Ohio’s teacher retirement system lacks investment transparency
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Ohio’s teacher retirement system lacks investment transparency

For the 2020 fiscal year, STRS reported paying $175 million in fees to alternative investment managers.

An external audit of Ohio’s State Teachers Retirement System has raised serious questions about the pension fund’s transparency and investment practices. The forensic audit, commissioned by the Ohio Retired Teachers Association, concluded that the pension plan serving Ohio’s teachers provides insufficient public information about some of its investment funds and pays excessive fees to asset managers.

The audit’s initial report, conducted by Benchmark Financial Services, Inc., and released in early June, focused on the performance and costs of the State Teachers Retirement System’s (STRS) private equity investments as well as the system’s unwillingness to fully disclose information about these investments. In August, STRS published a detailed rebuttal to the report saying it included “baseless allegations.”

STRS currently invests about 18% of its assets in private equity, hedge funds and other so-called “alternative investments.” These assets, which do not regularly trade, are difficult to objectively value and often require high management fees and other investment expenses. For the 2020 fiscal year, STRS reported paying $175 million in fees to alternative investment managers. This payment dwarfed the $60 million in fees the pension plan paid for all other types of investments, even though these other asset classes accounted for 82% of STRS’s investment portfolio.

The Benchmark Financial Services report’s author, Edward Siedle, a former Securities and Exchange Commission attorney, questioned whether the $175 million in alternative investment fees reported by STRS included all of the pension plan’s payments to asset managers. Due to STRS’s incomplete responses to Siedle’s public records requests, he could not determine whether the system’s reported fees include transactions costs and performance fees, also known as carried interest. $175 million is already a lot to pay asset managers and anything on top of this amount should concern taxpayers and employees even more. That said, the STRS rebuttal makes clear that the $175 million figure includes all types of fees.

In 2020, the State Teachers Retirement System carried interest costs were likely minimal due to the poor performance of its alternative asset holdings. For that year, STRS had overall asset returns of 3.14%, but its alternative assets declined in value by 1.03%, weighing down the overall portfolio. It should be noted that STRS overall returns and the returns on its alternative assets staged a strong rebound in 2021 according to preliminary reports.

This poor performance, attributed to the outbreak of COVID-19 in the second quarter, broke a long streak of positive annual returns on alternative investments for the plan. Pre-COVID-19, STRS and other pension systems poured money into alternative assets, chasing their supposedly high returns. But in the 10 years ending Dec, 31, 2019, US stocks logged similar or better returns than private equity and hedge fund investments on average.

So, if alternative assets incur high management fees and don’t actually improve pension fund investment returns, Siedle and other critics are right to question whether STRS should take on the investments.

STRS needs to economize costs and optimize returns because the pension plan is severely underfunded. In 2020, the system reported over $24 billion in unfunded pension liabilities. The system’s $74 billion in assets is only enough to cover about three-quarters of the system’s future retirement benefit obligations.

Further, STRS’s liabilities were calculated by discounting future payments based on an assumed rate of return of 7.45%. This discount rate is above the median used by public pension systems annually and is likely hiding the system’s full funding shortfall. As an example, If STRS had instead used a more realistic discount rate of 6.45%, it would have reported a net pension liability of over $34 billion: $10 billion more than it showed in its annual financial report.

The retiree organization backing the audit has called for “the restoration of the COLA [cost-of-living adjustment] for retired teachers, and the rollback of additional years of service required for active teachers.” While providing cost-of-living adjustments and liberalizing benefit eligibility provisions may be good public policy, doing so may not be feasible given the pension plan’s poor funding.

To ensure that promised pension benefits will be there for current and future teachers, Ohio policymakers should pay off the public pension plan’s debt and fully fund the State Teachers Retirement System going forward based on realistic actuarial assumptions.

Although STRS’s investment returns are doing better than similar-sized pension systems, Siedle may be correct that it has room for improvement by relying more on public equities and less on alternative assets. Further, STRS could serve its stakeholders by being more transparent about its alternative investments and follow the best practices of California’s teachers’ pension plan and the South Carolina Retirement System, which prioritize open communication with taxpayers and retirees.

Right now, the State Teachers Retirement System can’t even fund the benefits it has already promised to teachers. If the state wants to provide benefit increases or even expand the K-12 school funding, STRS needs to get its investment transparency and pension debt under control.

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