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Was it constitutional for Proposition 124 to replace PSPRS' permanent benefit increases with a capped 2% COLA?

In this blog I and multiple commenters have broached the subject of the suspect constitutionality of PSPRS' replacement of the old perma...

Wednesday, October 3, 2018

PSPRS is number one! (in investment management fees, of course) plus investment returns through July 2018

Some of you may have received a recent email from PSPRS with this bit of information:

PSPRS generates $660 million in returns for FY18 

7.8 percent gross return rate helps trust tops $10 billion in assets 

ARIZONA – Arizona’s Public Safety Personnel Retirement System netted investment returns of nearly $660 million over the last fiscal year, with the help of strong performance by the trust’s public and private equity assets.
The fund’s investments generated a gross return rate of 7.8 percent for the year, helping the system, which serves more than 55,000 members, top the $10 billion mark in assets under management for the first time in its 50-year history. Net of fees, the overall returns stood at 7.1 percent for FY2018.
“Our investment team has made enormous strides in building a portfolio capable of producing solid returns while we take less risk than the vast majority of our peer funds,” said PSPRS Board Chairman Brian Tobin.  “It can be hard to show the value of a low-risk approach in a bull market but we have to keep perspective if we want to avoid the same mistakes that led to significant losses in the past. This strategy protects our members, Arizona employers and millions of taxpayers while the system continues to recover.”
Investments in private equity made possible by 2008 changes to state law have performed admirably by exceeding benchmarks based on the Russell 3000 index, which has grown steadily during the nation’s historic bull market featuring positive returns for most of the last decade.
PSPRS investment returns in asset classes including private equity, fixed income, private credit, global trading strategies, real assets and risk parity continue to meet or outperform long-term benchmarks, while overall returns were hampered by pre-recession joint venture real estate investments.
“Our portfolio is built around the fact that we need to invest responsibly because losses over the course of even a single year could prove disastrous for some employers and potentially harm our ability to meet our obligations to retirees,” said PSPRS Chief Investment Officer Mark Steed. “This requires a balanced strategy across multiple asset classes and far less reliance on the stocks and bonds that make up the typical investment portfolio.”
The 2018 fiscal year returns are below the 9 percent threshold required under state law to trigger pension increases for retirees of the Corrections Officer Retirement Plan and the Elected Officials Retirement Plan.
PSPRS investments generated just under $3 billion of investment returns over the past five years. Retirement plans managed by PSPRS typically distribute about $1 billion of retiree, survivor and disability benefits each year.
While we should not be surprised considering this comes from PSPRS' management, this press release is deceptive from nearly the beginning.  The sub-headline trumpets a "7.8% gross return rate," (actual was 7.76%) and you need to look into the second paragraph to see that PSPRS paid 0.7% in investment management fees and only earned 7.1% (actual was 7.07%) for fiscal year (FY) 2018.  This is 0.3% below PSPRS' assumed rate of return (ARR) for FY 2018, and 0.64% below its own benchmark of 7.74%.  If PSPRS included this information, the "7.8%" and "$660 million" figures do not look quite so good.  Even worse, PSPRS is paying more in investment fees than it has in past years, 0.69% in FY 2018 versus 0.63% in FY 2017.

The FY 2017 annual report states that PSPRS' assets were $9.3 billion as of June 30,2017.   For comparison the Arizona State Retirement System (ASRS) earned 9.5% in FY 2018.  If PSPRS had earned that additional 2.4%, it would have increased PSPRS' assets by $223 million.  In FY 2018, PSPRS paid $65 million in investment fees to earn $223 less than if ASRS had been managing PSPRS' assets.  Over the past ten years, ASRS' annualized returns were 1.9% per year higher than PSPRS' (7.4% versus 5.5%).  That additional 1.9% per year on $9.3 billion in assets would be worth nearly $2 billion in ten years, yet we keep hearing the same tired explanations from the likes of Board of Trustees Chairman Brian Tobin and new Chief Investment Officer (CIO) Mark Steed that PSPRS is well prepared for the next market crash.

PSPRS has already missed the last ten years of the current bull market during which the Russell 3000's annualized return was 10.24%.  I am not saying that PSPRS should simply invest all its money in the Russell 3000, but based on ASRS' results, it is obvious that there is a better strategy out there already being executed (within just a few miles of PSPRS' offices, I might add).  Look at ASRS' annual returns over the past 36 years.  Even after the rough patches in FY's 2000 and 2001 and FY's 2008 and 2009, ASRS more than earned back all it lost and more during each of the two fiscal years following 2000-01 and 2008-09.  Market downturns are unavoidable, but as ASRS shows, they are manageable.  On the other hand, like generals preparing for the last war, PSPRS' management is preparing for the last market crash.

PSPRS' own analysis shows that while they are only suffering 31% of market downside, they are only getting 44% in market upside.  If we look again at ASRS' returns over the last 36 years, there were 31 years of positive returns, with 20 of those years producing double digit returns, versus only five years of negative returns with only one year of double digit losses.  Capturing only 44% of those 31 years of positive returns to limit  PSPRS to only 31% of the losses in the five down years is not a good tradeoff.  Ben Carlson of A Wealth of Common Sense has a longer historical perspective on markets and the unpredictability of market crashes and bull markets.  Whenever Mr. Tobin and Mr. Steed, PSPRS Adminstrator Jared Smout and recently retired CIO Ryan Parham speak about PSPRS' current investment strategy, it always sounds like they are longing for another market crash that will validate the strategy, but I think the verdict is already in.  PSPRS' current investment strategy is a failure.

However, PSPRS does have one dubious achievement it can claim.  On September 26, 2018, the Pew Center for the States reported in its State Public Pension Funds' Investment Practices and Performance: 2016 Data Update that PSPRS paid the highest external management fees of the 44 funds that report returns, net of fees, for FY 2016.  As a percent of assets, PSPRS paid 2.23% in external management fees.  Not only did PSPRS top the list in external management fees paid, it ran away with the title, more than doubling second place South Carolina Retirement Systems, which paid 1.00% of assets in external management fees.  ASRS paid 0.49% of assets in external management fees in FY 2016.  Of the 44 pension funds listed, PSPRS was 42nd in 10-year annualized returns.  ASRS was 9th.  PSPRS also had the highest investment expenses at 1.76% of assests; ASRS was at 0.59% of assets.  These achievements all occurred in a fiscal year in which PSPRS earned a whopping 1.06%.

When I read that Mr. Parham was retiring as PSPRS CIO, I was hoping that he had been finally been forced out due to his consistent record of poor results and that more significant changes were in the offing .  However, that does not appear likely.  PSPRS' Board of Trustees has promoted his Deputy CIO Mark Steed to replace him, so we can expect PSPRS to continue with its failed investment strategy.

Finally, the following table shows PSPRS' investment returns, gross of fees*, versus the Russell 3000 through July 2018, the first month of fiscal year (FY) 2019, with the past five FY end returns included for comparison:

Report PSPRS PSPRS Russell 3000 Russell 3000
Date Month End Fiscal YTD Month End Fiscal YTD
6/30/2014 0.78% 13.82% 2.51% 25.22%
6/30/2015 -0.73% 4.21% -1.67% 7.29%
6/30/2016 -0.32% 1.06% 0.21% 2.14%
6/30/2017 0.22% 12.48% 0.90% 18.51%
6/30/2018 -0.66% 7.76% 0.66% 14.78%

7/31/2018 1.03% 1.03% 3.32% 3.32%

There is usually about a two-month lag in PSPRS reporting its investment returns.

There is not much to comment so early in the fiscal year, but we once again see PSPRS lagging the Russell 3000.  For the 2018 calendar year, the Russell 3000 has returned 6.64%, double the 3.30% return of PSPRS over the same seven months. 

* Returns, gross of fees, are used because PSPRS usually does not report returns, net of fees paid to outside agencies, except on the final report of the fiscal year.  Returns, gross of fees, are used in the table for consistency.  Returns, net of fees, were 13.28% in FY 2014, 3.68% in FY 2015, 0.63% in FY 2016, 11.85% in FY 2017, and 7.07% in FY 2018.