What's Happening with the Pension Fund? -- Part 14

by Charles Schwartz, Professor Emeritus, University of California, Berkeley
schwartz@physics.berkeley.edu                              December 18, 2002

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

They Really Did It This Time !

The regents' attack on the UC pension fund, which I predicted in Part 13, has come to pass more suddenly and drastically than I had imagined. Putting aside for now many questions about excessive secrecy and possible chicanery involved in this action, we take a close look at the numbers which UC has published in justification. Several layers of errors are uncovered, revealing that the regents' investment oversight and leadership is incompetent and/or dishonest beyond anything I have carped about before. Immediate corrective action is called for.

     At their November meeting the UC Board of Regents approved (in secret) a drastic change in their investment strategy, titled, "Implementation of Multiple Active Investment Management Programs." I quickly submitted a Public Records Act request for all relevant documents behind this action, but I am still waiting for any response. Here is how the University's officlal press release (posted on November 26) explains the new Multiple Manager Equity Investment Strategy:

     Already, the 9-member staff of equity investment professionals in the Treasurer's Office have been fired and all the UC stockholdings (probably worth around $15 billion) have been temporarily dumped into an externally managed Index Fund that UC had previously established with State Street Global Advisors. The hiring of an unspecified number of external managers (private investment companies) is expected soon.

[Author's note. I have previously used the word "privatization" to describe this transfer of investment management from the University to the private sector. Some have suggested to me that "outsourcing" is a more appropriate term. In my public comment to the regents at their last meeting, I referred to it as "theft."]

     In this paper I shall examine the facts (i.e., the numbers) that UC has presented to justify this extraordinary move. This analysis will pass through several layers.

The First Layer

     In Part 13, I reported how the Regents' Investment Committee, at their September meeting, heard a presentation from the UC Treasurer and from UC's Investment Consultant (the man from Wilshire Associates) about how the internally managed equity investments lagged well behing the established benchmark in investment returns over the past decade. I complained that a proper evaluation of investment performance should look at "risk-adjusted returns" and not just the raw returns on investment. And I cited earlier data showing that this more educated approach completely changed the conclusions that one can draw from the numbers. That criticism remains unanswered. But I am going to put it aside for now and just look at the simple data on returns, without consideration of risk data.

The Second Layer

     The focus is on the numbers given in the UC press release quoted above: over the past ten years, the return on UC's equity investments fell behind their benchmark by an annual average of 11.6% - 10.3% = 1.3%. If true, that is something to be concerned about.

     In Table 1 is a collection of official data, previously published by UC's Treasurer showing the yearly and 10-year annualized rate of return on U.S. equity (common stock) investments in the University's pension fund (UCRP). Also shown are the Policy Benchmark returns, as given in the same source documents.
Table 1.   Total Returns on U.S. Equity (Common Stock) Investments
FY 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
1-Yr %  16.5   9.8  13.9  14.6  -0.1  29.2  25.8  30.9  23.3  21.1  11.4 -13.5 -21,4
10-Yr  % (Annualized)     17.9  17.4  14.7  10.3
1-Yr %  16.5   7.4  13.4  13.6   1.4  26.1  26.0  34.7  30.2  22.8   7.3 -14.1 -17.4
10-Yr  % (Annualized)   18.8  17.8  15.2  11.6
Data Source: University of California Treasurer's Annual Reports
The University's Fiscal Year (FY) ends on June 30 of the calendar year indicated.
Policy Benchmark is the S&P 500 Index up to 6/30/00 and the Russell 3000 Index since then.

     On the right hand end of Table 1 one sees the ten-year annualized returns -- 10.3% for UC, lagging behind 11.6% for the benchmark -- which are the key numbers cited by UC in support of the new outsourcing strategy.

     I decided to check the calculation of the 10-year annualized numbers, using the numbers shown in the "1-Yr" rows of Table 1. This is a simple calculation, often referred to as a "geometric" averaging. I am sure many of my readers can do this calculation and check how closely the results compare with what is shown in the "10-Yr (Annualized)" rows of Table 1. I found that the Benchmark numbers checked out perfectly but the UCRP numbers showed some discrepancies. In almost all cases the discrepancies, which amounted to 1 or 2 tenths of a percent, could be plausibly attributed to round-off error. In one case, however, the discrepancy seemed rather large: for the latest year, FY2002, I calculated the 10-year annualized return for UCRP to be 10.7%, not 10.3% as claimed by UC.

     That is not an earth shattering discovery, but it was enough to prompt me to write to Treasurer Russ, reporting on this discrepancy and asking him to provide me with the data which he had used in his calculations so that I might ferret out the source of disagreement. I have gotten no response at all. I actually sent a second request to the Treasurer's office, where the staff had been very helpful in providing similar data that I had requested some time ago; but they also have been silent now.

     If I can't resolve questions right now about UC's own data, let's move on to look at the Policy Benchmark numbers.

The Third Layer

     Using the Russell 3000 Index as a benchmark to measure performance of UCRP equity investments was a policy established by The Regents when they formally adopted the recommendations of Wilshire Associates in March 2000. What was the "policy benchmark" before that time? I do not know the official answer to that question; so I did some research.

     Reading through the many Annual Reports of the UC Treasurer up through fiscal year 2000, I have found no language to indicate that there ever was any "policy benchmark" at all. In the tables and the text of those earlier official reports one can find a variety of numbers which are presented for comparison with peers and with common market indices. Following are the relevant excerpts from the FY 2000 annual report:

Returns (page 16)
"UCRP has performed extremely well over the years versus its peers. As illustrated in Table VI ... UCRP has a proven history of above-median investment performance when compared to the CRA universe of balanced funds. ... UCRP's annualized total return for the past 20 years through June 30, 2000 was a strong 15.7% versus 13.1% for the CRA Balanced Fund Median. UCRP also outperformed the Wilshire Large Pension Plan Median for the last five-year period, the longest period for which data is available, at 18.7% versus 16.5%."

Equity Investments (page 18)
"UCRP's common stocks returned 11.4% during the year, outperforming the CRA Equity Only Median return of 8.6% by a wide margin. For the past 10, 15 and 20 years, UCRP's common stocks have outpaced the CRA Equity Only Median."

     Reviewing the annual reports over many years, the most consistently cited comparison for returns on equity investments (common stocks) was the "CRA (formerly SEI) Equity Only Median"; and the "S&P 500" is the second most frequently listed datum for additional comparison with UC's returns. If I take the CRA numbers as the de facto "historical benchmark" for the years up to 6/30/00, and then link this with the Russell 3000 Index after that date, then the comparison with UCRP data shows that UC internal equity investments beat this benchmark with an edge of 0.5% over the most recent 10-year period. That turns Mr. Russ' analysis completely on its head.

     But Mr. Russ and Mr. Nesbitt (the Wilshire investment consultant) and Regent Parsky (chair of the Committee on Investments) and all his fellow regents have taken the position that the "historical benchmark" is the S&P 500. Maybe there is some dusty document that I have never seen that could justify their position. Or I suppose that The Regents have the power to simply declare it so, ex post facto. It may be "unfair" of them to rewrite history in that way; but what can I do?

The Fourth Layer
[See Correction]

     I can check their S&P 500 numbers, that's what I can do.

     With some very helpful advice and guidance from a colleague who is an expert in these matters, I was able to go to the internet and download big tables of historical values for the S&P 500 Index, as well as the Russell 3000 Index. (http://finance.yahoo.com) To my amazement, it turned out that the "S&P 500" numbers used by UC's Treasurer are wrong. Table 2, below, shows the numbers I got, substantially lower than those shown for the Policy Benchmark in Table 1.
Table 2.  Correct Total Returns for the S&P 500 and Russell 3000 Indices
FY 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
Corrected Policy Benchmark
1-Yr %  12.6   3.7  10.0  10.4  -1.4  22.6  23.1  32.0  28.1  21.1   6.0 -13.9 -17.2
10-Yr % (Annualized)  15.8  15.1  12.9   9.8

     Comparing the 10-year annualized returns shown in Table 2 with those calculated for UCRP (Table 1 data, corrected) we see that UC's internal equity investment performance actually beat the "Policy Benchmark" returns by a substantial margin: averaging 10.7% - 9.8% = +0.9% over the most recent 10-year period. This result not only turns Russ, Nesbitt, Parsky & Co. on their collective head; it turns them inside-out.

Conclusions and Recommendations

     It appears that some terrible mistakes have been made. Whether those errors arose from mere incompetence or by deceit is not yet clear. But what is clear is that The Regents have an affirmative duty to take certain corrective steps without delay.

1. Check my numbers and verify that my criticisms are sound.

2. Release publicly all relevant records pertaining to this fiasco.

3. Suspend those officials whom they had hired to be in charge of the University's investment management. (That would include Treasurer Russ, Senior Vice President Mullinix, and Consultant Nesbitt.)

4. Bring in some independent outside experts to conduct a full investigation of this whole mess, including all of my previous charges. This investigation must also look into the likelihood of misconduct by some regents.

5. Freeze the University's investment assets in their present management configuration, i.e., cancel or at least postpone any further implementation of the new Multiple Manager Strategy.

     Whether it is feasible to restore the University's internal equity investment office or accept that demolition as irreparable damage is a question I am unable to judge. Whether the regents might ask the deposed former Treasurer Patricia Small to return and try to clean up the mess her successor has made, is another difficult choice.

     As for the safety and wise investment of the equity funds, their present disposition in a well managed Index Fund may be as good as any other option.

    Above all, the regents must stop all the cover-up and stonewalling I have complained of throughout this series of papers.  Fiat Lux.

_ _ _

     I am most grateful to Professor Dwight Jaffee of the Haas School of Business at Berkeley for his generous servings of expert advice and teaching.