Public Fund Incentives Draw Fire, Focus

Should public fund staff receive bonuses when the fund suffers a loss?

Much like their Wall Street brethren, investment managers at some of the country’s largest public pension funds receive incentive bonuses when fund performance exceeds established benchmarks.    When public funds experienced significant investment gains on assets, bonus payments flew under the radar.   Amidst the last year of fund losses, however, those bonus payments are drawing howls of criticism.     

In Missouri, Governor Jay Nixon called $300,000 in bonus payments to the 14-member staff of the Missouri State Employees’ Retirement System (MOSERS) “unconscionable.”     MOSERS’ performance last year exceeded that of its peers, but the Missouri pension fund still lost close to $1.8 billion㬓.9% of its value.    To show its disapproval, the Missouri Senate Appropriations Committee cut the state’s contribution to MOSERS by $300,000.    Chairman of the committee, Senator Gary Nodler (R), says bonus payments are inappropriate in years when there is no fund growth.  

There are sound reasons for paying bonuses in today’s economic environment, even if a pension fund has lost money for the year, says Keith Brainard, the Research Director for the National Association of State Retirement Administrators in Georgetown, Texas.     “If a ship’s captain encounters a hurricane at sea and navigates it successfully but with some damage to the vessel, does the company he works for praise him for saving the ship or blame him for the hurricane?” asks Gary Findlay, the Executive Director of MOSERS.    

The pay-for-performance program has been in place at MOSERS since 1998 and, since it began, the investment staff has added over $1 billion in value to the MOSERS trust fund, says Findlay.    MOSERS' incentives are based on a five-year cycle.      The bonus payments paid this year were based on fund performance from January 1, 2004, through December 31, 2008.   In that period, says Findlay, MOSERS had an overall return of 3.9% compared with its benchmark of 1.8%. (the benchmark is the performance of the asset allocation if it were invested passively).  

The difference to MOSERS between a 3.9% rate of return and a 1.8% rate of return over that period, points out Findlay, is $600 million.    So, the MOSERS investment staff added $600 million in value to the fund's assets for bonus payments of $300,000, which is 5/100 of 1%.     The performance of MOSERS' investment staff is particularly striking, notes Findlay, in that many public pension funds did not even earn 1.8% in the same five-year period.     "We're getting blamed for recognizing that the staff got it right," says Findlay.  

But Nodler argues that payment of bonuses makes no sense in any year in which the fund experiences no actual growth.     When the fund loses money, he says, then there is no money from which to pay the bonuses except to go into current assets.   And that, he says, is a misappropriation of funds and a breach of fiduciary responsibility.   

Competing for Talent

Incentive bonus payments to investment staff are not the norm in public pension funds.     Less than 50% of all public funds provide them, says Brainard, but 25% of large state pension funds have them.    At the largest funds, providing incentive payments is viewed as essential in competing for, and retaining, investment talent, he says.   

Furthermore, says Brainard, public-sector bonus payments are generally based on several years' returns.    To look at just the past year, he says, is not a valid analysis.   If a fund suffered losses one year, but managers added value over a five-year cycle—entitling them to bonuses—those managers earned their bonuses.    "What gets lost in the discussion," says Findlay, "is the size of the bonus versus the value added."

If a $1 billon fund would have earned 10%, based on its asset allocation model and market conditions, but actually earns 12%, it's easy for people to accept that $20 million of value was in some way added by those managing the fund, notes Findlay.    On the other hand, if the same fund would have had a negative return of 25%, based on that same asset allocation model and different market conditions, but actually had a negative return of 20%, people seem to focus on the $200 million loss, rather than the $250 million that might have been lost in the absence of good management - $50 million in value added.  

"Did the manager do a better job in the up market or the down market which, in objective terms, is the same as asking is $50 million to the good better than $20 million to the good?" asks Findlay, who notes that "It just seems to be part of the human condition to embrace relative positive return in up markets but to expect absolute positive return in down markets.   The fact that it's unrealistic does not keep it from being an expectation."

But Nodler argues that no matter how the fund did over the previous years, the core issue is that a bonus payment is being made in a year in which the fund experienced no growth and no profits.    "If the fund loses money, you don't have profits from which to pay the bonus," he says.   The money being paid out as bonuses, he says, represents assets of future retirees.

Rethinking Bonuses

There is no doubt that, following the AIG debacle and the media circus that arose around certain incentive payments, the word "bonus" acquired a dirty connotation.     Paying a bonus, particularly to a state employee after a fund has booked losses, just does not go over well with the general public.    As a result, the boards at some public pension funds have gauged the public sentiment and rethought incentive bonuses.    In April, the Colorado Public Employees Retirement Association announced that it would not pay 2009 bonuses to its staff for 2008 results.   Colorado PERA had paid out $722,000 in incentives to its staff for 2007 performance.  

In January, the board of Ohio STRS voted to suspend bonus payments from February through June.     Ohio also began a study of its Performance-Based Incentive Program last fall.   In December, the board of the Pennsylvania Public School Employees' Retirement System voted to end its incentive program after investment staff members received more than $854,000 in bonus payments in a year when the system lost $1.8 billion.

Other funds have chosen to defer payment of bonuses.    Last February, the chief investment officer at the Teacher Retirement System of Texas, T. Britton Harris, announced he was deferring his estimated $167,838 bonus after the fund lost 27%.    Harris offered to forgo his bonus, and the board voted in February to accept his offer.   Harris was eligible to receive up to 125% of his pay in bonus if certain targets were met against the policy benchmark and the system's peer group.   Another $2.5 million in incentives due to more than 80 investment staff will also be deferred until the fund posts positive returns for a year.    Additionally, Texas Senate Finance Chairman Steve Ogden announced an intention to hold hearings on compensation packages at all the state's trust funds.  

Other funds, however, made payments and plan to continue.      A Sacramento Bee news report stated that both CalPERS and CalSTRS paid bonuses to investment staff in 2008.   CalPERS paid some $4 million in incentive bonuses to 58 investment employees in August, with $224,171 going to Senior Investment Officer Leon Shahinian and $208,677 to former CIO Russell Read.   CalSTRS awarded $2.9 million in bonuses to 35 employees, with CIO Christopher Ailman receiving $322,952 and CEO Jack Ehnes $205,000.   The Bee reported that the value of CalPERS' assets has fallen 25%, from $239 billion to $175 billion, while those of CalSTERS have fallen nearly 30% from $162 billion to $114 billion.    The Bee reports that both funds expect to pay bonuses this summer.   

The payments did not sit well with some.    CalPERS should not be making actual, deliverable awards in a time period where the fund is not showing positive returns, says James McRitchie, a retired state worker and the moderator of is an organization based in Elk Grove, California, that works to make CalPERS more responsive to its members.   

CalPERS is an activist investor that criticizes corporations for giving management bonuses structured to have no downside risk, argues McRitchie; yet, its bonus structure for its own staff has no downside risk.    Points are awarded to managers if goals are met, he says, but nothing is subtracted when they are not.    There are also no "clawback" provisions to recoup previously paid unearned bonuses—another feature CalPERS often champions in the corporate realm.    Bonus payments also should be delayed to ensure actual performance reflects market, rather than book, value, he adds, particularly for managers in real estate and alternative investment, and for other managers where value is not measured as frequently as equities.  

Many public-sector funds are contractually obligated to staff to make these payments, notes Brainard, and not paying opens up the fund to legal liability.       It is a sensitive subject, because people are unemployed, says Brainard, but public pension funds need to honor their employment contracts and retain top talent.  

Nodler, however, argues that employment contracts should not require payment of a bonus in a year in which a public pension fund experiences losses.      "Any contract that obligates a fund to pay bonuses even if the fund loses money is poorly written and doesn't represent the best interest of the fund participants," he says.    The message, he says, is that the fund investment staff is to be protected, not the fund members, and that could be a breach of fiduciary responsibility.  

Brainard, however, argues that not paying a bonus otherwise earned can lead to competent employees seeking employment elsewhere.     "If not paying a bonus causes a good employee to walk, what good is that?" Brainard asks.  

—Elayne Robertson Demby