Friday, October 24, 2008

It Goes Both Ways

In her blog, retired Ohio teacher Kathy Bracy has published a string of posts in which she and others are outraged that the State Teacher's Retirement Fund has lost a pile of money in the stock market and other investments of late. In their latest blog, they're crying for the suspension of bonus payments to STRS executives "during this time of economic upheaval."
First of all, one would presume that the bonus packages paid to these managers would be based on how they performed over some period of time, meaning you wouldn't pay them any bonus unless the investment portfolio had grown in value by the target amount. So my first assumption is that these bonuses are set to be paid because the STRS portfolio generated very good returns their last fiscal year. Presumably the STRS members have been happy to pay bonuses to these folks in the past, and would have been happy to pay out these bonuses as well had the stock market not tanked.
So now the STRS members want to reach back a year and take money away from managers they hired to generate those results. The justification is that this year is going to suck, and a lot of money has been lost, so therefore the managers should sacrifice bonuses they have already earned…
… in order to pay to the retired teachers benefits they feel they have already earned. Seems duplicitous doesn't it?
Americans have been feeling pretty cocky about their stock market skills. After all, they've seen their portfolios climb steadily over the past 30 years since the development of the 401(k), albeit with a couple of bumps along the way. Little did they understand that they weren't riding the investment market to higher levels of value, they were just driving the prices up by chasing investments with all that 401(k) money. The saying goes: "All boats rise with the tide."
Retirement fund managers were caught in a trap. Even if they were smart enough to know a dangerous bubble was developing, they had to go along for the ride because their members expected to share in the extraordinary opportunity, even if they didn't understand why it was happening.
Now the bubble has burst, they've taken a huge paper loss, and they want to hold someone accountable. The first victims in their crosshairs are their own fund managers, the same ones who apparently made them so much money in the past that the STRS members granted them these lucrative bonus programs.
The STRS members face a serious situation: a big loss in the value of their portfolio jeopardizes the ability to fund the pension benefits of both the current retirees and those who have yet to retire. But they have an interesting backstop – state law. Section 3307.28 of the Ohio Revised Code gives STRS the power to increase the contribution required by the employers (ie the School Board) as necessary (up to 14%) to prevent funding shortfalls. So when the STRS portfolio takes a hit, the burden can be transferred back to the taxpayers to make up the difference.
What happens if the hit is really large, as is happening now? We can be pretty sure that the teachers' union – spearheaded by the Ohio Education Association – would lobby our legislators aggressively to get this 14% limit raised. They have a strong voice, as OEA is a large contributor to the campaigns of state politicians.
Where is a school district supposed to come up with this additional money? That's easy: ORC 3307.30 says we have to raise our taxes with another levy. What if the levy doesn't pass? Got that covered too – ORC 3307.31 says the State will just withhold it from their normal state funding payments to the district.
I wish my 401(k) had that kind of backing. How about you?


  1. I am curious as to what would comprise a "funding shortfall". Seems like it would have to mean there were no funds to pay the pensions, that the fund would be totally broke. I am thinking that is not a likely scenario, even with the recent downturn. Of course, I may be way out of bounds on that. As far as the bonuses go, those fund managers would not be the first to get bonuses after a lousy year - I think it happens all the time in that industry, when they out perform the market in general, and maybe even when they don't. And yes, I would like to have that built into my 401(k) too!

  2. Hillirdite:

    From an actuarial standpoint, a funding shortfall would exist when the projected inflow is insufficient to fund the projected outflow. In other words, they're forecasting that the fund would go broke at some time in the future - be it twenty or thirty years out.

    It's kinda the same thing as trying to deflect a killer asteroid. If you pay attention and detect it early, it takes only a little energy to deflect an asteroid when it's a long long way away. But if we wait until it gets really close, it could take all the nuclear warheads we have to pulverize it into harmless specks.

    So the actuaries are charged with detecting potential shortfalls far in the future, and figuring out what the "small" amount is that we can increase contributions now and avoid a big problem later.

    It goes both ways - if they project a surplus, we could supposedly cut back on the contributions, but I doubt that this ever happens (that's when they raise the benefits).


  3. The following comment was received via email:

    Who wrote this? It is not accurate. STRS investment staffers WERE paid handsome bonuses for positive stock market returns in 2004, 2005, 2006, and 2007…….when STRS made money. We are talking about years when STRS LOSES money. We lost big bucks in fiscal year 2008 and we are currently losing even more in the first 4 months of fiscal year 2009. It is an insult to the STRS membership when 87 people are given bonus checks averaging $65,000 (on top of $100,000 - $200,000 base salaries) when we lost money. We are not talking about the past. We are talking about the future. STRS assets have dropped $25 billion in the past 12 months, which is 31.25% of everything STRS has. Bonus checks shouldn’t even be in the picture right now.

    Please share with Hilliard. I voted NO on the bonus compensation due to the information summarized above.

    Dennis Leone
    STRS Retiree Board Member

  4. I still don't understand why the STRS Board is complaining about a compensation structure that the Board itself must have approved. Why do you think it is fair or just to retroactively adjust the compensation deal you made with your investment managers? I suspect that you may have made those deals while you were giddy with the paper profits generated by your portfolio over the past few years, and now want to take them back after being burned by a market you don't understand. I'm not defending your investment managers for the way they have managed your portfolio. In fact, they probably deserve to be fired. Furthermore, you should never have hired them in the first place. But a deal is a deal. You need to have the integrity to pay what you promised. But that means accepting much of the blame for what happened, doesn't it?

    The appearances are that the members of STRS are as naive about investing as most of America has been for the last twenty years. There is a fundamental truth in investing: Reward and Risk are inexorably connected. The problem is that when you mix naive investors with a long bull market, the perception among those naive investors is that risk is near zero. The reality is that the opposite is true. The more money the naive investors pump into the market, the bigger the bubble gets, and the higher the risk that some little thing will pop the bubble and bring about a price collapse, which is what we are seeing now.

    If STRS wanted safe investments, it was certainly possible to do so. I'm not sure if this is still the case, but at one time Ohio law limited the Treasurer of Ohio to investing in only US Treasury instruments and high-grade commercial bonds with maturities of two years or less. While that kind of investment would never produce spectacular yields, the risk of default would be very low. If the STRS members wanted very low risk, you should have adopted a similar investment strategy.

    Instead you, like many Americans, thought you had stock market savvy, and developed expectations that the stock market could bring you historically extraordinary returns without being exposed to any risk. Unfortunately, you've learned an expensive lesson.

    If you want to avoid making this mistake again, buy a copy of The Intelligent Investor by Benjamin Graham, written in 1973. Graham was Warren Buffett's mentor. You'll learn that Buffett isn't the richest man in the world because he just threw money at the stock market and hoped it would generate returns. He understands, perhaps better than anyone in the world, the connections between risk and reward, investing and speculating, and value versus hype.

    I too am retired, living on the income produced by our nest egg. Unlike you, I understand the risk/reward relationship very well, and began shifting our portfolio from the stock market to US Treasury Bills, municipal bonds (we own a good deal of school bonds in fact), and certificates of deposit. We've not lost a dime on any of those investments. Yes, we could have made more money had we sold at the peak of the market in 2007, but if we were still in the stock market, we would have been decimated, and would likely be forced to return to the workforce to survive.

    Your ignorance and greed have put you in this position, and as a fellow retiree, I have sympathy for you. But don't puff up now and claim that you have been wronged and that someone else (e.g. me and all the other taxpayers in Ohio) is obligated to make you whole.

  5. Ms. Bracy has picked up this thread on her blog. Unfortunately, she disallows comments, and so there is no dialog there - only her perspective.

    I received a clarification - the compensation deal that STRS negotiated with their investment fund managers apparently calls for the managers to be paid a bonus if the performance of the STRS fund is better than certain benchmarks. A consequence of this is that the managers can receive bonuses even in a scenario where money has been lost as long as the magnitude of the loss is less than the benchmarks.

    It's a stupid way to compensate investment managers. When portfolio values were skyrocketing, investment managers sold the idea that they should be compensated a fraction of the value of the portfolio - say 5%. The problem I had with this is that as long as the portfolio had any value at all - they got paid. The investment managers would argue that this system motivated them to grow your portfolio.

    But like a real estate agent, they're betting only a fraction of value. Let's say I have a $100,000 portfolio, and the investment manager gets an annual commission of 5% of the portfolio value. Two years ago, the portfolio grew 10% - to $110,000. The investment manager gets $5,500 and I'm left with $104,500.

    This year, the market tanks and the portfolio loses 20%. I've lost $20,900, but the portfolio manager still gets a commission of $4,180. After his commission, I have $79,420. Do you really care if you manager lost less money than the other equally stupid managers out there?

    STRS members - retired and active - this is the deal you struck. By all means, feel free to negotiate with your investment managers and see if you can brow-beat them into giving some of their commission money back. Perhaps they'll do so under fear of losing their jobs.

    But you have no right to take it back. You made a stupid deal, and this is the way the cards fell.

    And most importantly, this is your problem - not mine.