Friday, May 3, 2013

Expanding North Carolina’s Investment Authority, Again: Part I

Expanding North Carolina’s Investment Authority, Again: Part I

The North Carolina State Treasurer has introduced a bill to increase the pension’s investment authority in alternative investments.[1]  While I think Treasurer Cowell has been an excellent steward of the pension plan, I don’t think this bill is a good idea. It is going to take a couple of posts to lay out the arguments.  In the next post, I’ll look more closely at the question of alternative investments.  However, readers will find any number of posts over the last six months that explain the pitfalls and shortcomings of alternative investments in public pension plans.

Many Products, Only One Sells (1999)

In this post, I want to explore the investment statute in North Carolina. In fairness to the Treasurer, North Carolina has a convoluted approach to permissible investments for its pension plans.  The State has had this archaic approach for over thirty years, so Treasurer Cowell has been left with an antiquated approach to investment oversight.  When I became CIO, I could have used a Talmudic scholar to help interpret the ins and outs of sections 147-69.1 and 69.2 of the North Carolina General Statutes (NCGS). 

In progressive states, investment authority is governed by the “prudent person” standard rather than a laundry list of permissible investments.  In fact, North Carolina recognizes this modern approach for all kinds of investors other than the State Treasurer.  The State has enacted the Uniform Prudent Investor Act for most forms of investment by fiduciaries, trusts, endowments and foundations.[2]   In short, here’s what it says:

A trustee shall invest and manage trust assets as a prudent investor would, by considering the purposes, terms, distribution requirements, and other circumstances of the trust.  In satisfying this standard, the trustee shall exercise reasonable care, skill, and caution.[3]

In contrast, the Treasurer’s investment authority runs for several pages specifying the appropriate types of investments and overall limitations on each of those investments.[4]  It is an enormous challenge to understand what’s actually allowed or disallowed.  For example, the current statute limits equities to 65% of the portfolio and real estate to 10%.  At the same, it requires the portfolio to hold at least 20% in fixed income.  A statute is no place for these kinds of limits because you don’t want a legislative body making investment policy.  Nonetheless, Treasurer Cowell inherited this irrational system.

My issue with the Treasurer’s legislative proposal is that it will make this legal list approach even worse, and will do so in an environment where the Treasurer has absolutely no control over and few true allies in either the Executive or legislative branches.  Before discussing the proposed bill, I have to lay out the key constraints of the existing law.  In addition to the 65% limit for equities (there is no maximum exposure for investment grade fixed income), the current plan has the following ceilings:

5%         non-investment grade credit
10%       real estate
6.5%      hedge funds
7.5%      private equity
5%         protections on the risks of inflation

These categories and percentages are a dog’s breakfast.  The percentages have no particular financial rationale, and the categories don’t have any substantive meaning.  The percentages simply reflect what a succession of Treasurers could “get” from the General Assembly. 

Let’s examine the categories.  Real estate and private equity are recognized asset classes, and credit is a sub-asset class of fixed income.  The inflation-related grouping is filled with all sorts of stuff, including equity, fixed income, commodities and real assets.   Meanwhile, the hedge fund bucket describes a legal structure that can contain any kind of investment.  By the way, if you’re looking for the words “hedge fund” in the statute, you won’t find it.  When Treasure Moore proposed the original 5% allocation in 2001, his lawyers craftily created the authorization without mentioning the words.

Treasurer Cowell created most of the new categories[5] listed above because it was the only way to increase her investment authority above the 5% limitation on alternative investments. Now the Treasurer is seeking further flexibility by asking to increase each of the categories to 15%.   However, the Treasurer doesn’t intend, and the legislature would never allow, the plan to get to 75% alternatives (five categories times 15%).  As a result, there’s an overall cap of 40% on the five groups.  I’m including the actual language in a footnote, because I want readers to compare this language with the prudent person standard cited above.[6]

For my readers outside of North Carolina, you need a quick lesson in our state’s government and politics.  Our Treasurer is independently elected and the sole fiduciary of the pension plan assets.  As in other states, we have two houses in our legislature, called the General Assembly, and a Governor.  At present the Treasurer is a Democrat, and the Governor is a Republican.  Republicans control our House of Representatives and Senate, and they have veto-proof majorities.  I don’t think we’ve had this political make up in the history of the pension plan.

Our legislature are the same folks who are gaining a national reputation for extreme and bizarre legislative proposals, and who have little regard for the US constitution when it comes to matter such as voting rights.  Scott Mooneyham, a very fine political reporter in Raleigh, has compiled a top ten list of bad legislative proposals this session that will give you an idea of what our General Assembly has been up to.[7]

This bill invites our off-kilter legislature deeper into the oversight of the investments in the state’s pension plans.  I think that’s a bad idea, especially as the Treasurer is asking for more authority in the alternative asset classes (more about that tomorrow).  What do you think the legislature will do when one of these alternative asset classes doesn’t work out as planned or the capital markets take one of their periodic swan dives?  It’s pretty straightforward; the General Assembly is going to second guess the Democratic State Treasurer and start tinkering with the statute.  When things go wrong, Treasurer Cowell will have to depend on the good sense of the legislators or the support of the Governor and his veto stamp.  I wouldn’t be willing to make that bet.  Ironically when an investment area tanks, there’s an opportunity to invest, but this political set up won’t let that happen.

I’d be all in favor of pushing for needed changes in the Treasurer’s investment authority.  I’d gladly go to Raleigh to support enactment of a prudent person standard.  However, it’s hard to support a proposal that lets this legislature deeper into the pension plan’s investment policy, especially when the statute is incredibly convoluted to begin with.  For now, the best thing would be to make no proposals at all.       

[3] § 36C-9-902. (a)
[4] see §147-69.2(b)
[5] The real estate limit was already 5%, and had been created by Treasurer Boyles.
[6] (10a) With respect to Retirement Systems' assets, as defined in subdivision (8) of  this subsection, the market value of any of subdivision (6c) or (7), sub-subdivision b. of subdivision (8), or subdivision (9) or (9a) of this subsection shall not exceed fifteen percent (15%) of the market value of all invested assets of the Retirement Systems; and the aggregate market value of all assets invested pursuant to subdivisions (6c) and (7), sub-subdivision b. of subdivision (8), and subdivisions (9) and (9a) of this subsection shall not exceed forty percent (40%) of the market value of all invested assets of the Retirement Systems. In the event that the market value of any of subdivision  (6c) or (7), sub-subdivision b. of subdivision (8), or subdivision (9) or (9a) of this subsection increases during a fiscal year by an amount greater than three percent (3%) of the market value of all invested assets of the
Retirement Systems as of the prior fiscal year end, then the quarterly report.
provided by the Treasurer pursuant to G.S. 147-68(d1) shall describe how that increase complies with the duties described in G.S. 147-69.7 and the consequent expected impact on the risk profile of the Retirement Systems' assets.

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