The Art of Translucency: Kentucky Retirement Systems
A month ago I glanced at a report by James McNair of the Kentucky Center for Investigative Reporting (KCIR), called “When it Comes to Investments, Kentucky Keeps Pension Holders in the Dark.” This past weekend I decided to read the report more closely and look into some its claims. KCIR’s report attempts to link three themes, the poor financial condition of the Kentucky Retirement Systems (KRS), the KRS’s huge foray into alternative investments, and the KRS’s lack of public disclosure.
KCIR’s report correctly points out that the KRS is among the worst funded pension plans in the country. On average, the five plans in the system are only 43% funded, according its 2013 annual report. With a third of its assets in alternatives, KRS is among the leaders in its commitment to hedge funds, real estate, and private equity. While the KRS’s website is filled with data on aggregate performance and individual holdings, it reveals very little about the performance or fees of its managers. The legislature in Kentucky has given the pension plan a broad exemption when it comes to the performance and holdings of managers. Kentucky has transformed the concept of transparency into translucency. Clearly, there’s something happening on the other side of the glass, but it’s impossible to get a clear picture.
The KCIR report makes the same mistake as many other critics of public pension plans. It confuses KRS’s poor financial condition with the plan’s foray into alternatives. The plan was already in trouble when KRS turned to alternatives. In other words, KCIR is off base when it comes to the cause and effect of KRS’s troubles. Alternatives were meant to be a cure for the disease. However, alternatives turn out to be an expensive treatment that doesn’t work. So while KCIR’s broad premise is off, it is on the right track when it tries to figure out what’s going on in the alternative portfolio.
Unfortunately, in the world of investments there’s no equivalent of the Food and Drug Administration to require money managers to prove the efficacy of their products. It’s quite the opposite. State legislators, pension trustees, and investment staff are hiding the details of KRS’s alternative program. KCIR wisely zeroes on $1.5 billion in fund of fund’s exposure (13% of the assets) managed by three managers, Blackstone, PAAMCO, and PRISMA. Kentuckians know even less about these three portfolios than they do about the rest of the assets because KRS doesn’t reveal the managers or the funds inside these fund-of-fund portfolios.
In fending off KCIR’s inquiries, KRS makes a series of ridiculous claims that are only worthy of the patent medicine vendors of the 19th century. For example, interim CIO David Peden claims that hiding the identity of the underlying managers results in getting better financial terms. He asserts that the plan saves at least $17 million through this practice. It’s a great claim to make because it can’t be verified. Verification would require KRS to reveal the very information it is unwilling to disclose.
Alternatively, Mr. Peden argues that revealing the names of the underlying funds would be the equivalent of Coca-Cola disclosing its formula for the soft drink. In my view, Mr. Peden is making the case that the formula for water is proprietary because KRS’s fund-of-fund holdings are about the equivalent of a couple of atoms of hydrogen and an atom of oxygen.
KCIR’s report reveals one of the most incomplete disclosures on fees in the world of public pensions and the worst response to the lack of proper disclosure. In its annual report, KRS only reveals the aggregate fees paid to its equity and fixed income managers. The plans paid $41.8 million or 0.38% on 62% of their assets. In my view, those fees are rather high for equity and fixed income services. However, KRS doesn’t reveal anything about the fees in the remainder of the portfolio, and that’s where KRS is paying out a multiple of what they’ve publicly disclosed.
I’m going to end this post with an incredibly damaging admission by KRS’s executive director because it best summarizes the deeply troubling situation in Kentucky. According to the KCIR report:
Not even KRS Executive Director William Thielen knows how much money was paid out in fees to the underlying funds. That information, he said, is “proprietary” even to him.