What's Happening with the Pension Fund? -- Part 11

by Charles Schwartz, Professor Emeritus, University of California, Berkeley
schwartz@physics.berkeley.edu                            September 28, 2001

>> This series is available on the Internet at http://socrates.berkeley.edu/~schwrtz

Incompetence, In Depth

They can't get their arithmetic right the first time, or the second time, or even the third time. What is one to think about the University's top experts in charge of the financial health of the $40,000,000,000 Retirement Fund?


The previous ten Parts of this series, "What's Happening with the Pension Fund?", have raised a large number of questions and criticisms about the competence and the integrity of the University's chosen investment consultant, Wilshire Associates Inc. Despite earlier promises from the UC President's Office, almost none of those serious charges have been answered (for a brief review, see the Appendix of this paper.)

There is one particular issue which presents an exception to this pattern of official stonewalling: the whopping discrepancy I had pointed out last January in looking at forecasts of Asset/Liability Ratios for the University of California Retirement Plan (UCRP). Here we had data presented to The Regents from two outside firms of presumed expert consultants; and nobody else noticed how very different their numbers were. That was the beginning of a drawn out correspondence with the University's top finance officials, which I will detail in this paper.

The original data presented by Wilshire Associates is shown in Table 1, giving forecasts of the Assets and the Liabilities of UCRP over the next 20 years. In Table 2 is shown the forecasts made by Towers Perrin, the University's actuary for UCRP. The discrepancy is apparent upon looking at the Ratio of Assets to Liabilities over the years: Wilshire shows a declining ratio while Towers Perrin shows an increasing ratio.
Table 1.  Wilshire's Forecasts of UCRP Assets & Liabilities  (Mean Values)
                          Year 2000 2005 2010 2015 2020
Assets ($Billions)   40.7   56.6   78.8 108.4 150.4*
Liabilities ($Billions)   23.9   36.1   55.5   84.8 126.6
     Ratio  (A/L) 170% 156% 140% 126% 118%
Source: Exhibit 9, on page 10, of Wilshire's March 16, 2000 report to The Regents
* Includes a $2.7 Billion "Contribution" to assets in 2020.
Table 2.  Towers Perrin's Forecasts of UCRP Assets/Liabilities  (Mean Values)
                        Year 2000 2004 2009 2014 2019
     Ratio  (A/L) 154% 176% 184% 191% 204%
Source: Graph on page 13 of Towers Perrin's January 2001 report to The Regents.

The First and Second Official Responses

Senior Vice President Joseph Mullinix, head of Business and Finance for the University system, wrote to me on April 16 with an explanation for the discrepancy. "Given the same inputs both the Wilshire and Towers Perrin models produce nearly identical results," he wrote. However, it turns out that the two consultants differed in their input assumptions, as follows:

1. "Lump Sum Distributions: Wilshire assumed no lump sum distributions while Towers Perrin assumed a 20% lump sum election. The effect of lump sums is to reduce assets and liabilities in equal dollar amounts ..."

2. "New Entrant Age and Salary: The remaining difference in liability projections is explained by assumptions made for the average age and salary of new entrants. ... Wilshire assumed new entrants would come in at a significantly higher age and salary than did Towers Perrin, a difference that caused a more rapid growth in Wilshire's liability projections. ..."

Although Mullinix did not give numbers for the amounts of these corrections I was able to discuss the implications of his admissions of error in my Part 9.

On June 5, Associate Vice President Judith W. Boyette, head of UC's office of Human Resources and Benefits, wrote to me with more detailed data on the Towers Perrin forecasts (data which I had requested two months earlier). The numbers are shown in Table 3 and we can use this quantitative data to fill out the qualitative explanations given previously by Mullinix.
Table 3.  Further Data on Towers Perrin's Forecasts of UCRP  (Mean Values)
                          Year 2000 2004 2009 2014 2019
Assets ($Billions)   37.0   58.7   82.3 112.7 144.2
Liabilities ($Billions)   24.1   33.1   45.0   59.0   72.0
Source: Letter from Associate Vice President Boyette, June 5, 2001

Comparing the separate values projected for Assets and for Liabilities by the University's two outside consultants, Wilshire Associates (in Table 1) and Towers Perrin (in Table 3), we see that:

  • The Liability numbers from Towers Perrin are (mostly) lower than those from Wilshire

  • - which is in accordance with what Mullinix said;
  • The Asset numbers from Towers Perrin are (mostly) higher than those from Wilshire

  • - which is in contradiction with what Mullinix said.

    This is a new discrepancy, and I wrote back on June 7 pointing out this error.

    The Third Official Response

    In a July 16 letter, Boyette responded to my new criticism, amplifying upon the explanations given earlier by her boss (Mullinix):

  • "Wilshire's asset number is the market value of assets. Towers Perrin's number is the mean Actuarial Value of Assets, which is a smoothed number [i.e., smaller]. ..."

  • -- This makes the discrepancy I pointed out a bit more severe.
  • "Wilshire assumed 100% annuity benefits (no lump sum distributions), while Towers Perrin assumed that 20% of new benefits would be paid as lump sum distributions. ..."

  • -- This makes the Towers Perrin asset projections lower than Wilshire's, which is the opposite of what we saw from Table 3. This is the discrepancy I had pointed out.

    Then Boyette gave the new explanation:

    "I believe that you are familiar with both of the studies based on your previous questions and have probably noted the difference in the two returns on investments. Therefore, the final key element is the difference in portfolio return. Exhibit 9 in the Wilshire study shows one economic scenario, which assumes a constant 8.5% per year, compounded return. ... The Towers Perrin analysis of the capital markets, applied to their modeling of assets and liabilities, produces an average portfolio return of 9.2%, compounded annually. ... When Exhibit 9 in the Wilshire study is adjusted for both the Towers Perrin benefit distributions level and portfolio return, the 2015 assets would be $117.1 billion, which is only a small difference from the Towers Perrin average market value of $116.4 billion.

    "In summary, the following chart shows these changes: [for the year 2015 forecast]

    Wilshire forecast from Exhibit 9                      $108.4
    Adjust for higher benefit distributions                -17.7
    Net                                                                       90.7
    Adjust for higher portfolio return                      +26.4
    Net                                                                     117.1
    Towers Perrin mean Market Value                    116.4
    Difference between adjusted values                       0.7 (0.6%)
    "Thank you for your interest on this topic. I hope this clarification addresses your concerns.
                                                                                                  "Sincerely, " etc.

    This is a whole new story. The fact that Towers Perrin assumed a higher rate of return on UC's investment portfolio now appears as the biggest factor (that +$26.4 Billion in the chart quoted above) in explaining the difference between their calculations and Wilshire's. Yet this crucial difference was not even mentioned in Mullinix' earlier letter. Going back to January, when the Towers Perrin calculations of the UCRP asset/liability study were presented to the regents, Mr. Steven Nesbitt, the consultant from Wilshire Associates, stated that the two sets of calculations used consistent assumptions. Wrong again.

    [Was I aware, as Boyette guessed I might be, of this difference in assumptions: Wilshire's 8.5% vs Towers Perrin's 9.2% expected annual return on investments ? Yes, I was. This is one of several questions I have been waiting to discuss with UC officials and their expert consultants. In almost every letter I have written to University officials I have asked to meet with their competent experts and discuss the technical questions that have arisen. They have never responded to this collegial invitation.]

    But there is a pitfall in this new explanation, yet one more discrepancy in the arithmetic coming out of the University of California Office of the President (UCOP)! To see this, take that difference in investment returns, 9.2% - 8.5% = 0.7%, and compound it over 16 years. That's a simple calculation; any one of the regents is smart enough to do it. It comes out to about an 11% increase in the accumulated assets for the year 2015. But the chart given in Boyette's letter, above, shows an increase of $26.4 Billion, due to this consideration, above a Net of $90.7 Billion. That's an increase of 29%, close to three times the 11% I just calculated. That beautiful agreement between the Wilshire and Towers Perrin results, which Boyette shows at the bottom of her chart, is phoney.

    I wrote back to Boyette and Mullinix on July 18, pointing out this new error. I received a note from an assistant on July 30:

    "Associate Vice President Judith Boyette has asked me to acknowledge receipt of the email message you sent to her on July 18th. We are discussing your concerns with our consultants and gathering information.
    "We plan to respond to you within the next few weeks."
    Six weeks later I wrote a follow-up inquiry, but still wait for the next episode in this sorry tale.

    What Does It Matter? - I

    How can one understand such a compounded series of errors? Anybody can make one mistake, even two. Any organization of people might be so off balance that a single mistake passes unnoticed through more than one individual's attention. But what we see here is a whole array of highly regarded experts who continue, time after time, to make serious blunders in the handling of numbers, mistakes that any alert observer might have caught.

    Each time that I have written to UCOP officials about major errors I have found in this study of UCRP Assets and Liabilities, these questions have been taken back to their outside consultants - Wilshire Associates and Towers Perrin. Next, those experts' responses are reviewed by the professional staff in the University's offices which are responsible for managing the UC Benefits program. Then, the letter "explaining" the outcome is written to me and signed either by Associate Vice President Boyette (Human Resources and Benefits) or by Senior Vice President Mullinix (Business and Finance), who are each themselves relied upon by The Regents to be fully competent in these matters. (It would not surprise me to learn that other high level officials are also involved in reviewing the letters sent to me.) Yet, once, twice, thrice, I find that there is some major blunder, appearing each time as an internal inconsistency in the numbers these experts present.

    The inescapable conclusion is that the University is afflicted here with an appalling case of incompetence in depth. This matters a great deal if one wants to have any degree of confidence in the abilities of those charged with managing the $40 Billion retirement funds. Some serious fixing is needed.

    What Does It Matter? - II

    Here, in Table 4, is data on the actual investment returns of the UC Retirement Plan funds over the past fiscal year.
    Table 4.  UCRP Quarterly Investment Returns for 2000-2001 Fiscal Year
                                 Quarter: 9/00 12/00 3/01 6/01 Full Year
    Equity Investments   0.10% -4.73%  -13.17%   3.83% -14.02%
    Fixed Income Investments   2.82%   6.06%    1.82%  -0.44%   10.55%
    Total Portfolio   0.9%  -0.9%   -7.5%   2.1%   -5.5%
    Source: Data provided by UC Office of the Treasurer

    The Total Portfolio numbers in Table 4 are close to the weighted sum (0.65 x Equity + 0.35 x Fixed Income) according to the asset allocation policy specified in the Wilshire study, which the regents adopted in March 2000. The Full Year investment loss suffered by UCRP (5.5% x $42 Billion assets at 6/30/00 = $2.3 Billion) may be thought of as not too bad considering how much the stock markets have dropped over that period. But there is another way to look at these figures.

    Suppose that, instead of the asset allocation (65% Equity + 35% Fixed Income) recommended by Wilshire Associates, the regents had adopted the much more conservative (i.e., low risk) investment strategy of 100% in Fixed Income securities (bonds). Then, over that past fiscal year, UCRP would have enjoyed an overall gain of 10.6% instead of a loss of 5.5%. That is a difference of almost $7 Billion in assets as of 6/30/01.

    What am I saying here? Is this just some cheap Monday morning quarterbacking? No. There is a much more substantial argument behind my "suppose that" scenario; and it is tied directly to the issue of errors made in the Asset/Liability forecasts for UCRP. In Part 9, I explored the logical implications of Wilshire's errors, as they were first acknowledged by Mullinix. It became clear that the central recommendation which Wilshire gave to The Regents depended precisely upon the outcome of the calculation they did forecasting future Asset/Liability ratios for UCRP. And that calculation is now known to have been wrong: they came out with large overestimates of the future Liability of the retirement fund compared to its expected Assets.

    In their March 2000 Investment Strategy Study, Wilshire laid out explicitly the choice which the University faced. The safest investment strategy - all assets put into fixed income securities (i.e., government bonds) - would suffice for only a modest number of years, they calculated, because of the expected increase in UC employment levels throughout the coming decade. Therefore, Wilshire said, UC should follow a more risky but potentially more rewarding strategy dominated by stocks and other equity investments.

    But we now know that they made a big blunder in that calculation forecasting the level of future liabilities. So we conclude, following Wilshire's own stated logic, that if they had done that calculation correctly, then they would have led UC to put a substantially larger portion of its investment portfolio into fixed income securities -- and consequently UC would have experienced a much better return, over the past year, than that multi-billion-dollar loss which we have identified above. How much of that potential $7 Billion loss can one blame on Wilshire's mistakes? I cannot estimate the net figure without getting the final numbers which I have been asking UCOP to produce. Certainly, however, one can expect that we are talking about a claim of damages in the range of one or more billion dollars.

    That's right, I said a claim of damages. Not an abstract error, but something which can and should motivate The Regents to go to court asking for restitution.

    Analogy: Suppose the University contracts with an outside firm of architects and construction engineers to put up a new building on one of our campuses. Suppose that the structural experts hired for this job make a mistake in their calculations of the design intended to withstand an earthquake of some specified magnitude; and suppose that such an earthquake does indeed occur later on and the building suffers great damage. Would The Regents sue the architects and engineers for damages? Of course they would. They would have a fiduciary responsibility to do so, even if the people they sued happened to be their personal friends, or business associates, or whatever.

    This demonstrates why It Matters, in the dominion of lawsuits and money, that UC officials pay attention here and get this matter straightened out. (To put it even more crudely, if The Regents don't sue Wilshire for the losses they are responsible for, someone else may well sue The Regents for neglect of their fiduciary duties.)


    July 6, 2001

    Independent Analysis of Wilshire Associates' Investment Strategy Study

    The first Whistleblower Report, dated January 8, 2001 [see Part 6], summarized a large number of serious flaws found in Wilshire Associates' "Investment Strategy Study," following the detailed analysis given in Parts 1-5 of the series, "What's Happening with the Pension Fund?" - posted on the website http://socrates.berkeley.edu/~schwrtz .

    In a response dated January 30, the University Auditor formally acknowledged my "five part series regarding pension plan matters, principally the Wilshire asset allocation plan" and he informed me that it was "the University's intent to provide additional information and responses that will attempt to address the questions and concerns you have raised." Senior Vice President Joseph Mullinix had been assigned to coordinate that effort. That promise remains empty.

    Subsequent work, reported in Parts 6-10 of this series, has added to my list of criticisms:

  • Textbook-level errors in Wilshire's rebuttal of two earlier complaints;
  • Major discrepancy with Towers Perrin's projections of UCRP Asset/Liability ratios; **
  • Risk-adjusted analysis of UC Treasurer's past performance - which Wilshire failed to do;
  • Expose of a regent's story on what was wrong with UC's former investment activity;
  • Comparison of Texas v. California on issues of Secrecy, Conflict of Interest, Privatization.

  • Mr. Mullinix has reported on this one matter (**) and admitted that Wilshire Associates made major blunders in their earlier calculations of UCRP future liabilities. While I am still waiting for a full and coherent set of numbers from UCOP, my estimates lead to a conclusion that those errors invalidate Wilshire's asset allocation recommendations as delivered to The Regents last year.

    As things now stand - with so many serious criticisms unanswered - an objective observer would have lost all confidence in Wilshire Associates as a consultant to The University. On more than one occasion your Auditor has informed me that the comprehensive response to my critiques, which was promised in January, had been drafted and was awaiting top level review before being sent to me; but I still wait to see any of that. I infer that my criticisms stand valid. The question now put before the Board of Regents is, What are you going to do to resolve this matter? It is time to end the shameful attempts at stonewalling and coverup. Let's get the full truth out in the open.

    Sincerely yours,

    Charles Schwartz
    Professor Emeritus

    There has been no response to this letter.