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Taking risks

The state pension fund invests aggressively, keeping two-thirds of its assets in stocks. Though returns aren't guaranteed and the fund lost millions when Enron collapsed, don't expect a change in strategy. Overall the approach has paid off handsomely.

By HELEN HUNTLEY, Times Staff Writer

© St. Petersburg Times
published March 24, 2002


Investing is risky.

Any doubts Floridians may have had went down in flames with Enron Corp. More than $300-million of state pension fund assets evaporated as the company's fortunes plummeted last summer and fall.

It may be years before all the accusations can be sorted out. Florida already has sued Enron's officers, directors and auditors and is preparing to go after the money manager who bought the state's shares.

The episode also is prompting state officials to take a hard look at the way they invest the pension fund's $95-billion. But don't expect them to stop taking risks.

They can't.

"The state's job and our job is to take risks," said Philadelphia money manager Ted Aronson, whose company manages $1.7-billion for the state. "The goal is to take them as intelligently as possible, but the very word risk indicates this stuff isn't certain."

The Florida Retirement System is deliberately an aggressive investor. It keeps two-thirds of its assets in stocks, the kind of investment strategy a financial planner might recommend to a midcareer worker saving for retirement.

That approach makes Florida a bigger risk taker than the average large pension fund, which stashes a greater percentage of its money in bonds and cash.

The State Board of Administration, which manages the pension fund, says the approach is a carefully calculated bet of what it will take to provide future pension paychecks for today's public employees. Because Florida is a growing state, its public employees are a younger group, on average, than public workers in some other large states. That means future costs are more difficult to predict with accuracy. To pay their benefits, the state estimates the fund needs to earn an average 4.3 percent above the rate of inflation each year.

"With 600,000 active members (in the pension plan), there's a huge unknown future liability out there," board director Tom Herndon said. "The only market where we have a reasonable expectation of meeting our goals is the equity market."

The state's approach paid off handsomely during most of the 1990s, when stocks did exceptionally well. Over the past 10 years, the Florida fund earned an annual return of 10.4 percent compared with 9.8 percent for the average large fund. Small though it was, that performance edge generated $6-billion in additional wealth for the state, according to the calculations of Chicago investment consultant Ennis Knupp & Associates.

Strong investment returns created a surplus that allowed state and local government employers to save millions of dollars. Their required annual contribution to the plan, which was about 17 percent of payroll in the mid-1990s, is 7.3 percent this year and scheduled to decline further in July. Right now the fund is collecting less in contributions than it is paying out in benefits, taking the difference out of the surplus.

But the stock emphasis that gave Florida a performance boost on the market's way up turned into a disadvantage on its way down.

Last year the Florida fund lost 5.8 percent of its value while the average fund lost 5 percent. Unless politicians are prepared to start tinkering with the benefits promised to 612,000 workers and 213,000 retirees, the shrinking surplus means contributions eventually will be headed back up.

Contribution rates also will be affected by the transition to a two-tier retirement system. Public employees are being offered the option to switch to a plan that replaces guaranteed benefits with the investment return earned on their individual accounts.

"Our projections are that in two years the contribution rate will start to creep back up again," Herndon said. "In the not too distant future, they'll be twice what they are now," he predicted.

Only a fraction of a percentage point of last year's Florida loss was due to Enron. Across all accounts, the pension fund lost $322-million on Enron stock and $11-million on Enron-related bonds, some of which it still owns.

Still the size of the Enron loss is prompting pension fund administrators, their advisers and critics to look for ways to prevent future disasters.

"Somehow we are the biggest loser in this thing," lamented Tampa accountant Gil Hernandez, who serves on a citizen advisory committee for the fund. He suggested looking to large pension funds in California and New York for answers: "Get on the phone with the people in Sacramento and the people in Albany and say, "Guys, what are you doing?' "

But there are no easy solutions. Although those funds lost less on Enron, their overall performance was worse than Florida's last year.

The problem for anyone trying to reduce risk is that risk and return are closely related. As in baseball, it is not unusual to strike out when you swing for the fences.

Ultimately the performance of Florida's pension fund, like that of many large pension funds across the country, depends to a large degree on the luck, brains and intuition of a few dozen stock pickers fortified by a small army of analysts, traders and computer programmers.

For the $64-billion the Florida fund keeps in stocks, it relies on 19 outside money management companies and a single state-employed stock picker.

About 60 percent of the money in U.S. stocks and 42 percent of that in foreign stocks is invested in funds that track market indexes, such as the Standard & Poor's 500. The rest is actively managed, handed over to smart stock pickers with good track records who think they can beat the market. That's how Alliance Capital got hired back in 1984.

The recent selection of a single new money manager began with the screening of 360 potential prospects and wound its way through questionnaires, conference calls, reference checks and lengthy interviews.

Barring any unusual circumstances, managers get three years to prove their worth. While they invest, state employees and independent consultants look over their shoulders, tracking their performance, their trading costs and their adherence to their contracts.

"It's our view, based on our analytics and consultants, that three years is about the time you can really tell who's lucky and who's skillful," Herndon said.

Pension fund experts say managers should be judged over time.

"They ought to be managing not for the year but for the long run," said Olivia Mitchell, executive director of the Pension Research Council at the Wharton School. "If you continually focus on the daily or weekly or monthly time horizon, you may make a lot of decisions that look sensible in the short term, but you're giving up the possibility of doing a different investment strategy that would make sense in the long term."

Most of the Enron losses, $281-million worth, came down to a huge bet by one person, Alliance Capital money manager Al Harrison, who thought Enron was temporarily down, but not out. Not only was he wrong, but he incensed Herndon and other pension fund managers by failing to tell them when he reversed course and dumped the state's 7.6-million Enron shares for 28 cents apiece. Florida fired Alliance Capital.

The episode raised questions about the state's supervision of its money managers. But it turned out that in the Alliance's case, state employees were watching and asking questions.

Trent Webster, the board's in-house stock picker, said Enron never made sense to him -- not when the stock was soaring to more than $80 a share and not when it was giving back all those gains.

"Enron was a stock that we had watched for years and we couldn't understand why it kept going up," he said. Webster, 33, came to work for the state five years ago as a newly minted MBA from the University of Toronto. Now part of his job is managing a $426-million stock portfolio and part is watching over outside managers such as Alliance, which at one time had $5.7-billion of the state's money.

Webster took his concerns about Enron to his bosses and to Alliance, but Harrison reassured them. No one told Harrison to sell Enron, and it isn't likely the state will start telling other managers when to sell their investments either.

Money managers say that's the way it should be.

"When a sponsor intrudes in an asset manager's decisions, that's a mistake," said Rob Arnott, whose California company, First Quadrant Corp., formerly managed money for Florida. "If a sponsor tells a manager what they can or cannot hold, it interferes with the manager's normal investment process and is actually damaging to returns. Suppose they (Florida) had called Alliance and said, "The numbers don't add up. Please sell Enron.' Then suppose Enron had then gone back from $20 to $80 a share? There would have been second-guessing in the other direction."

He said fund administrators such as the state are correct to ask questions, but ultimately have to trust their managers' judgments.

"Everyone has investments that don't work," he said. "Asset management is a business of mistakes. The winner is the one who makes the fewest mistakes, not the one who makes no mistakes."

But mistakes such as Enron have some people, including Herndon, asking whether the fund should reduce its stock market exposure or put more of its money into index funds rather than relying on individuals' stock picking skills.

Those are questions the Board of Administration will be addressing in the months ahead as it raises cash to fund the individual accounts in the new retirement plan.

"The fund faces some very significant changes," Herndon said. "We're going to redo our entire asset allocation next summer. I wouldn't be surprised if the fund becomes more conservative."

He said there also is a strong possibility that the fund will move away from active investing, putting more of its stock investments in index funds.

The argument for indexing is that it's next to impossible for even the best managers to beat the market over long periods of time. Over the past decade, the Florida fund's U.S. stock picks have done slightly better than the index used for comparison, up an annual average of 12.5 percent vs. 12.3 percent for the Wilshire 2500 Stock Index. But last year they did worse: down 11.6 percent vs. 11.5 percent for the index.

In recent years the Board of Administration has chosen not to try to time the stock market or to predict whether growth or value stocks will be winners. Rather, it sets target percentages for each type of investment, then periodically rebalances to keep the fund's investments within a few percentage points of the target.

If the board reduces its target percentage for stocks next year, it will end up increasing the percentage for one or more of the other categories, which have risks of their own.

On the fixed income side, the pension fund owns about $23-billion worth of mortgages, government and corporate securities. About $1-billion of that is in portfolios of high-yield debt, the riskiest side of income investing.

But even government bonds are subject to market fluctuations, appreciating in value when interest rates fall and declining in value when interest rates rise, as they may in the year ahead. About 60 percent of the state's fixed-income portfolio is managed in-house, the rest by a dozen outside money managers under contract.

About $4-billion of the pension fund's money is invested in commercial real estate. The fund started out pooling its money with other big investors when it began investing in real estate in 1984. Since then it has moved into direct ownership and now owns 45 properties, mostly office buildings, apartments and warehouses spread from New York to California. Its Florida properties include the Board of Administration headquarters in Tallahassee, a Tampa office building, four Orlando warehouses and 7,500 acres of citrus groves.

Most of the work of acquiring and managing property is done by outside contractors -- real estate advisers, auditors, engineers, appraisers, lawyers and property managers -- who are overseen by the board's nine-person real estate department.

Another 4 percent of the pension fund is in "alternative investments," partnerships that invest in private companies, where the risk and the possibility of hitting a home run are higher than they are with publicly traded companies. Thirteen outside companies handle those investments.

But neither real estate nor partnerships can be readily bought and sold, which means they are not likely ever to become a large share of the overall pension portfolio.

Pension experts say there is no "best" investment allocation that's right for every public pension fund. Some funds have legal restrictions on how they are permitted to invest. Either law or state policy may limit the percentage that can be invested in stocks or prohibit investments in certain types of stocks, such as tobacco stocks, which were at one time on the forbidden list for Florida pension fund managers.

"One thing we have found is that when you have plan participants on the boards of trustees, the plans tend to invest a little more conservatively, to be more focused on bonds and fixed income," said Mitchell of the Pension Research Council.

Pension plan participants have no investment decisionmaking role in Florida. The Board of Administration has only three trustees: the governor, the treasurer and the comptroller. The board also has an advisory committee of financial professionals appointed by the trustees.

Retired teacher Joan King, who has been watching the board closely for a decade, said participants should be represented on the board. But she said she has no complaints about the way the money has been invested.

"I've been pretty well pleased and I started out being extremely skeptical," said King, who lives in Orlando. She said many retirees were alarmed when they heard about the losses on Enron, but were reassured when they learned their benefits were safe.

"They feel pretty secure now," she said.

But their future financial security still rests on what cannot be predicted: the stock and bond markets' returns and the size of taxpayer-funded pension plan contributions.

-- Helen Huntley can be reached at huntley@sptimes.com or (727) 893-8230.

Florida Retirement System Pension Fund

How big is it? About $95-billion. As the stock market rises and falls, the fund's value fluctuates by millions of dollars.

Who contributes to it? The state and participating local governments pay a percentage of their payroll, which changes annually. For most employees the current rate is 7.3 percent. Rates are higher for law enforcement employees, senior managers and elected officials, who receive better benefits.

Who invests the money? The State Board of Administration, which employs 46 investment professionals and 123 support workers. It also contracts with and supervises private money managers, investment advisers, consultants, auditors and appraisers. The board's budget is $23-million, not including money managers' fees, which are deducted from the funds they invest.

Who's covered? 213,169 retirees and 612,391 current employees of the state and participating counties, cities, school boards and government agencies. Some local governments have separate plans.

What kind of benefits do they get? Employees are vested after six years of service and in most cases can start collecting regular retirement benefits at age 62 or after 30 years service. Pensions, which are administered by the Division of Retirement, are based on pay and years of service. Employees now have a choice to opt out of that plan and sign up for individual self-directed accounts in which investment performance will replace guaranteed benefits.

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