Home News Tribune
5/10/05
By KEN TARBOUS
Gannett New Jersey
In the back offices of the state Treasury Department, a small, nondescript division has had a huge impact on the state's public pension funds.
In a little more than two years, the state Division of Investment lost nearly $18 billion - enough to run New Jersey government for six months.
Those losses, along with diminished investment returns, have forced state taxpayers to contribute nearly $200 million to the pension system this year and an expected $1.5 billion in next year's budget, which could be spread over five years.
New Jersey is a dinosaur among pension funds, the lone state that has bureaucrats rather than outside investment professionals managing billions of dollars each day.
Even after the disastrous loss of $18 billion from first-quarter 2000 to July 2002, changes that would make the division more efficient and more responsive to moves in the market have been slow, according to state Treasurer John E. McCormac.
McCormac blamed an archaic system and the State Investment Council, the division's board of directors that oversees the pension investments, for the extended period of losses that drained the once self-sufficient state pension fund from a high of $85 billion in March 2000 to $68.9 billion today.
“There was a reluctance to change. It was ‘buy and hold,’ and it was ‘stay the course.’ Quarter after quarter of negative results was met with, ‘Don't worry. It's only temporary,’” McCormac said. “But three years of bad performance is not temporary.”
James W. Karamanos, 60, of Highland Park is a part-time substitute teacher not enrolled in the state pension system. He's been following the debate over retirement financing and is unhappy with the state’s pension fund.
“Whether it was the bad investments or not, I'm not too pleased,” Karamanos said. “As a taxpayer that directly affects (me).”
He acknowledged the value of his own investments has been drastically reduced in recent years, but he thinks the state must change its outlook.
“The situation leaves something to be desired. We are not fiscally responsible, whether it's the Republicans or the Democrats,” Karamanos said.
State, county and municipal employees, teachers, police and firefighters pay about 5 percent of their salaries into the pension fund system, which invests the money.
Regulations and laws limit the investment portfolio. The fund's market value constantly changes. Portfolio gains and losses are combined with money flowing in from participants and the state, then are paid out in benefits.
As of June 2004, the state's pension fund was invested 66.5 percent in stocks, 26.4 percent in bonds and fixed income, 5 percent in cash, and 2.1 percent in mortgages.
A survey by the California-based investment-consulting firm Wilshire Associates found the median asset allocation of public pension funds to be 62.3 percent in stocks, 26.3 percent in bonds, 3.4 percent in cash, and 2.6 percent in alternative investments as of Dec. 31, 2004.
New Jersey's taxpayers have to support the fund if its return on investments drops below a five-year average of 8.25 percent per year. As of June 2004, New Jersey's five-year average return was 1.5 percent. The median in the Wilshire study was 3.66 percent over that same period.
The investment division, founded in 1950, and the investment council barely acknowledged widely accepted practices of investment and risk management, putting the money mostly in stocks, according to McCormac.
When the S&P 1500 Index, a large group of stocks used to measure how the overall markets are performing, plunged in the early part of this decade, so did the value of the pension fund.
“That's insane,” said Sheryl Gaugler, 50, of North Brunswick, a secretary at Johnson & Johnson in New Brunswick. “We're a rich state, and we can't manage our money?”
Changes pushed
McCormac is pushing for investment diversification and external money managers to increase returns. He wants to move billions of dollars, up to 13 percent of the overall portfolio, out of stock and bonds and the hands of division employees.
McCormac's plan calls for placing that money into alternative investments like real estate and privately owned companies, using the services of private, fee-based investment managers.
The $17.9 billion collapse over two years – nearly a fifth of the total pension fund - and the condition of the pension funds' investment portfolio are the fault of arcane rules and procedures left in place from previous councils and administrations, McCormac said. The council does not invest the money, but rather, is meant to ensure the integrity of the division.
As an example of how poorly the system functioned, McCormac said, the department would meet each Tuesday on “trading day,” deciding which stocks to sell that week and leaving the funds at the risk of the markets' fluctuations for relatively long periods of time.
Bill Clark, the division's new director, said some criticism of the council’s operations is valid.
“In hindsight, it’s probably fair. We had a very good run in the ’90s, and we had pretty big positions (owning millions of shares of one company) in some tech stocks in particular,” said Clark, who has been at the division since 1999 and took over as division director in March. “We probably should have been more aggressive in taking some of those chips off the table.”
But a former division director said selling stocks is not that easy for the state.
The division may hold hundreds of millions of dollars in shares in a particular company, and selling off such a huge amount at once can drive the stock price down.
To stop such a sudden impact, it might take up to 20 days for the state to sell blocks of shares without disturbing the market, said Steven E. Kornrumpf, who served in the Division of Investment from 1971 to 2002. He spent six years as the deputy director and his last four as director.
For example, in the spring of 2001, as shares of New Jersey-based Lucent Technology Inc. nose-dived, the division took 30 days to sell 5.915 million shares at a loss of more than $35 million.
On March 20, 2001, the first sale of 200,000 shares was made at a price of $12.58 each, the highest sale price the state received over the period. The state’s sale price slid to a low of $7 on April 17, 2001. The last sale of the bulk of shares was made for $7.59 per share on April 18, 2001.
State policy defended
But all the finger-pointing by McCormac and current council members sounds like political rhetoric to Roland Machold, a former state treasurer and the director of the Division of Investment for 23 years before his retirement in 1998.
“It’s just dead wrong. We met once a week to make our major decisions,” said Machold, who served under both Democrats and Republicans. He came back as treasurer under Gov. Christie Whitman from 1999 to 2001.
The meetings would bring together all the brainpower of the division, but trading would go on throughout the week, he said. If special circumstances arose, such as adverse stock news or steep price drops, the director or deputy director could make decisions between meetings, he said.
“Remember, we're making long-term investments,” he said. "We were not traders; we were investors.”
Despite ups and downs in market value, the fund has a long life, with money deposited for workers today set to be withdrawn 30 or 40 years in the future, Machold said.
“Volatility over that period of time averages out. If you took the full period, the volatility would be minuscule. That's the reason we were willing to do that,” Machold said.
He presided over much of the fund's windfall years when the market value more than doubled, from $36 billion in 1994 to $85 billion in 2000. By the end of 2002, it had retreated to $58 billion.
Soon after arriving in Trenton, the McGreevey administration cleaned house at the top levels of the division and the council.
In September 2003, Independent Fiduciary Services Inc., brought in by the state to review the division’s operations, called for an overhaul, making about 80 recommendations for changing and updating procedures and policies.
The independent study recommended adding staff. The division handles $68.9 billion with only seven portfolio managers and 10 investment analysts, an addition of one each since the report.
Proposals for growth
Regulations still handcuff portfolio managers from selecting appropriate investment vehicles, according to McCormac. Nearly three years after its $17.9 billion loss, the division is undergoing a slow makeover to streamline procedures ranging from electronic trading to analysis of real-time financial data as suggested by the IFS report, he said.
McCormac said the state has difficulty attracting investment professionals because state employees’ income is based on salaries, not on commissions and bonuses that can top millions of dollars at private investment firms.
McCormac wants to allow outside managers to handle money and diversify the portfolio by placing money in investment classes such as private companies, hedge funds, and real estate that are riskier than stocks or bonds but sometimes have produced larger returns in recent years. When added to a portfolio of more conservative investments, these riskier investments can moderate losses in tough economic times.
“We knew the No. 1 issue was diversification early on,” McCormac said. “Every state around us, every state in the country, had implemented some form of diversification. We had not.”
In late 2002, Orin Kramer, a New York-based hedge-fund manager with significant investment experience, joined the Investment Council. He was named chairman in September.
“There is not another major fund in the United States which is 100 percent internally managed and has no alternative investments,” Kramer said.
Diversifying the portfolio by adding riskier asset classes would reduce overall risk to the pension fund, he said.
Since 2002, the current council has changed the trading and investment procedures to make the division’s work more visible and responsible to the public. As a result, the ups and downs of the fund’s value and the risk of loss have declined, Kramer said.
“The process didn't meet the standards that are expected of major public funds in terms of public disclosure,” he said.
Forcing managers to defend their work at regular meetings reduces risk, he contended. First-rate investors can lose money, he said, but that is not the standard by which investment professionals should be judged.
If 15 percent of the portfolio had been invested in alternative investments over the 10-year period ending last year, the state would have been $9.2 billion richer, Kramer said.
And it wasn't until Kramer's arrival in 2002 that the state became involved in shareholders- rights and corporate governance issues.
New regulations permitting the division to move money out of its control and to private investment firms are still pending, McCormac said.
But the view that outside managers can do a better job has drawn some heat, and there is disagreement as to how much latitude the council has and whether the Legislature has barred certain types or categories of investment.
The New Jersey Education Association, with its 188,000 members paying into the system and drawing pensions, has resisted some of the state’s actions and has filed two lawsuits against the state, NJEA spokesman Steve Baker said.
Baker contended that although the pension fund is sound, the state has not properly been paying its share.
Given the severity of the pension-fund crisis, which will become obvious over the next few years, the structure of the investment portfolio must change, Kramer said. “It would be derelict of fiduciaries to ignore everything everybody knows about modern investment theory.”
