When the NC House passed Senate Bill 558 last night, the proponents of the bill said the North Carolina Retirement System pension fund needs to sell a huge chunk of its bond portfolio and put more into alternative investments and real estate. I guess the folks that want this bill have very short memories. They have obviously forgotten that during periods of economic stress (2008 for example) the only true safe haven is bonds.
Not even heaven will be able to help the NCRS pension fund during the next economic stress test if S558 becomes law and our state treasurer sells much of the bond portfolio as she plans. It is mathematical fact that if you don't own bonds, your portfolio will be decimated during economic stress. Here is a quick reminder of how ugly it can get.
How quickly we forget.
The chart below from a recent Vanguard analysis further drives home the point that selling bonds from a portfolio in favor of ANY other asset class raises the risk profile of the portfolio.
The North Carolina House voted 61-51 to allow our state treasurer to invest more pension fund money in junk bonds, hedge funds, leveraged buy-out funds, and commodity derivatives. There are MANY things that bother me about Senate Bill 558, but I guess what bothers me the most about S558 is that it expands the treasurer's ability to "invest" in commodities. The treasurer calls it the "Inflation Portfolio." S558 allows the treasurer to "invest" 7.5% of our $81 billion pension fund in commodities. If one does the math, that means the treasurer can buy up to $6 billion of commodities.
So what does the "Inflation Portfolio" look like? As the snap shot from page 107 the State of North Carolina's Comprehensive Annual Report below shows, the treasurer has already "invested" over $2 billion in such items as wheat, corn, heating oil, crude oil, and aluminum.
North Carolina Retirement Systems
Inflation Portfolio Holdings
1.45 million barrels of crude oil
28.73 metric tons of aluminum
13.57 million barrels of heating oil
7.12 million bushels of wheat
10.12 million bushels of corn
I'm sorry, but the above shopping list is NOT an investment portfolio. Raw aluminum, wheat, corn, and oil are not investments as they do not pay interest or dividends or earn money in any way. These are pure and simple "bets."
So, how have these "bets" paid off? The "Inflation Portfolio" has lost an average of -8.5% per year for the three years the portfolio has been in place.
With all the hubbub about the North Carolina budget, how does our Treasurer have the gall to ask our legislature for a 42% budget increase? I'm one of the few who have read and deciphered Senate Bill 558 and gone as far as to translate what it means in terms of expenses within the pension fund. I wonder if Senate Bill 558 would pass if it had to go through the typical state budgeting process?
Increasing the "alternative investments" allocation to 35% within the North Carolina Retirement System (NCRS) pension fund, will increase Wall Street fees paid by the pension fund by 42% or $160 million PER YEAR and that is exactly what Senate Bill 558 will do. As NC State Finance Professor Richard Warr recently told the NC House Finance Committee, "there will be champagne toasts all over New York City" if Senate Bill 558 becomes law.
The following table shows the impact of Senate Bill 558 on investment expenses in North Carolina's pension fund:
North Carolina's already high allocation to alternative assets are partly responsible for why 70% of all public pension fund returns beat our returns the past three years. And, it's only getting worse as 83% beat our returns the past year (see page 38 in the May 29, 2013 Investment Advisory Committee presentation file by clicking here).
On page 37 of the presentation file above (see snapshot below), you will also find
Below is a summary of investment expenses incurred by North Carolina Retirement System's (NCRS) pension fund managed by our publicly elected Treasurer. The data are taken from the last annual Government Operations Report from June 30, 2012 provided by North Carolina's Department of State Treasurer.
I've calculated an Expense Ratio for each asset class provided in the "Gov Ops report" in much the same way a mutual fund would calculate an Expense Ratio. I've also included long-term 10-year return information for each asset class where available as printed in the March 31, 2013 NCRS Quarterly Investment Update.
I'd like to point out that the State Legislature is currently mulling over Senate Bill 558 which would give the North Carolina State Treasure authority to invest up to 40% of the NCRS pension fund into Alternative Investments by primarily taking money out of the internally managed bond portfolio. As can be seen in the table above, every dollar moved from the internally managed bond portfolio to Alternative Investments will incur expenses that are 178 times more expensive as the Internally Managed Bond portfolio. That isn't a misprint. Yes, the Alternative Investments portfolio expenses are 178 times MORE expensive than the Internally Managed Bond portfolio.
Recently Moody's Investor Services estimated North Carolina's pension fund is approximately $7.5 billion underfunded. North Carolina's Treasurer complained to Moody's as this might cause confusion since the North Carolina annual report shows an underfunding of only $3.7 billion. The difference is the NC annual report must follow Governmental Accounting Standards Board (GASB) rules which result in horribly underestimated liabilities and overly optimistic future returns on assets. The Moody's analysis, while still flawed is closer to reality.
What is interesting is that both of these estimates are too low - and our Treasurer knows it. GASB plans to change their pension fund accounting standards from horribly ridiculous to merely ridiculous. Recently the Treasurer hired Buck Consultants to estimate how underfunded our pension fund will be when the new GASB standards take effect after June 30, 2014. Buck Consultants found the State Employee and Teacher's portion of the plan will show to be $8.4 billion underfunded under then new GASB standards, and the Local Employee portion of the NC Retirement System will be underfunded by about $2.0 billion. Thus, the entire NCRS would be underfunded by a whooping $10.4 billion under the new GASB pension fund accounting rules.
The full Buck Consultants analysis from 11/14/2012 can be found by clicking here. Below are the two most relevant pages that show
