous losses would be more than made up in the next boom.  We all know how wrong that was.  Only now is an investment philosophy being put in place that recognizes that PSPRS can not just play the boom and bust cycle of the market.  PSPRS must try to maximize gains but not at the expense of losing capital.  That is what Mr. Parham is trying to do with the new asset allocation (For more information see this Institutional Investor article).

Those who are upset about bonuses need to understand that we will not see the real value of Mr. Parham's wisdom until another market crash.  Based on PSPRS' own amortization schedule, it will take years for PSPRS to reach full funding again, so to expect a bonus structure based on PSPRS' funding level is not realistic.  However, if Mr. Parham's strategy keeps PSPRS from being devastated again during the next crisis, he will have been worth every penny it took to retain him.  Of course, only time will tell how it works, but we do know the old strategy was a disaster.  It would be a shame if Mr. Parham was driven out by a penny-wise, pound-foolish lynch mob.

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