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Jacksonville Public Pension Called Out in Audit

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We recently came across an article from The Florida Times-Union highlighting a private audit report on the Jacksonville Police and Fire Pension Fund that is leaving some of the local leaders up in arms. City Councilman Bill Gulliford, “threw down the gauntlet to anyone who disagreed with report’s findings,” which, among other items, included a sub-par investment performance that is leaving the taxpayers of Jacksonville on the hook for an estimated $370 million.

Other public pension officials are throwing the reported findings at the wayside. According to Florida Retirement System spokesman John Kuczwanski, “it’s a useless scenario” and it is “just a case of using 20-20 hindsight to proclaim that a different investment strategy would have earned more money.” While there is some merit to the spokesman’s argument, we believe he may be missing the finer point that the audit report was making.

The audit was performed by Benchmark Financial Services President, Edward “Ted” Siedle. Mr. Siedle is a South Florida attorney who has worked for the Securities and Exchange Commission (SEC) in the past and has over 30 years of investigating public pensions for potential conflicts of interests, excessive fees, and any potential wrongdoing. Within the Jacksonville audit, Mr. Siedle examined the pension’s investment performance for the 27-year period from 1988-2014 and compared it to a portfolio that was made up of 75% S&P 500 and 25% Barclay’s Aggregate Bond Index to see how it compared. This is where he found the $370 million shortfall by the public pension.

Now we readily agree with the spokesman that using hindsight to find a better investment solution is, in fact, worthless. But Mr. Siedle wasn’t simply proposing an alternative asset allocation made up of private placements, hedge funds, MLPs, or active managers. He consciously chose to use indexes, which is a much more profound statement that needs to be unpacked. It is not a criticism of the outcome of the public pension plan, but the process. The belief that excessive fees for subpar investment performance will lead to greener pastures is becoming more and more scrutinized everyday. This isn’t just a specific event that applies to Jacksonville. They are just another example of the mounting evidence that following a passively managed strategy is not only a superior strategy, but prudent. IFA has already applied this same approach to the state pension plans in the US, which we coined Pension-Gate. When applied to the millions and billions of dollars found in most public pensions, the benefits of passive management are magnified.

Spokesman Kuczwanski acknowledged that he has seen this type of comparison before, but stated that it misses how public pensions operate in real time. Specifically, “you have to take what you have at the time and you make the best effort within risk tolerances.” We agree. Public pensions don’t necessarily follow the same type of investment process and implementation that individual investors do with their own portfolios. While individual investors may follow the more traditional balanced approach of stocks and bonds with a glide path overlay, public pensions traditionally follow an asset/liability matching (ALM) approach. In simple terms, public pensions know exactly how much in benefits they need to pay out in any given year (liability) and the portfolio manager attempts to minimize the risk of not being able to meet that liability by matching the duration (sensitivity to interest rates) of the assets to the duration of the liability. For example, if I know that I need to payout $50,000,000 (not adjusted for inflation) in benefits in 10 years, the best way to meet that liability is to buy $50,000,000 worth of zero coupon Treasury Notes that mature in 10 years. Unless the US Government goes bankrupt, I know that I am going to get $50,000,000 in 10 years to meet that legal obligation.

Now aside from the income generating part of the portfolio, there is also a growth component associated with the portfolio whose sole purpose is to grow any surplus that may be needed just in case there is any shortfall. This growth part of the portfolio is very much made up of higher yielding fixed income and even stocks. Within Jacksonville’s plan, this is where we find the real estate, MLPs, stocks, etc. But the income producing aspect of the public pension doesn’t change the fact that the portfolio managers attempted to use more speculative asset classes to help grow their surplus. In essence, managing a specific risk tolerance within a public pension is still better served by using index funds, and this may be the finer point that these city officials may be missing in their assessment.

Mr. Siedle also mentioned that they would have liked to have done a more detailed audit, but as he mentions in his report, “due to the Board’s failure to diligently scrutinize fund performance, the performance history is so uncertain that any analysis is inherently speculative.” In other words, we could probably create a fictional story based on the limited amount of performance data provided by the pension board. But Mr. Siedle did the best with what he had.

Based on our own curiosity, we took Mr. Siedle’s methodology further and incorporated a more globally diversified portfolio of stocks and bonds of multiple risk tolerances to the comparison. Below shows the results of our analysis.

As you can see, over the last 27 years, the Jacksonville public pension was most similar to the IFA Index Portfolio 55 in terms of standard deviation, which corresponds to 55% stocks and 45% bonds. It is important to note that this is based off of the limited data that was provided by the pension board. The portfolio of index funds would have grown the public pension’s assets by approximately $300 million more. Now if we go off of Mr. Siedle’s assessment, which indicated a more aggressive asset allocation of 75% stocks and 25% bonds, then we would look to compare performance based off of IFA Index Portfolio 75, which would have produced $1.16 billion in additional assets. This is less money that would need to be paid out by taxpayers and more money that could be earmarked for other public initiatives like education or public safety.

And this is really where we get to the heart of the matter. If taxpayers are on the hook for the investment decisions made by public officials, then it is not only prudent, but also necessary to implement a passively managed strategy in public pensions. There is enough academic and empirical support to conclude that active management is speculative at best. When the bets made by active managers do not pan out, taxpayers are left to clean up the mess. After taxpayers have been squeezed dry, then public officials have no choice but to start cutting programs. Again, this is all because the nation is currently facing a pension crisis that has stemmed from poor actuarial assumptions and very poor investment decisions. Adopting a more passive investment strategy is a very easy way to start moving the needle back in the right direction. We echo Mr. Gulliford’s statement that if anyone believes there are any inaccuracies with what we are proposing in this article, then prove it.