How to Stop the Public Pension Brain Drain?

I had a great lunch today with someone from a US investment firm that manages roughly $8 billion. This person used to work for a well-known investment consulting firm and he's plugged with public and private pension plans down south.

We talked about everything: our backgrounds, my recent CCSVI procedure, my blog and how I can monetize it, future projects, the stock market, Japan, my views on hedge funds, private equity, real estate, investment consultants, and pension governance. One of the subjects we touched was how lousy the compensation system is at most US state plans. He was surprised to hear how senior pension officers at large Canadian public pension plans are compensated so well, with many senior officers making in excess of a million dollars when you include their long-term bonus (typically based on four-year rolling return over the benchmark).

After our lunch, which he graciously treated me to, he sent me this timely article written by Dan Primack of CNN Fortune, How to stop the public pension brain drain:

Some of America's largest public pension systems are in crisis. And, no, I'm not talking about the trillions of dollars in unfunded liabilities.

Instead, this is about how new regulations are impeding management of those systems' most lucrative assets. Some of the rules are in response to bribery scandals in states like California, New York, and New Mexico. But they threaten to make unstable financial situations even shakier (ok, I guess this sort of is about those unfunded liabilities).

Just last month, California's largest public pension lost two senior investors who had helped manage around $22 billion of private equity assets for California's largest public pension. Not because of below-market salaries, but because they felt handcuffed by the new rules. Others have executive recruiters on speed-dial.

So I've come up with a list of four reforms that public pensions should institute immediately. Otherwise, their money soon will be managed by newly minted MBAs whose institutional knowledge begins yesterday.

1. Stop fretting about the middlemen

The pension system crackdown came after a small number of placement agents—people who help private funds raise capital—were found to have traded political favors (or cash) to secure pension fund investments for their clients. The knee-jerk reaction in some states has been to either ban placement agents or to criminalize inadequate disclosure of their involvement.

This strategy is akin to baseball focusing on steroid dealers instead of on steroid use by its own players.

The placement agent scandals were enabled by pension systems turning a blind eye to how certain investments were made. Was a former pension board member acting as a placement agent and raising money for his former colleagues? Did those colleagues then put pressure on investment staff to approve the deal (or worse, overrule a staff recommendation against investing)?

Bribery is a two-way street, so pension systems should eliminate all nonpublic interaction between board members and investment staff. They also should enter all prospective investments into a database—including placement agent details—and create a step-by-step chronology of how the investment was introduced and vetted.

2. Fix compensation

The typical public-pension portfolio manager gets a salary, plus a bonus tied to the prior year's performance. But some long-term asset classes do not lend themselves to one-year performance reviews. Private equity investments, for example, typically produce something called a J-curve, in which performance is flat or slightly negative for the first several years and then quickly curves up.

Consequently many portfolio managers are credited for or discredited by the work of predecessors (since today's returns can be the result of much older investments).

Public pensions should defer bonuses to such managers until more accurate data is available. Not only will that encourage smarter investing, but it could help lock up talent.

3. Commonsense travel and gift rules

We obviously don't want pension investment staff receiving $7,000-a-night hotel suites from outside firms seeking business (yes, that happened). But we do want them to be able to do their job. Institute and enforce a $50 gift limit for items (golf balls, tote bags, etc.), but provide significant, supervisor-approved leeway for business-related meetings, meals, and travel.

For example, if portfolio managers are expected to work on laptops during 10-hour trips from Sacramento to London, it is counterproductive to make them sit in coach.

4. Let your people leave

Some states have begun pushing to prevent pension staffers from leaving to take jobs with firms that have received pension investments. Unfortunately, that could become a major impediment when recruiting new talent, particularly at large systems invested with hundreds of outside firms.

My solution: Prevent staffers from hiring on only at firms where they were responsible for the relationship. If it was someone else's deal—something we'll know from our database—then fly, fly away.

And exempt junior folks who do not have the authority to make decisions. Otherwise, it looks a bit like indentured servitude.

The best solution may be to spin out pension investment offices into quasi-private, independent organizations, kind of like what many top universities have done with their endowments. But that isn't politically feasible.

My proposed reforms, on the other hand, can be adopted immediately without too much blowback. If public pensions wait much longer, they will only keep losing their best people. And even more money.

This is a subject that I can go on and on about. In my "ideal governance" scenario, all pension fund managers get compensated on six year rolling return basis. Senior public pension officers get compensated properly, based primarily on the fund's overall results, and if they deliver results, they're entitled to a decent bonus that is competitive relative to the private sector.

One caveat to this: if the Fund loses 10% or more on any given year, no bonus whatsoever even if they beat their benchmark. This may sound harsh but it's a politically wise decision.

As for travel and gifts, I have no problem with pension officers traveling business class but the points one accumulates should be used for future business trips, not personal trips. If the public pension fund is paying your business class trip to Asia, Europe or wherever, then you should use the points you collect from these trips for business trips or pass them to other employees who also travel for the pension fund. As for wining and dining, most pension funds have strict rules when it comes to dinners and gifts, but very few actually enforce them.

Unfortunately, the pension business is fraught with potential bribes, frauds and scams. When someone can sign multi-million dollar cheques over to some fund, some consultant, some IT vendor or whatever, then they can easily arrange to get kickbacks under the table. And good luck tracking this stuff. Nowadays, anyone can set up an offshore bank account and have money wired into an account. Nobody will ever know that a kickback took place unless this idiot goes off and starts living the high life and raising eyebrows.

The one scam that really pisses me off is when a senior pension officer invests hundreds of millions to some private equity fund, hedge fund or real estate fund and then goes off to work for them soon after. Public pension funds should have an iron clad rule that employees are not allowed to go work for any fund they invest with for a minimum of five years after they leave the pension fund. If they do, then the pension fund should have the right to pull their money out of that fund. This is one rule that needs to be enforced. Senior pension fund managers setting themselves up on easy street by abusing their power is simply not acceptable.

As for investment consultants, I agreed with the gentleman I had lunch with today. Most of them offer no value added whatsoever. There are some excellent ones, but so many of them offer bogus advice, have conflicts of interest and act like gatekeepers to US public pension funds who practice cover-your-ass politics. The SEC, FSA, and Canadian regulatory authorities should take a long hard look at the investment consulting business and clamp down on some egregious abuses and questionable practices.

Finally, there is nothing wrong with public pension funds seeding internal managers who want to start their own private equity, hedge fund or other fund. We talked about that today. In the US, there is more of an entrepreneurial culture. Endowment funds have done this and so have family offices like the Bass family. But here in Canada it's rare and in Quebec, it's almost unheard of. I don't understand it. I can gather ten experienced professionals I know in Montreal and Toronto to start a top-notch multi-strategy hedge fund that would rival the best out there but nobody is willing to seed any fund up here. It's truly pathetic, as if we don't want people to succeed.

If I was a large global fund looking to seed top talent, I'd come to Montreal and set up an office. You'd be surprised at how many talented individuals there are in this city who can offer you true alpha, not just bogus leveraged beta.