Becoming Antifragile: Investigating South Carolina's Pension Problems

I learned recently that there's been a lot of fraud and mismanagement in government pension funds at the local, state, and national levels. In response, I decided to investigate my relatives' pensions to answer two questions:

Can my relatives rely on their pensions?
If not, how can my relatives adjust their living situation so they're not dependent on pensions which are unable to meet their obligations?

I developed a plan to attack these questions, which I discussed in this post. That post also shares some of the news articles which motivated me to review the safety of my relatives' pensions.

In this essay, I describe my research into one relative's pension fund, the South Carolina Retirement System (SCRS) managed by the SCRS Investment Commission. I did this research over 2 evenings, excluding writing this essay.

With this kind of research, it's easy to get bogged down in unintelligible financial details and huge charts of numbers. I decided to stick to high-level questions and then only pursue more detail as needed.

I decided on three main questions:

Are the people running the pension honest? That is, do the SCRC managers serve the people of South Carolina or themselves and other monied interests?
Is the fund currently sound?
Are the fund's investment plans and expected returns reasonable, or do they expect unreasonably high returns to meet their future needs?

First I'll explain briefly how pension funds work, which should help clarify why these questions are important.

Think of a pension fund like a big pot of money. Some things add to the pot and some take away:

Quick explanation: workers and employers contribute into the pot while the worker is employed. If the worker was employed for long enough, they get payouts when they retire. In addition to those contributions, the money is invested in stocks, bonds, and other things, and the fund value can increase or decrease depending on whether it's invested well or poorly. It costs money to manage the fund. "Management fees" are things like salaries and office space for the management staff, and usually it's a small percentage of the value of the fund.

So, how is the South Carolina Retirement System doing at this?

Are the people running the pension honest?

There seems to be a lot of corruption, with many politicians, political appointees, and government workers either engaging in fraud, covering it up, or not prosecuting it.

My first step here was to just search online for "South Carolina pension fund". This first search brought up some interesting headlines (numbered so I can reference them easily later):

South Carolina's Pension Push Into High Octane Investments
South Carolina Pension's Hedge Fund Bet Trails as Fees Soar
South Carolina treasurer censored by state retirement board
Another SC Pension Fund Battle This linked to other good articles, including:

Skimming the first 3 articles gives a pretty good lay of the land. Article [3] is actually a great place to start - read the article and the censure resolution. The sequence of events is roughly:

The Pension has had a disastrously high fee-to-expense ratio for a long time, meaning it was way overpaying for the quality of its investment management.
South Carolina Treasurer Curtis was elected in 2010 and resolved to attack this problem.
Curtis got stonewalled by the rest of the SCRS Investment Commission when he had questions about unusually complex investments, found that they were overpaying fees, and noted other problems.
The treasurer got censured for discussing this publicly.

Read the statement of censure; it's pretty amazing. Some good quotes from Treasurer Curtis about the Commission include:

“We have people who are attacking that trust fund. We have people who are wanting to spend that money in ways that it shouldn’t have been spent, and people who want to open up the doors so it will be less efficient and more people will have their hands into it”.
“I found where contracts that we voted on that have a certain amount of fee structure are not the contracts that are realized. So we're paying more in fees than we voted on-- millions of dollars”.
“I probably have 25 or 30 outstanding requests (for information)”
“They claim that they're 29% less risky than the average plan. I've asked for (the underlying math). I can't get it”.
“Either the elites in Columbia and New York have control, or the people who own the money have
control”.

Without going into the details of the Treasurer's accusations, I believe in the gist of his accusations: that the fund is being scammed and that the Investment Commission is purposely enabling it. I believe this for a few reasons:

Members of the Commission have already been caught engaging in criminal behavior as shown in articles [4-1] and [4-2]. The articles show several examples, but I'll quote just one from article [4-2]:

In fact, the New England Pension Consultants firm was contracted by the state to conduct due diligence on its various pension fund investment deals – although that didn’t always happen.
Why not? Because during his tenure as the head of the SCRSIC, Borden unilaterally exempted the New England Pension Consultants firm from providing oversight over the state’s estimated $12 billion worth of higher-risk “alternative investments.”
One deal in particular, the Lighthouse/ Apollo deal, involved a $3 billion investment that sources tell FITS could result in the state taking a “catastrophic loss.” This is one of the specific deals that the New England Pension Consultants firm was allegedly exempted from overseeing.

Read more at http://www.fitsnews.com/2012/02/03/the-real-pension-pay-to-play/#dCuXYRj15TMmxemY.99

Another shady deal [Treasurer] Loftis was investigating involved SCRSIC commissioner Reynolds Williams, who spent several months championing a $30 million timber deal that the commission approved late last year. At the last minute, Williams recused himself from voting on the deal. Why? Because his law firm had lined up a deal worth hundreds of thousands of dollars to represent the company receiving the payoff.

Another shady deal Loftis was investigating involved SCRSIC commissioner Reynolds Williams, who spent several months championing a $30 million timber deal that the commission approved late last year. At the last minute, Williams recused himself from voting on the deal. Why? Because his law firm had lined up a deal worth hundreds of thousands of dollars to represent the company receiving the payoff.
Read more at http://www.fitsnews.com/2012/02/03/the-real-pension-pay-to-play/#qxTzXl5Y6xsjMss3.99

Another shady deal Loftis was investigating involved SCRSIC commissioner Reynolds Williams, who spent several months championing a $30 million timber deal that the commission approved late last year. At the last minute, Williams recused himself from voting on the deal. Why? Because his law firm had lined up a deal worth hundreds of thousands of dollars to represent the company receiving the payoff.
Read more at http://www.fitsnews.com/2012/02/03/the-real-pension-pay-to-play/#qxTzXl5Y6xsjMss3.99Another shady deal Loftis was investigating involved SCRSIC commissioner Reynolds Williams, who spent several months championing a $30 million timber deal that the commission approved late last year. At the last minute, Williams recused himself from voting on the deal. Why? Because his law firm had lined up a deal worth hundreds of thousands of dollars to represent the company receiving the payoff.
Read more at http://www.fitsnews.com/2012/02/03/the-real-pension-pay-to-play/#qxTzXl5Y6xsjMss3.99

Another shady deal Loftis was investigating involved SCRSIC commissioner Reynolds Williams, who spent several months championing a $30 million timber deal that the commission approved late last year. At the last minute, Williams recused himself from voting on the deal. Why? Because his law firm had lined up a deal worth hundreds of thousands of dollars to represent the company receiving the payoff.
Read more at http://www.fitsnews.com/2012/02/03/the-real-pension-pay-to-play/#qxTzXl5Y6xsjMss3.99

The 6-year Investment Chief Borden has a long history of funneling pension fund investments to Wall Street firms and hedge funds, and seems to have been well rewarded for it. To quote from article [1] above:

What is sure is that while [ex-South Carolina Investment Chief Borden] was running things, South Carolina ended up paying hundreds of millions of dollars in fees — $344 million last year alone — to a Who’s Who of hedge fund managers and private equity deal makers. In return, it got a trove of investments that haven’t really provided the bang that people here had hoped for. Today, the pension fund has a higher share riding on private-equity and hedge-fund plays — called “alternative investments” in some circles — than almost any other state’s: $13 billion, or more than half its total.
What is also certain is that Mr. Borden is long gone. Mr. Borden, who resigned last December to join a private investment firm, says he is proud of what he accomplished...
As I detail later, about 50% of the SCRS fund is invested in 'alternative investments' managed by hedge funds and other Wall Street firms which the SCRS Investment Commission has purposely caused to not be audited.
In addition, Governor Haley and Investment Chief Borden seem to get along well, at least in one scheme to defraud the fund, as pointed out in article [4-2]. Seeing how much money there was in 'managing funds', Borden wanted to set up his own company to get a piece of the pie. When this failed, as the corruption was apparently too brazen, Governor Haley signed off on a modified version of the plan.
(Updated): Apparently, since politicians' private income isn't disclosed in South Carolina, bribing a politician is as easy as 'hiring' them while they're in office as a consultant, and paying them as much as you want.

Matt Taibbi has explained how Wall Street investment firms corrupt state officials, getting paid massive fees in exchange for providing poor investments. South Carolina certainly seems to fit this description.

Is the fund currently sound?

The fund is not currently sound. In this section, I'll share information I pulled from three financial documents released by the South Carolina Retirement System Investment Commission, each the latest as of November 5, 2013:

1. Financial Statement
2. Actuarial Valuation Report
3. 2011-2012 Annual Investment Repor
I found these documents here, and that page should include newer reports as they become available.

First, I'll share the SCRS figures and then I'll discuss some more details I found which paint an even worse picture.

From page 15 of the Actuarial Valuation Report, the nominal value of the fund is $25,540,749,000, but the accumulated nominal liabilities are $39,457,708,000, meaning the fund is currently $13,916,959,000 in the hole. Yes, the SCRS is ~$14 billion in the hole, with ~$25.5 billion in assets. That means the fund is only 64.7% as large as it needs to be. Yikes!

Ok, things are rough. But what's the trend like?

Source, page 6. This chart compares the SCRS fund's assets to its liabilities. 100% means it can pay everything it has promised current and future retirees. In 2012, it hit 64.7%.

The trend is also negative. And this despite a massive, Federal Reserve-stoked bull market in stocks since the 2008 crash:

Source This is a graph of the S&P 500, representative of the US stock market from 2002-2013. Compare with the "Funded Ratio" chart above and noticed that the funded ratio seems to drop whether the market does well or not. Note that the fund is invested in things besides stocks, including bonds and 'alternative investments' which are more opaque to the public.

In summary, the fund doesn't have nearly as much money as it needs to meet its obligations, and this trend is getting worse over time - each year it becomes less able to meet its obligations. To be clear, it is currently paying 100% of what retirees expect, but it's ability to meet future obligations is shrinking quickly.

Sounds rough, right? Actually, it's a lot worse for at least 3 reasons: a) the actual, market value is lower than reported, b) there are huge gaps in the fund's audits, and c) the fund is ~50% invested in opaque, poor-performing 'alternative investments'. Let's take them one at a time.

"Actuarial Value" vs Market Value

The SCRS fund is invested in stocks, bonds, real estate, and other securities with a "market value". "Market value" is the amount of money you could get if you sold your securities on the market immediately.

However, the fund values I discussed above weren't the "Market value" of the fund's assets and liabilities. Those were 'actuarial values', meaning that accountants manipulated the apparent value of the funds' assets and its increases and decreases in value from year to year. Why would its accountants do this? I'll quote from the Actuarial Valuation, page 7:

The actuarial value of assets (“AVA”) is based on a smoothed market value of assets, using a systematic approach to phase-in actual investment return in excess of (or less than) the expected investment income. This is appropriate because it dampens the short-term volatility inherent in investment markets.

The 'phase-in' period is 5 years, meaning that one year of huge gains or huge losses won't be immediately reflected in the 'actuarial value of assets' - the gains or losses of each year, from an accounting perspective, will be distributed over the following 5 years.

So what does this accounting BS mean? Well, the advertised "$25.5 billion" fund value isn't its real, market value. Its market value - meaning, what someone would be willing to pay for its assets right now - is $21.5 billion, $4 billion less than advertised according to the Actuarial Valuation, page 2. The fund uses accounting mechanisms which are currently disguising huge losses. The supposed purpose of this accounting trick is to smooth out gains and losses so the Commission doesn't make rash decisions after one great or terrible year. Right now, the fund is in bad shape, and auditors expect it to get worse as the accounting values 'catch up' with the real values (Actuarial Valuation, page 2):

The funded ratio of the System decreased from 67.4% (after reflecting Act 278) to 64.7%. This decrease was primarily due to the continual recognition of the extraordinary investment loss that occurred in prior years. Absent favorable experience, we expect the funded ratio will continue to decrease for the next several years as those investment losses are fully recognized in the development of the actuarial value of assets.

So the SCRS knows full-well the $25.5 billion figure is fake, and it'll get worse before it gets better assuming its investments keep doing well because they still haven't taken all their 'accounting' losses from previous years!

So what would the SCRS funding level be if we used the market value rather than the accounting, or 'actuarial' value? From the Actuarial Valuation, page 2:

If the market value of assets had been used in the calculation instead of the actuarial (smoothed) value of assets, the funded ratio for the System would have been 54.6%, compared to 58.9% in the prior year...

To get an idea how much the actuarial and market values of the fund have diverged, check out this chart from the Actuarial Valuation, page 7:

The 'actuarial' accounting mechanism has completely hidden the plummeting fund value from 2007-2009. The accounting value of the fund is near an all-time high, but the market value is the same as in 2004.

In conclusion, the funded level is worse than advertised: just to meet its anticipated obligations, the fund would have to increase 100% in value rather than the 50% increase it advertises.

Huge Gap in Audited Investments

The SCRS is supposed to be fully audited to ensure that the fund is well-run and that the reported financial figures are honest. However, there are huge gaping holes in the audit where the auditor appears to accept some valuations at face value - particularly valuations of 'alternative investments'.

To quote from the auditor's most recent Financial Statement, page 2:

The financial statements include alternative investments valued at $11.8 billion (45% percent of net assets), as explained in Note 1, their fair values have been estimated by management in the absence of readily determinable fair values. Management’s estimates are based on information provided by the fund managers or the general partners.

So 45% of the entire SCRS fund's value is given by... the fund managers. And who are they? These would be the 'alternative investments' run by Wall Street financiers, hedge funds, and others who've proven so upright and competent. And since the investments have no 'readily determinable fair values', the auditor throws up his hands and says "Fine, I'll just take their word for it!"

In addition, ongoing due diligence of these investments is supposed to be done according to South Carolina law. It seems this has been deliberately avoided as well. From this article [4-2 from above]:

In fact, the New England Pension Consultants firm was contracted by the state to conduct due diligence on its various pension fund investment deals – although that didn’t always happen.

Why not? Because during his tenure as the head of the SCRSIC, [Investment Chief] Borden unilaterally exempted the New England Pension Consultants firm from providing oversight over the state’s estimated $12 billion worth of higher-risk “alternative investments.”

One deal in particular, the Lighthouse/ Apollo deal, involved a $3 billion investment that sources tell FITS could result in the state taking a “catastrophic loss.” This is one of the specific deals that the New England Pension Consultants firm was allegedly exempted from overseeing.

If this is true, the SCRC is avoiding both continuous due diligence and yearly auditing of about half the fund's values. I would say the very best case is that their market values are as advertised. After all, if the alternative investment valuations were better, they'd be published. In the worst case, they are worth pennies on the dollar, and the SCRS funded level goes from ~54% to ~25%. This is a distinct possibility - after all, the foxes are guarding the hen house, and the auditors are simply taking the foxes' word for it that everything's fine inside.

A Huge Percentage of SCRS Fund is in Alternative Investments

These 'alternative investments' seem to be the bane of public pension funds. As Taibbi described, they are poorly performing investments which act as looting vehicles for finance companies and fund management. Ideally, we'd see as few as possible.

I've found a few estimates of how much of the fund is in these alternative investments. It's varied over time, but here are the last 3 years:

2011: 52.3% (Actuarial Valuation, page 20)
2012: 58.1% (Actuarial Valuation, page 20)
2013: 45% (Financial Statement, page 2)

Hopefully the lower 2013 value is a sign that the proportion of the fund in these alternative investments is diminishing. Still, ~50% of the fund is in these opaque, poor-performing, unauditable assets managed by known scoundrels. That sounds like a recipe for massive hidden losses to me!

Why do I assume the worst in these assets with no 'readily determinable fair values'? We've seen this before, and it ends badly. When fund managers can't point to an impartial, market-based valuation of an investment, they get to make up whatever they want. Here's how it works:

When a fund manager invests in publicly trade stocks, for example, the value of his fund is the value of those shares of stock on the market. He can only say he has, for example, $1 billion of stock if he could sell that stock on the market today and get $1 billion for it. He can't just make up the $1 billion figure out of thin air. This is called 'mark-to-market'; managers are marking the value of their funds to the market.

On the other hand, if there's no market for the investment, how does the fund manager value it? What if the investment doesn't yield any return at all for 5 years, and no one is buying or selling that kind of investment on a regular basis? Fund managers create financial models to figure out what their expected return-on-investment will be and what its value is, but these models can be very complex and infinitely tweakable to allow managers to say their fund's value is pretty much whatever they want. This way of valuing investments is called 'mark-to-model', as the value of the fund is marked to the value of the model, not to any actual market. In 2008 and 2009, people called this 'mark-to-fantasy' as the models had no bearing with reality and so many investments crashed in value.

"Mark-to-model" seems to be the mechanism used to value about 1/2 of the SCRS funds here, and since fund managers are the same people and institutions who committed so much fraud leading up to 2008, I sincerely doubt their asset valuations. I expect the fund's real value - what they could sell the assets for on the market today - is much lower than they state.

Are the fund's investment plans and expected returns reasonable, or do they expect unreasonably high returns to meet their needs?

The fund expects unreasonably high returns which it cannot reasonably hope to achieve. Furthermore it has a strange written policy encouraging it to reduce contributions if it ever gets within 90% of being fully funded, so it's very unlikely to ever be fully funded under the current rules.

Unreasonable Expected Growth Rate of 7.5%

The fund is obligated to fix any shortfall in its ability to pay out, and it is allowed to 'amortize' this catch-up over a 30 year period. That means it must have a plan to make up for its 50% shortfall over the next 30 years.

So what's a reasonable rate of return to assume for the next 30 years? Well, according to the Annual Report page 12, the average return for the last 5 years has been 1.3%. According to this article, Georgia's return over the same period was 2.95%, and it was in the top quartile of states.

So how did the SCRS fund decide on the 7.5% figure as a good rate of return? One guess is that they looked at historical stock market returns. The S&P 500 index has had a 7.5% yearly return rate from 1973 to today:

The S&P index has had a 7.5% annualized return rate for the 40 year period from 1973-2013. However, it's also almost stopped growing since 2000: since the dotcom boom it's had a 1.17% average annual growth rate.

I can imagine some financial executive telling the fund manager, "Look at the schlubs making 7.5% in the stock market without even trying! We can easily do better."

There are a few problems with that. First, the stock markets have hardly grown since the dotcom peak in 2000, averaging just 1.17% annualized growth rate. Second, that 1.17% doesn't account for inflation, so the 'real', or inflation-adjusted, growth rate in equities has been negative. The SCRS fund notes (Financial Statement, page 36) the 7.5% growth figure includes an inflation rate of 2.75%. So while the market has gained 1.17% per year over the last 13 years without factoring inflation, the fund expected to grow 10.25% during that time (2.75% inflation + 7.5% real growth). Clearly it's been losing a lot of ground.

Now, the SCRS fund doesn't just invest in equities; it invests in bonds, real estate, and other asset classes too. But this equities discussion does show just how unreal the fund's expectations of the future are. And we haven't factored in the 50% of their assets in 'alternative investments' which are opaque and poor-performing!

Let's look at bonds quickly too, because this is a big part of the investment picture for pensions:

This chart shows the interest rate pension funds like the SCRS could expect on bonds in the past. In the 1980s, they could expect 6-19% in very low-risk bonds. Today they can expect just above 0%.

The 'quantitative easing' program enacted by the Federal Reserve has sent bond interest rates down to near-0%. In the 90s, a pension fund like the SCRS could lend money to the US Government or solid corporations and expect a 5-8% return rate - right in line with their investment goals! And since these were low-risk bonds, they didn't need to worry much about default.

Nowadays, pension funds investing in bonds can choose either a) a near-0% return rate by investing safely or b) a higher return rate by investing in very risky, so-called 'junk' bonds. Since pension funds must meet their obligations and their expected return rate, they're forced into the riskier investments that have a higher likelihood of defaulting, losing all of the invested value. This is an amazing example of forced 'financial speculation', and it's a direct result of current Federal Reserve policy.

A final note on investments: I do expect another major market crash to come soon like 2008 or worse. The same fraudulent institutions and people that caused the 2008 crash are still active and are now anointed "Too Big To Fail". Thus, I fully expect these fraudulent financial behemoths' behavior to be a drag on investment returns, including when the financial markets crash again. The SCRS investment returns are still hurting from 2008's crash; they are not ready for another one to come anytime soon.

In summary: I don't believe the fund can possibly meet their investment goal of 7.5% average annual return over the next 30 years.

The Fund Has a Policy Which Prevents Becoming 100% Funded

This sounds strange, but it's true. From the Financial Statement, page 21:

After June 30, 2015, if the most recent annual actuarial valuation of the system shows a ratio of the actuarial value of system assets to the actuarial accrued liability of the system (the funded ratio) that is equal to or greater than ninety percent, then the board, effective on the following July first, may decrease the then current contribution rates upon making a finding that the decrease will not result in a funded ratio of less than ninety percent.

Translation: If their asset value ever gets within 90% of their liabilities, they can lower contributions until they get back to 90%.

A well-managed fund would seek a funding level > 100% to account for future surprises like occasionally achieving less than their expected investment return. This fund doesn't shoot for 100% funded; if it ever gets to 90%, it plans to reduce employee and employer contributions. This is very irresponsible, and it appears to just enable politicians to give voters a cash windfall at the expense of the voters' own retirement income.

Summary: Don't Count On This Fund

To recap, I asked these questions:

Are the people running the pension honest? That is, are they not corrupt?
Is the fund currently sound?
Are the fund's investment plans and expected returns reasonable, or do they expect unreasonably high returns to meet their future needs?

(1) Many but not all of the fund leaders seem dishonest just like Taibbi found in government pension funds across the country. They avoid audits of large parts of the fund's assets, steer assets towards Wall Street firms with high fees and low performance results, and engage in criminal behavior.

I didn't discuss the competence of the SCRS managers in this article because competence is irrelevant if the leaders are dishonest. Thus, I didn't even discuss how this fund has higher management fees and lower performance than most other state pension funds. This poor performance isn't the problem; it's a symptom of the real problem which is that the SCRS fund managers, the SCRS Investment Committee and politicians which support them, are corrupt. Though at least one member of the Committee, Treasurer Curtis, seems to be pushing for less corruption and more transparency, it hasn't been enough to change the situation dramatically.

(2) The fund does not seem sound. Its own accounting shows it to be ~65% funded, but using more reasonable estimates of its value show it to be ~55% funded. In addition, the actual market value for ~1/2 the fund isn't known by auditors, and we're just trusting the same hedge funds and Wall Street firms we've come to know and love to be honest and do a good job. This seems like a recipe for disaster, not recovery.

(3) The fund has unreasonable expectations of future growth, and its own policies even discourage it from becoming fully funded. It expects 7.5% growth rate in investments while averaging 1.3% for the last 5 years, and the auditors expect several more years of bad results due to past losses. Every year it misses this target, the future growth must be even higher to meet its stated objectives, so it becomes ever less likely that it will. In addition, even if a miracle occurs, it will not get past 90% funded because the SCRS Investment Committee will reduce required contributions if the 90% funded level is breached.

The stated purpose of the fund is to provide retirement benefits to people who previously worked for the State of Carolina. With ~$9 billion in audited assets and ~$39 billion in liabilities, it appears the real purpose of the fund is to provide a vehicle for looting the public with minimal effort and political consequences. My recommendation to anyone dependent on this fund is to save all the money you can and arrange your lifestyle and expenses so that if and when the fund ceases to pay its retirees, you will be able to carry on as well as possible.

Epilogue

On Government Effectiveness
I don't mean to lambast government effectiveness in this article. The South Carolina government and fund managers aren't incompetent; they're corrupt, and no more corrupt than many companies (like Hostess, for example). Across the country, citizens are unable to prevent those in power from looting public resources like retirement funds, taxes, natural resources, and other public wealth. This is just another example.

Understanding the Fundamental Problems
I believe we face more than just financial problems in this country; we face problems related to energy, the environment, fresh water, farmland, and others that threaten our way of life. The problems I outlined in this article are only partially symptoms of fraud and corruption. Even without such fraud we cannot expect economic growth to continue indefinitely, but unending growth is what our pensions and other institutions expect and depend on. I hope to write more about this soon. In the meantime, the best one-stop place I've found to get a decent review of our challenges is here: the Peak Prosperity Crash Course. Learn about the resource and environmental problems we face and consider how to respond. I look forward to hearing your thoughts and sharing my own here in the future.

Wednesday, November 6, 2013

Investigating South Carolina's Pension Problems