Industries Banking/Finance

Guarding the nest egg

Bolstered by a new funding plan, the Virginia Retirement System will now examine how to better invest its cash

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Print this page by Tim Loughran

Christmas for Robert P. Schultze, director of the Virginia Retirement System (VRS) came about nine months early this year when the 2012 General Assembly, in its final hours, passed two laws designed to help shrink the $20 billion shortfall facing the state’s largest public pension fund.

“We all were pretty surprised,” says Schultze. “The day before the final vote, I was told there would be no pension reform this year. It all came about sort of at the last minute.”

The legislation, pushed and prodded through both houses of the legislature by its chief sponsor, Sen. John R. Watkins (R-Powhatan), mandates that the state government, local government and school boards stop a longstanding habit of underfunding the 70-year-old VRS.

Pointing to VRS data collected since 1992, Schultze says that state legislators and successive governors have, since 1995, annually shortchanged the two largest pension funds managed by VRS (teachers and state employees) by a cumulative total of more than $3.7 billion. 

That cash, if invested with the rest of the VRS’ capital, would have produced an additional $5.7 billion in assets for the retirement needs of the 612,415 active workers, current retirees and future beneficiaries enrolled in the system at the end of last year.

Schultze says that even with an extra $6 billion in assets, the VRS still needed all the legislation the General Assembly has passed in the past three years to cover its long-term benefit obligations. Beginning in July 2010 state lawmakers said all new VRS members would be required to pay 5 percent of their salaries toward their retirement benefits. The law permitted municipalities and school boards to pay some or all of that contribution on behalf of their newest employees, but did not force them to do so. In 2011, this same 5 percent salary contribution requirement was extended to all state employees, regardless of their hire date. The legislation passed by the General Assembly earlier this year closed what Watkins and other legislators felt were loopholes in the system’s new “hybrid” funding model, which combines the VRS’s original employer-funded system with one that requires more contributions from state employees.  (See related story:  Who will pay? )

“This is a very big deal for us,” says Schultze. “As Senator Watkins said, ‘Unless you increase the state government’s contributions [to the VRS] all you will be doing is treading water.’”
According to Schultze, VRS operates under a constantly extending 85-year timeline that actuarial experts calculate will cover the retirement needs of current workers and their beneficiaries. At the end of fiscal year 2011, the VRS was, on paper, about 30 percent short of its scheduled benefits payout for the year 2097.

By comparison a decade ago, before the nation’s sustained economic expansion and Wall Street bull market during the 1990s succumbed to two difficult recessions, VRS officials estimated that the combined market valuation of the stocks and bonds in its various investment portfolios meant the state’s public pension funds had 4 to 7 percent more than they needed to cover the 85-year liabilities the system had at that time.

Like most U.S. public pension systems, about two-thirds of the benefits VRS pays to its members are generated from investments in financial markets around the world, with the rest coming directly from the accumulated annual contributions of employees and employers. Unfortunately, some state systems have tried to recoup their losses and reduce the level of their unfunded liabilities by making increasingly aggressive bets on higher-risk stocks and bonds.

That’s a mistake the VRS will not make any time soon, says Ronald D. Schmitz, the system’s new chief investment officer. “At this point it’s better to be conservative than aggressive,” he says.
Schmitz joined VRS on Oct. 31 after eight years as chief investment officer of the Oregon Public Employees Retirement Fund. There he attracted nationwide attention and a 2007 citation from Institutional Investor magazine for impressive returns he generated with the help of increased investments in private equity. At VRS, his combined base salary and sign-on bonus package is $485,000. (Schmitz is also eligible for an annual bonus worth 70 percent of his $375,000 base salary, or $262,500, if he hits certain performance targets, the specifics of which he and Schultze declined to discuss for this article.) 

In contrast to an 8 percent annual growth target that many U.S. state pension funds have kept in spite of three years of bloodshed on Wall Street, the lower 7 percent growth target the VRS adopted in 2010 has served the system well, according to Schmitz.

Like many other state pension plans around the country, the VRS board endorsed successive annual targets of 8 percent growth before 2005; but as forecasts for stocks and bonds soured that target was lowered to 7.5 percent between 2005 and 2009, and it dropped again to 7 percent in 2010 when it looked like financial assets would not recover anytime soon.

“When you have an 8 percent [profit]assumption you have a lot of pressure from the board [of directors] to go after it,” he says. “When your return [target] is 7 [percent], that’s a meaningful difference… and that can keep you from reaching too far.”

On the other hand, Schmitz says the VRS’s “conservative” annual investment target of 7 percent may be an important contributing factor to the system’s roughly $20 billion long-term funding shortfall. For that reason, he and the system’s nine-member board of trustees have decided to hire an outside consultant to facilitate “a very involved risk policy discussion” tentatively scheduled for later this year to discuss investment strategies for the long term.

“We’ve decided to have a third party come in and help the board through this discussion. Historically, [changes in VRS risk policies] have been driven by staff. For a variety of reasons it was decided to bring in an outside party to lead the board through that discussion and have consensus on what the mission is and what the right risk tolerance is and what are the objectives of the investment group,” says Schmitz.
On Sept. 30 the VRS reported net assets of $49.6 billion, down from $54.6 billion on June 30, the end of the last fiscal year. By Dec. 30, VRS assets had recovered to $51 billion and at the end of March they had reached $54.1 billion, according to VRS officials. In fiscal year 2007, before the worst stock market collapse in decades, the VRS reported net assets of $58.3 billion, the highest fiscal year-end total since the VRS morphed from a teachers-only program started in 1908 to a retirement plan for almost all Virginia state employees in 1942. 

Tasked like most pension fund managers with slowly building value while protecting existing assets, Schmitz predicts the overall ratio of stocks to bonds in the VRS investment portfolio may remain roughly 60/40, with a small percentage spread among credit instruments, real estate and cash.

“Typically, there’s not a lot of change…Maybe we could go to 70/30 or 50/50. But if it goes beyond those parameters then I’d be a little surprised. But it could stay exactly where it is,” he says.

In late March about 55 percent ($29.9 billion) of all the VRS’ financial assets was in equities; 37 percent ($20 billion) was in various debt, loan and credit instruments; 7.6 percent, or $4.1 billion was in real estate and the remainder was held in cash. (VRS’s equity investments include publicly traded company stocks and private equity, such as ownership stakes in privately held companies or investments in private equity funds.)

More specifically, according to Schmitz, one of the subjects to be discussed later this year as part of the upcoming “risk tolerance” summit between VRS investment staff and the full board of trustees will be what he called Virginia’s “conservative” target of 7 percent annual investment gains, a policy he says may explain a bit of the increase in the VRS’s unfunded liabilities during the last few years.

Like many other state pension plans around the country, the VRS board endorsed successive annual targets of 8 percent growth before 2005; but as forecasts for stocks and bonds soured that target was lowered to 7.5 percent between 2005 and 2009, and it dropped again to 7 percent in 2010 when it looked like financial assets would not recover anytime soon.

Periodic reviews of any pension plan’s funding objectives, investment goals and risk tolerances are perfectly normal and usually very complex, argues Schmitz, who before serving as CIO for the state employees’ pension plans in Oregon (2003-2011) and Illinois (1998-2002) began his career with private funds at Kraft Foods Inc., Sears & Roebuck & Co. and Blue Cross and Blue Shield Association.

He adds that the most important result of any review is that trustees and internal investment staff work toward the same goals. “A lot comes into play about what the board’s [investment and funding] objectives could be, or should be. Frankly, there’s no right or wrong answer.”


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