Over the past several months, this column has focused on individual retirement and investment issues. However, theres another retirement issue that you should care about, and thats the financial health of North Carolinas public employee pension plan. As salaries and working conditions have deteriorated in our states public sector, the pension plan has become one of the few benefits that help us retain our teachers, first responders and civil servants. However, as taxpayers, we also have a stake in our public pension plans because we are ultimately responsible if the pension experiences a shortfall.
After reading the national press, you might be more than a little worried about the financial stability of the states pension. The bankruptcies in Detroit and several municipalities in California, as well as the precarious health of the Illinois pension system, make for scary reading. Moreover, the state pension plan has been attacked by an odd combination of interest groups. For example, the American Legislative Exchange Council and the State Employees Association of North Carolina have both questioned the sustainability of our pension system. According to the latest financial reports, North Carolinas pension plans are well-funded. The ratio of the plans assets to its liabilities is among the highest in the United States. While public officials in both parties have long, if different, lists of extreme challenges facing our state, the pension plan doesnt belong on anyones critical list.
Having had some responsibility for the investments of the pension plans as the states chief investment officer, I know that there are always challenges. In todays financial markets, State Treasurer Janet Cowell and her investment staff have to grapple with the consequences of a low interest rate environment. Its the same problem many of you face in your municipal bond portfolios and mutual funds. In the case of the pension plans, low interest rates make it far more difficult to achieve the long-term investment target of 7¼ percent. If the plans fail to meet the target over the long run or the state decides to lower the target, the taxpayers have to make up the difference in order to keep up the pensions financial health.
Hefty price tag
Cowell, like just about every other public pension plan official in the country, has decided that a higher commitment to alternative investments is the way to solve this conundrum. Regular readers of this column know that I am not a proponent of large doses of alternative investments, particularly hedge funds. When big pension plans, like North Carolina, simultaneously attempt to invest tens of billions of dollars in the same types of strategies, those strategies tend to disappoint investors. Put simply, too much money is chasing too few compelling opportunities. Moreover, alternative investments come with a hefty price tag. Between management fees, incentive fees, and transaction costs, alternative investments can consume one-third of any investment gains. And while many alternative investments have attractive risk characteristics under normal market conditions, many of these strategies can become highly illiquid or even toxic under extreme conditions (the technical term is tail risk).
While I disagree with the decision to move so dramatically into alternatives, I have to respect the decision by Cowell and other fiduciaries to head in this direction. Why? Because after more than 30 years of investing, I know I could be wrong. Investments are a matter of judgment, and there is little doubt that our treasurer and her staff have studied this issue in-depth. We will, in due course, find out who is right. Frankly, I hope she is right and I am wrong, because it will be a difficult and slow process to reverse the commitment to alternatives.
What I dont understand is the vehement attack spearheaded by SEANC. SEANC charges that the pension has performed poorly and is being hobbled by excessively high fees. Moreover, SEANC has retained a consultant to probe the pension plan for potential improprieties. To some degree, I can understand SEANCs concerns. The pensions fees are rising, and the alternative investment strategies are more opaque than stocks and bonds. Furthermore, Cowell, like her predecessors Richard Moore and Harlan Boyles, doesnt reveal a great deal about the plans managers or their fees.
Bad for all of us
However, SEANCs attack on the plans performance and rising fees represents a profound lack of understanding about the investment structure developed by the late Boyles and maintained by both Moore and Cowell. The investment portfolio has always been structured conservatively. In sharply rising markets, like we have just experienced, North Carolina always lags other pension plans. In normal markets, we do just fine, and in terrible markets, which come around all too often, the plan is a stellar performer. Not surprisingly, North Carolina has trailed many other pension plans in recent time periods because our plan does not have as much exposure to the stock market as other pensions.
Theres nothing nefarious about rising fees. As the pension increases its commitment to private equity, real estate, and hedge funds, fees must rise. The market rate for these products is substantially higher than those for conventional stock or bond portfolios. Any investor who decides to invest in alternatives will incur higher fees. Like SEANC, Id like to see more detail about the performance and fees associated with alternatives. However, theres no reason to launch investigations, use inflammatory language, or bury the investment staff in public records requests. Our teachers and public servants have enough to worry about in their jobs without SEANC and others casting doubt on the performance and integrity of the pension.
The states pension plans weathered the 1987 stock market crash, the S&L debacle of the early 1990s, the dot.com bust of the early 2000s and the credit crisis. While I have concerns about the increased exposure to alternatives, the pension plan should be able to meet its obligations to both retirees and current employees. However, if politics drags down the investment process, we may undermine the publics willingness to support the plan. This would be very bad news for the beneficiaries and all of us.
Andrew Siltons Meditations on Money columns can be found twice a month in The N&Os Work&Money section. He is a retired money manager living in Chapel Hill. He was CIO for the North Carolina Retirement System from 2002-2005. He writes the blog http://meditationonmoneymanagement.blogspot.com/