In our December issue of What’s Up? Annapolis, we summarized the criticism of the performance of the Maryland State Retirement and Pension System, particularly as expressed by two Washington Post articles in 2016 and 2017 featuring analysis by Jeffrey Hooke, a Managing Director of Focus Securities and a senior lecturer for the Carey Business School at The Johns Hopkins University (read the full article at whatsupmag.com). Earlier this year, we interviewed Mr. Hooke and five Maryland state legislators who sit on the Joint Oversight Committee on Pensions: Delegates Brook Lierman (D-Baltimore) and Michael Jackson (D-Prince George’s County), and senators Douglas J.J. Peters (D-Prince George’s), Adelaide Eckardt (R-Dorchester, Caroline, Talbot and Wicomico counties), and Andrew Serafini (R-Washington County). First up: Jeffrey Hooke.
Mark Croatti: I’ll get right to the point: How has the Maryland State Retirement and Pension System performed since 2016?
Jeffrey Hooke (hands me the March 31, 2019 Maryland State Retirement and Pension System Quarterly Investment Update): Fiscal year-to-date, the total plan investment performance has been 3.4 percent; for the past three years, 3.9 percent; for the past five years, 5.7 percent; for the past ten years, 9.5 percent. That means that the fund is doing worse the past three years than it was doing five and even ten years ago.
Croatti: Why?
Hooke: Poor fund management, even though Maryland pays almost $350 million a year in investment fees to professional fund managers. Maryland is in the top five of states in fees as a percent of assets; they don’t even know exactly what the fees are because they’re estimated. The legislature doesn’t have to approve the fees; if they had to, they’d rethink it. The fees are not providing a sufficient return; they’re lousy. The legislature should approve the fees!
Croatti: What about the Kumar Barve Bill passed in the 2019 legislative session?
Hooke: It was watered down considerably. It was supposed to force the disclosure of both “regular” and “hidden” fees but the pension board watered it down. The legislature has no say in who sits on the pension’s Board of Trustees; the Governor appoints the trustees while a few are on the board by law. They meet every three months and select asset managers of all kinds—bonds, stocks, private equity, real estate, hedge funds, etc. The various funds in the Maryland State Retirement and Pension System can choose their own asset managers who then set up a phony benchmark as a performance goal, but always find a way to “beat” it, giving the illusion that the System is doing well. However, few states can beat the 60-40 index; most are far below. The $350 million in fees can be better spent; instead of using high-priced professionals to actively manage the fund according to a phony benchmark, Maryland should index everything and simply copy the 60-40. Low fees can still be paired with active management.
Croatti: What does this mean for future retirees?
Hooke: Ultimately, Maryland will have to cut benefits if the funds aren’t where they’re supposed to be in ten to twenty years, or they’ll have increase employee contributions from those who haven’t retired yet, or the state’s annual contribution may need to go up as much as 50 percent from the $1 billion annually already provided, so they’ll have to raise taxes. The legislature should be asking, “Why aren’t the annual returns high enough to fully fund the number of future retirees?” But they have very little oversight. The trustees could change all of this tomorrow with one vote but they don’t want to. The Governor could have some pull, but he signed the compromise bill in 2018.
Next, we drove to Baltimore to meet with Delegate Brooke Lierman.
Mark Croatti: So, did it turn out that the pension fund was actually performing as poorly as The Washington Post articles described?
Delegate Brooke Lierman: It’s all about asset allocation. The Board moved away from the 60-40 index in order to diversify the portfolio from a more concentrated asset allocation, but they did it in a bad year, 2009, following the housing market crash, so that it would be less volatile. The model was Washington state in terms of diversification and annual returns. We are moving to where Washington is; we’re not there yet but we’re getting there.
Croatti: Jeffrey Hooke doesn’t think so.
Lierman: I know Jeffrey, I’ve talked to him many times. But according to the S&P 500, within the last thirty years, we’ve had the two best ten-year return periods, historically. Right now, we’re in a fluke period; we have to find the “sweet spot”—the lowest risk with the highest return possible. That’s the quest of the Maryland State Retirement and Pension System, to ensure we’re always able to meet our obligations to our state employees.
Croatti: Hooke says the legislature has very little oversight to ensure those goals and no power to approve the $350 million paid to the fund’s professional managers.
Lierman: There’s risk in politicizing how the fund is managed. The Maryland State Retirement and Pension System did not have the level of help it needed to hire and retain their own investment team. The better professional managers cost more. Roughly 65 percent of the fund is in passively managed stocks. Where they’re using active management is in private equity, and they’re getting excellent returns for the investment fees that are being paid, net of fees and expenses. Every asset class has exceeded its ten-year benchmark. The Maryland State Retirement and Pension System disagrees that Jeffrey’s numbers are being used to accurately portray the status of the fund. You should talk to State Senator Andrew Serafini—he’s the real expert.
Croatti: Why did the legislature decide to take a more cautious approach to reform in 2018 rather than the more aggressive suggestions highlighted by those quoted in the Washington Post articles?
Lierman: If we want to have a diversified portfolio, we need to have a certain degree of active management. The question is, do we manage the fund ourselves or source it out? The legislature passed a bill in 2018 to give the Maryland State Retirement and Pension System the ability to hire and set compensation for investment staff with the goal of bringing as much of the management as possible in-house, which we expect will happen, and that will reduce the fees.
We amended what we did in 2018 when we passed the Kumar Barve Bill in 2019, which requires disclosure of the amount of carried interest paid. Nobody wants to pay investment fees but we all want the best return. How do we empower the Maryland State Retirement and Pension System to do that? Is it appropriate for a part-time legislature with limited investment knowledge to override the many financial decisions that the Maryland State Retirement and Pension System has to make? What the legislature can do is to ensure that the Maryland State Retirement and Pension System meets its responsibilities to our retirees by providing active oversight of the Maryland State Retirement and Pension System so that everybody owed a pension has it waiting for them upon retirement. A pension is a promise and I am committed to keeping that promise.
After our visit with Delegate Lierman, we sat down with Senator Douglas J.J. Peters and Delegate Michael Jackson in Jackson’s Annapolis office. They began by handing us a joint statement addressing the questions I had sent to them ahead of time. Some of their responses overlapped with Delegate Lierman’s, while others offered some interesting insight summarized here:
• The Maryland State Retirement and Pension System had the portfolio Jeffrey Hooke recommends through the 1990s and 2000s but the very poor performance of S&P stocks during the 2000s was the primary contributor in the System dropping from 107 percent funded in 2000 to 63 percent funded in 2010. This represents a significant decrease in the unfunded liability which the state, employees, and other sponsors are now working to pay down. The System diversified away from stocks to reduce the ability of any one asset class to significantly impact the contribution rates of the sponsors while maintaining confidence that the mix of assets will achieve the actuarial return over time. The legislature has focused on the asset allocation question in the past. In 2016, the Treasurer was required to fund a special consultant, NEPC, to review the issue. They advised that the System stay the course. The lower returns are largely a function of this lower risk diversified approach. Viewing the returns compared to the risk, the System performs better than the 60-40 portfolio recommended by Hooke.
• The legislature has had an impact on the System’s management. In 2006–07, the legislature moved the hire/fire authority from the Board of Trustees to the CIO, an example of implementing a best practice that demonstrated foresight. The legislature has a strong relationship with the Board and meets with its representatives on a regular basis. The Joint Oversight Committee on Pensions has used the annual review process to question the Board about its practices and suggest potential improvements based on what other states are doing, but none of the states mentioned in the Washington Post articles—New Jersey, New York, Nevada, North Carolina, and Pennsylvania—used legislation to enact their pension reforms.
I then asked Senator Peters and Delegate Jackson some direct questions:
Croatti: The other states you mentioned that didn’t use legislation to enact their reforms instead saw major decisions made by their fund managers that Maryland’s managers have so far not made, like cutting fees and switching to passively managed funds. Should the Maryland legislature make those changes if their System managers won’t?
Senator Douglas J.J. Peters: What the legislature can do is monitor, provide input, perform “stress tests,” and 100 percent fund the System. We’ve done all that, a lot of work the past three years. People want safety; that’s paramount for us, and that might mean less risky investments. Our retirees can’t be left with an underfunded, bankrupt plan.
Delegate Michael Jackson: We are always monitoring the System and making sure it’s properly funded. That’s our job. The decisions are made by a Joint Oversight Committee. This is a coordinated effort. Some of the issues mentioned in the articles are not under our control but we see counsel constantly to see if legislative adjustments need to be made.
Peters: For example, counties had to take on 50 percent of the pension plan’s state obligation in order to fully fund it. Getting the pension to within a percentage in line with other states was the goal because that made everyone comfortable. Maryland doesn’t have the worst pension system, and it’s not the best, but now we’re on the right trajectory. Jeffrey Hooke needs to come to our meetings and engage in the process, and then if he has the same opinion, I’ll understand.
Jackson: The meetings are also streamed.
We then spoke on the phone with Senator Adelaide Eckardt.
Croatti: Many states are engaging in some aspect of pension reform. In light of the issues raised in the Post articles, is Maryland doing enough?
Senator Adelaide Eckardt: We’re doing the best with what we have to work with. The Supplemental Retirement System does real well, all the time, so why doesn’t the main fund? Because the Supplemental Fund is contracted out. But the Maryland State Retirement and Pension System decided they wanted to hire their own people because the salaries were woefully inadequate to attract quality candidates. It’s possible that if the pension fund was run like the Supplemental Fund it might do better because that fund is managed by Nationwide and has done well. Of course, when the stock market dips, everything goes down. But if you look at annual pension system returns, we go up and down, from 4 percent up to 10 percent.
Croatti: Why doesn’t the legislature’s Joint Oversight Committee on Pensions push for a pension system that adopts the successful strategies of the Supplemental Fund?
Eckardt: Because the jury’s still out on whether all of the recent changes will, in fact, increase our investment return and our level of funding. Those are the two main factors: return on investment and the level of funding. Right now, the Maryland State Retirement and Pension System is 71 percent funded, up from 70 percent. So, we’re only inching our way up to the next goal of 80 percent funded. Getting the funding stabilized has been an ongoing issue.
Eventually, with all of the new retirees coming, we’ll need to get to 100 percent funded much faster than the very slow climb we’ve been seeing. We realized in 2011, the last time we made major adjustments, that we need to put more money away. How to do that is a never-ending battle. You need to talk to Senator Andrew Serafini; he does this for a living.
Croatti: You’re the second person on the committee to say that.
Eckardt: Take my advice—don’t submit your article without talking to him!
Senator Andrew Serafini has been in the financial services industry since 1985. He owns a financial services company in Hagerstown, the Serafini Financial Group. According to his website, he is a graduate of the College for Financial Planning and became a Certified Financial Planner™ practitioner in 1994. Also, a graduate of the Municipal Bond School of Chicago, he is an Accredited Investment Fiduciary® and “holds FINRA Series 7, 24, and 63 securities registrations as an Investment Adviser Representative of Commonwealth Financial Network®”. We spoke on the phone:
Croatti: I was starting to get the sense that everyone on the legislature’s Joint Oversight Committee on Pensions was going to take the Maryland State Retirement and Pension System’s assessment over the criticism of Jeffrey Hooke, but then I spoke to Senator Eckardt, who suggested that reforming the pension fund’s management might actually lead to an improvement in the performance of the investment return. What do you think?
Senator Andrew Serafini: I think I’m going to give you more financial information than you’ll ever want to know.
Croatti: I have a 2,000-word maximum for this article.
Serafini: I’ll bet you’re already way over that.
Croatti: How did you know?
Serafini: Because you’re talking to me last. This is my profession. I know how long explaining the details can take.
Croatti: Well, I was told by two members of the committee to make sure I talk to you, so maybe you can give me the summary version.
Serafini: I’ll try. Maryland has what’s called a Defined Benefit Pension or Defined Contribution (401c) between employer and employee. The System’s health is tied to the risk of the market but managing both the risk and reward is the responsibility of the employer. The state has to kick in an annual amount if the fund doesn’t have enough money for a particular year’s retirees. In Maryland, if a teacher leaves the profession before they’re vested, their money goes back into the System.
Croatti: How much time does it take to be vested?
Serafini: That was one of the reforms. Let’s go back to 2000 when Parris Glendening was governor. The System was not only fully-funded, it was over-funded. Since the state didn’t have to kick in anything extra that year, he gave away the excess funding as an enhanced benefit without maintaining that rate of funding. Maryland has not been in that position since; what Glendening did caused real problems. In 2011, when Martin O’Malley was governor, he tried to fix it. Employees went from a 5 percent paycheck contribution to 7 percent; vesting went from five to ten years. Adjusting the variables of the formula that Maryland uses to determine a retiree’s payout resulted in a reduced benefit, which not only makes it harder to recruit and retain teachers and other jobs whose retirees the System funds, it goes against the state’s constitutional mandate to provide what we promised.
Croatti: What about the reforms that Jeffrey Hooke has suggested?
Serafini: The Maryland State Retirement and Pension System doesn’t want an “aggressive,” volatile fund but we’ve missed out by not taking a more aggressive approach. We pay very high investment management fees, which take away the System’s return. There’s a competition nationwide to lower fees because they’re a drag on returns. Look, you either beat the S&P index or you don’t; it’s not a Republican issue or a Democratic one. Hiring more people in-house to manage the System for a lot less money could improve the System’s performance but it could also make things much worse. The bottom line is, we are underfunded and underperforming—it’s just a fact. Why? Is it the Board of Trustees? The professional managers? There are eleven separate systems managed in one pension pot. The state contributes a certain percentage of an employee’s contribution depending on the occupation. We provide 75 cents for every dollar a state police officer contributes, but only 20 cents for every dollar a teacher contributes.
Croatti: That’s shocking.
Serafini: It gets worse! According to the Trust Universe Comparison Service (TUCS), a pension plan analytical tool developed by Wilshire Associates, Maryland’s performance over the last ten years is in the 99th percentile out of 100, where the 1st percentile is the best. Some say if we were in only the 50th percentile, we’d be billions ahead.
Conclusion
It is amazing that there could be such a wide gulf of opinion on the performance of the Maryland State Retirement and Pension System. Dozens of states across the country and many countries all over the world have enacted some level of pension reform but the fear of enhanced risk is always present. Almost 40 years ago, Chile unveiled a “Mercedes Benz” model that replaced a pay-as-you-go plan (where current employees pay for each year’s retirees) with a new model where workers are mandated to save a percentage of their earnings, which are then invested in private funds. According to The Economist, “by many measures the system has been a success.” The investment returns fueled an economic boom that made Chile the richest country in South America. But now even Chile must consider major reforms because of discrepancies involving both the level and duration of contributions, the size of the payout to the average person, and an increase in life expectancy, among other factors.
No pension system, American or foreign, diversified or stabilized, actively or passively managed, can last forever without adjustments that correspond to identified weaknesses by recognized experts. Instead of looking at only the best performance variables or finding fault with specific criticisms, Maryland needs to collect all points of view on the health of the state’s Retirement and Pension System and then, if necessary, find a way to move forward, together, for the sake of their retirees.
Mark Croatti teaches American Government at the United States Naval Academy and Comparative Politics at The George Washington University. He has also taught conflict resolution courses within the University of Oregon’s School of Law.
