PENSIONS
New kids on the block
West Virginia's state pension funds began investing in stocks just three
years ago. They proceeded with native caution - which turned out to be
a good thing.
By Justin Dini
August 2001
Institutional Investor Magazine
Change comes slowly to West Virginia. The ground is still pitted with coal
mines, the Appalachian air echoes with the twangy sounds of string music,
and last year voters elected 83-year-old Robert Byrd to an eighth consecutive
six-year term in the Senate, a record in U.S. history. Until four years ago this conservatism also reigned at the state's public
pension funds. Operating under 19th-century guidelines, they were prohibited
from owning any stock or non-investment-grade bond. The result was disastrous.
Missing out on the long-running bull market in equities, West Virginia posted
among the worst returns of any public funds in the country. As the weakest
link in the state retirement system, the teachers' fund held just a fifth
of the assets it needed to meet its obligation to retirees, forcing the state
to pump in millions.
Finally, in 1997 the funds won the right to buy stocks, but Craig Slaughter,
the executive director of the West Virginia Investment Management Board,
moved with typical caution. By early 2000 he had put 40 percent into stocks,
mostly indexed in large-cap domestic shares, with the rest tucked into value
plays. After years of being eclipsed by more aggressive funds, Slaughter
had finally gotten a break. Though he got caught in the market downdraft,
his value stocks rallied, and his substantial bond holdings soared as rates
dropped, strengthening the state's returns.
The results were startling. With the Standard & Poor's
500 index down nearly 10 percent, the Nasdaq composite index off 39 percent
and the median
return among the nation's big pension funds off 2.54 percent, the West Virginia
Investment Management Board delivered a total return of 4.1 percent in 2000.
That figure made the state last year's top-performing fund among all public
plans, with more than $1 billion in assets, according to Wilshire Associates
Trust Universe Comparison Service.
It's a far cry from the fund's past performance. The plan recorded an average
annual return of 9.33 percent between 1987 and 1997, versus a median return
of 12.5 for large public funds. The five years ending December 31, 1997,
were especially dismal, as the fund returned 7.36 percent annually compared
with a peer group median of 13.3 percent. For both periods the pension plan
ranked at the lowest end of the bottom quartile of all big public funds,
according to TUCS.
"It doesn't hurt to have a little bit of luck," says Slaughter.
He adds that the fund's stock allocation has goosed returns as well. "Within
our equity portfolio, we are probably more diversified than most public funds;
half of our equity is large cap, the other half is mid- to small-cap," Slaughter
says.
For the West Virginia native, who has been fighting to broaden the fund's
investment mandate since he joined in 1989, the results are sweet satisfaction.
In 1993 the fund, still reeling from a derivatives debacle that predated
Slaughter, briefly dabbled in the market after winning approval from the
state legislature. It bought a few stocks, but they had to be sold when the
state supreme court ruled the move unconstitutional.
Voters kicked off West Virginia's pension fund revival in 1997, when they
passed a referendum amending the state constitution to allow the plan to
invest in equities. That year the state legislature lifted the 125-year-old
ban against stocks, although it simultaneously passed a law limiting the
plan's equity exposure to 60 percent.
Taking up their new mandate, the board of trustees at the
start of 1998 placed 3.5 percent of plan assets in an S&P 500 index
fund, upping the ante to 20 percent by year-end. Returns lagged, mostly
because of subpar
performance in the fund's fixed-income portfolio. In 1999, with equities
up to 40 percent, the plan returned 6.7 percent, weighed down by then-beleaguered
value stocks.
Today the equity allocation is up to 60 percent (still below an industry
average of 65 percent); half of the shares are in domestic large-cap stocks,
with 75 percent indexed. The rest of the equities are divided equally between
international stocks and small- and midcap domestic stocks. To manage them
West Virginia favors boutiques like the $1.9 billion Bellevue, Washington-based
Mastholm Asset Management, which runs a $220 million international stock
portfolio for the state.
"We consciously choose small managers," Slaughter says, mostly
because the fund prefers nimble stock pickers who can move quickly in response
to changing markets. "We believe the core strategy we have in place" -
a heavily indexed large-cap portfolio and active management in mid- and small-cap
stocks - "makes for a very strong, very stable portfolio."
Roger Hunter, the Charleston, West Virginia, attorney who
chairs the investment committee of the board of trustees, goes a step further: "We
would like to be the best public fund in the country."
They've got a ways to go. The West Virginia plan is essentially
an amalgam of 11 different state funds, including the state workers, teachers
and police
plans; the Workers' Compensation Fund; the Pneumoconiosis - or "black
lung" - Fund; the West Virginia Tobacco Settlement Fund; and the West
Virginia Prepaid Tuition Trust Fund, a tax-advantaged educational savings
vehicle. The funds report combined assets of $7 billion, including $5.5 billion
in pension funds, and fall under the supervision of the WVIMB.
Despite the recent performance boost, the West Virginia retirement plans
remain underfunded by some $4 billion. Almost all of the trouble comes from
the $1.05 billion teachers' fund, which in July 2000 was just 21.4 percent
funded, with an unfunded liability of $3.8 billion. The system faces its
shortfall largely because of decisions made in the late 1980s by the state
legislature and governors to shortchange the pension fund far below what
actuaries said was necessary to keep it stable. The state used the money
to cover holes elsewhere in its budget, whose deficits swelled through the
1980s. In 1987 West Virginia contributed just $16 million to the fund, and
in 1988 state officials tried to avoid making any contribution to what was
already an underfunded plan, until the state supreme court forced them to
make some payments to the plan. At the same time, the legislature bent to
the state's influential teachers' union and approved several pay hikes between
the mid-1980s and early 1990s, which further increased the liabilities of
the teachers' fund.
Beyond the $3.8 billion unfunded liability for its teachers' system, West
Virginia faces a $276.5 million shortfall in its state troopers' retirement
fund and $40.2 million in the judges' retirement fund. In the next year or
so, the state must float a $4 billion bond issue to help bolster the funds.
The $2.7 billion Public Employees' Retirement System, the other big fund
under the WVIMB's umbrella, has managed to stay fully funded because the
state has maintained a 9.5 percent annual contribution rate to that system
for years, and salary increases for state employees have been less generous.
Many other states have reduced state contributions to their pension systems
in the past four or five years, some below 1 percent, because the bull market
has made them flush with cash; West Virginia's mediocre returns made that
impossible.
Still, the state has come a long way since the grim days
of 1987. That year the retirement system and the state's $2.4 billion operating
budget lost
more than $287 million in a bond trading debacle that led the state to sue
Morgan Stanley & Co., Salomon Brothers and Goldman, Sachs & Co.,
among other Wall Street firms. The last dispute was not resolved until 1996.
The losses forced out the state treasurer, who quit after he was impeached
by the legislature.
Soon after the bond trading fiasco, a new governor, Gaston Caperton, took
office. As he moved to shore up the state's fiscal straits, raising taxes
and cutting government spending, he also took steps to reform the management
of the pension funds.
Until 1990 the West Virginia Board of Investments - made up of the governor,
the treasurer and the state auditor - oversaw the state's pension funds as
well as its operating fund. Under this arrangement the treasurer served as
the de facto chief investment officer for the state, and he and his staff
ran the day-to-day investment operations. After the scandal the legislature
pulled the investment management function out of the treasurer's office,
creating an independent staff for the West Virginia Board of Investments,
of which Slaughter was named chief of staff. In addition, the board was expanded
to include four more members. Today 13 trustees oversee the WVIMB.
Slaughter has honed his political and financial skills over
the years to keep his critics at bay. An avid cyclist and a graduate of
Cornell University
and West Virgina University College of Law, Slaughter carefully cultivates
the different constituencies that the fund must address: the state legislators,
local government representatives and the public workers themselves. "He's
doing everything he needs to do," says Patti Hamilton, executive director
of the West Virginia Association of Counties, a group that represents some
400 local government officials and is a reluctant supporter of the move into
stocks. Hamilton says that Slaughter has kept her group informed about the
WVIMB's performance and potential shifts in investment strategy. Says Slaughter, "We're
in a fishbowl, and that's a good thing."
In 1872 West Virginia lawmakers added a provision to the state constitution
that prohibited public funds from owning stock in any company or association.
Many states had similar taboos in place, but West Virginia saw itself as
particularly vulnerable to the vagaries of market forces, given the state's
dependence on the coal industry.
"This is a big company state," says Robert Plymale, the state
senator who played a crucial role in the 1997 reform. "Coal companies
owned most of the land, and they pretty much ran the store. There's been
a historic distrust among West Virginians that said if you allow the government
to buy into those companies' stocks, the companies would own the state."
By the 1960s most public funds nationwide placed at least a small portion
of their assets in equity markets. By the mid-1990s only three states prohibited
pension fund investment in stocks: Indiana, South Carolina and West Virginia.
(Today all three can invest in equities.) In the early 1990s staffers in
the West Virginia treasurer's office began muttering about trying to lift
the ban, but before that could happen, the state was forced to clean up one
very messy financial scandal.
Historically, West Virginia's state treasurer had wielded
enormous power over the state's finances. In early 1985 state treasurer
A. James Manchin
and two of his deputies moved to boost returns through trading in long-term
U.S. Treasury bonds - trading that a later report by special prosecutor James
Lees found to be "extremely speculative."
For two years the approach did in fact goose returns as interest rates fell,
but the strategy began to unravel in March 1987 when rates spiked higher.
Suddenly, West Virginia faced a $22 million trading loss.
Rather than eat the loss, West Virginia tried to claw its
way back into the black. Much later the state, citing the legal doctrine
of "know
your customer," alleged in court that Morgan Stanley and Salomon Brothers,
among other Wall Street firms, had used illegally "aggressive" sales
tactics to persuade the state treasurer and his staff to try to trade their
way out of the shortfall. But that only exacerbated an already ugly loss. "What
they were essentially doing was day trading," says Slaughter. "The
problem wasn't that big until they tried to day trade out of it."
The treasurer's office negotiated reverse repurchase agreements with some
of its investment banks, which essentially allowed the state to stall for
time in the hopes that interest rates would turn back in its favor. They
didn't, and West Virginia continued to get hammered. Within months the initial
$22 million deficit mushroomed into a $287 million loss.
The debacle became public in late 1988 following an independent audit of
the treasurer's office. The news broke soon after Caperton, a Democrat, had
won the race for governor but before he took office. It emerged, too, that
the treasurer had not just been playing around with the state's retirement
portfolios, but was also investing the government's $2.4 billion operating
budget. Most of the trading losses, in fact, came from the state's operating
fund.
Not surprisingly, state treasurer Manchin took a direct hit. In June 1989
the state legislature voted to impeach him, and he resigned that July after
41 years in state government. (In 1998, Manchin was elected to the state's
House of Delegates.)
In 1989 the state sued the Wall Street firms that had encouraged the bond
trading. Seven years later all the suits had been settled out of court, with
West Virginia recovering a total of $55 million. Morgan Stanley, which was
alleged to have orchestrated most of the losses, coughed up $20 million.
"This was a state in real distress. We could ill afford a scandal like
this," says attorney Thomas Heywood, who first served as Caperton's
legal counsel and later as chief of staff.
Through the late 1980s West Virginia, like most of the Rust Belt, suffered
the effects of deindustrialization - widespread factory closings, bankruptcy
filings and a sharp decline in tax revenues. In 1988 the state's unemployment
rate reached 9.2 percent, second only to Louisiana's 9.6 percent, and well
above the national average of 5.6 percent. The state's fiscal deficits swelled,
reaching a high of $500 million in 1989.
That same year, as a first step toward reforming the state pension system,
governor Caperton recommended adding four additional members to the Board
of Investments, stipulating that the new trustees should come from the private
sector.
The governor appointed Thomas Loehr, then a state senator, to serve as interim
treasurer. In August 1989 Loehr tapped Slaughter, whose law firm had worked
for Loehr's investment company, to be the treasurer's chief of staff. Then
in 1990 the legislature voted to split the treasurer's office from the Board
of Investments. The WVIMB assumed oversight responsibility for the operating
fund, and Slaughter became the board's chief of staff.
After instituting other controls - mandating independent
annual audits, hiring an internal auditor who reported directly to the
newly constituted
board - Slaughter began to think about buying stocks. "It was a no-brainer," Slaughter
says.
But West Virginians weren't so sure. "Our retirees were just scared
to death about investing in equities," Slaughter says. With fresh memories
of the 1987 bond trading scandal, voters also wanted to be sure that the
fund's managers acted responsibly. "People wanted safeguards put in
place," says Marie Prezioso, a fund trustee since 1995 and an executive
at regional investment bank Ferris, Baker Watts. "They wanted a highly
independent, professional board and staff."
When the legislature voted to put the stock investment referendum to a vote,
newly elected Republican governor Cecil Underwood was determined to get the
measure passed. With the help of a $330,000 advertising campaign, the amendment's
supporters made a strong case for portfolio diversification.
Boosting returns took on added urgency since several of the system's plans,
primarily the teachers' retirement fund, had become severely underfunded.
The inevitable fallout from decisions by the legislature in the 1980s and
early 1990s served to dramatically reduce state contributions to the pension
funds. Under then-governor Arch Moore, the state, wrestling with budget deficits,
used those scheduled contributions to the teachers' fund to cover shortfalls
elsewhere in the state budget.
Although fewer than 10 percent of eligible voters showed up at the polls,
in September 1997 the Modern Investment Management Amendment passed overwhelmingly,
with 78 percent of voters supporting the measure.
Newly empowered, Slaughter went to work.
His first move was both predictable and sensible - he hired
a consulting firm, St. Louis-based Summit Strategies Group, to recommend
an asset allocation
strategy. Its thrust: moving steadily toward West Virginia's new 60 percent
stock cap; indexing the vast majority of large-cap domestic equities; and
hiring boutique asset managers to handle the remaining portfolios. The firm
also endorsed Slaughter's instinct to manage none of the fund's assets in-house
and to overweight the actively managed stock portfolios with value names.
Says Slaughter, "We thought that value would prevail in the long run."
By February 1998 West Virginia had shifted nearly $20 million
of its assets into an S&P 500 index fund run by State Street Global Advisors, selling
bonds to finance the move. "We wanted to get equity exposure just as
quickly as possible and right off the bat," says Stephen Holmes, president
of Summit. "The strategy was to begin with index funds and build out
from there."
Acting on Summit's advice, the state adopted a performance-based fee arrangement
instead of the more traditional asset-based compensation. (According to a
recent Institutional Investor survey of public and private plan sponsors,
38.1 percent have some form of performance-based fee arrangement in place
with their managers.) By the fall the fund had hired all of its 16 active
and two passive managers. The roster that WVIMB installed by September 1998
has remained mostly intact.
Just as he settled into his new post, Slaughter was nearly
shown the door. In May 1999, as his three-year contract was about to expire,
the trustees
began a nationwide search for Slaughter's replacement, thinking that the
fund would be better served by a more experienced administrator. "At
the time, we really wanted someone who had a financial background but who
also had administrative experience," says trustee Prezioso.
Slaughter applied for his own job, and by September the trustees had whittled
the candidates down from 57 contenders to five finalists, including Slaughter.
That month the board voted to offer his job to Joseph Markus, West Virginia's
secretary of administration and an aide to governor Underwood, who was working
on West Virginia's $4 billion pension bond proposal (which is still pending).
Markus accepted the offer but a week later withdrew his name from consideration
when his insistence that he continue to oversee the bond offering sparked
criticisms from public interest advocates. They argued that for Markus to
do both jobs would be a conflict of interest. A week later the board offered
Slaughter his job back, and he took it.
By early 2000 Slaughter decided that he needed a chief investment officer
to help monitor the roster of money managers, as well as someone who could
help the fund diversify into alternative asset classes. In May the fund hired
as its first CIO Timothy Carlson, a 34-year-old former Marine who served
in the Gulf War. Carlson left a job as a senior investment officer at the
Iowa Public Employees Retirement System for the new job in Charleston, and
his timing proved impeccable.
He joined Slaughter just as the Nasdaq was imploding - and
West Virginia was consequently reaping the benefits of a 50 percent allocation
to fixed
income. "We weren't fully exposed to stocks in April 2000, so we did
a lot of our buying after the markets dropped," Slaughter notes. By
the end of the year, fixed income was down to 45 percent and equities represented
55 percent of fund assets.
Slaughter notes proudly that 16 of the fund's 18 managers beat their benchmarks
last year. Santa Monica, California-based Dimensional Fund Advisors, which
runs 50 percent of the small- and midcap portfolio using a modified value
approach, fell short as did Los Angeles-based Capital Guardian Trust Co.,
which runs an emerging-markets equity fund. New York's Silchester International
Investors turned in the most impressive performance, delivering a return
of 15.9 percent on its international equity portfolio, versus a 14 percent
loss for the Morgan Stanley Capital International Europe, Australasia and
Far East index.
Altogether West Virginia's equity investments declined 3
percent in 2000, versus the 6.8 percent loss produced by the fund's benchmark,
a blend of
the EAFE, Russell 2000 and S&P 500 indexes.
The fund's large-cap investment of $1.5 billion fell 7.9
percent, net of fees, versus the 9.1 percent decline in the S&P 500.
This was a real achievement given that 75 percent of the portfolio was
passively invested.
West Virginia's $780 million small- and midcap equity slice doubled up the
Russell 2000, rising 8.6 percent versus 4.3 percent. Among the fund's holdings:
St. Jude Medical, a medical equipment maker; financial services firm MBIA
and natural gas distributor Peoples Energy Corp. The fund's $811 million
international portfolio declined 4.2 percent. Its benchmark was down 14 percent.
"I didn't know what to expect when West Virginia hired us in July 1998," says
Theodore Tyson, the chief investment officer of Mastholm Asset Management,
one of the fund's international stock managers. "My fear was that they'd
be overwhelmed because they were dealing with all these new asset classes
for the first time. But they cleared up that concern in a nanosecond."
The fund's $2.8 billion fixed-income portfolio, comprised mostly of investment-grade
corporate and U.S. Treasury bonds, gained 13.1 percent, versus an 11.6 percent
return for the Salomon broad investment grade index. West Virginia's active
bond managers are Pasadena, California-based Western Asset Management Co.,
which manages 45 percent of the fixed-income portfolio using a core strategy;
and Austin, Texas-based Hoisington Investment Management Co., which handles
10 percent of assets using a macroeconomic approach.
"I think the incentivization of the managers was a key part of how
well we performed," says trustee Hunter. "If they perform well,
then we're willing to pay them for that."
If West Virginia is to keep up its winning streak, it will
almost certainly have to raise or eliminate its cap on equity investments
and dabble in alternative
assets, says Slaughter. After all, the average public fund has 65 percent
of its investments in public stocks, with at least a few percentage points
worth of private equity. Will the 60 percent cap be eliminated? If CIO Carlson
had his way, it would disappear tomorrow. "Academically, I don't think
we should have a cap. By having artificial restrictions like a 60 percent
cap in place, I think it really closes off your access to the entire universe
of investments," he says.
Still, in a state that wrestled with the issue for years,
there is nothing academic about the debate over the cap on equities. State
Senator Plymale
introduced legislation last year that would have eliminated the cap, but
it died in the state's House of Representatives after the Senate passed it
overwhelmingly, 32 to 2. At this point, at least one of the trustees wants
to keep the restraint. "I personally think 60 percent is a good number
because we're still new at it," says trustee Patrick Kelly. "I
don't think we should stay at 60 percent forever, but in the near term, I
think that's plenty."
"That cap, to many of my constituents, is very much a comfort level," says
lobbyist Hamilton, whose West Virginia Association of Counties was a reluctant
supporter of the referendum in 1997. Slaughter and Carlson must also persuade
their board to venture into private equity. The WVIMB is permitted to invest
in alternative investments under the 60 percent cap, and Carlson says he
has begun to look into expanding the fund's equity investments. "I think
it is something to keep an open mind about," he says. Earlier this year
the trustees authorized investing in corporate bonds with a B rating. "But," cautions
trustee Kelly, "this is still a fairly conservative board."
Many in West Virginia say that the board is especially cautious
because West Virginia is one of the few states that makes its trustees
and staff
personally liable "for any losses resulting from a breach of duty imposed
by the act." Says Kelly: "The personal liability aspect certainly
clarifies our decision-making process. That gets your attention."
This is a state that harbors sour memories of failed investing
ventures. "The
first two years after we were hired, all I heard were two words: James Manchin," says
Summit's Holmes. Adds trustee Hunter, "I think, given our state's unique
history, we do feel a heavy sense of responsibility to be extra cautious
and extra prudent."
And well they might: Just such a cautious streak propelled West Virginia
to the head of the pension pack.
©Copyright 2001 Institutional Investor, Inc.
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