Fascinating tale of what’s going on behind the scenes with Kentucky’s pensions. Here are a few excerpts:
In April 2008, a longtime investment adviser named Chris Tobe was appointed to the board of trustees that oversees the Kentucky Retirement Systems, the pension fund that provides for the state’s firefighters, police, and other government employees. Within a year, his fellow trustees named Tobe to the six-person committee that oversees its investments, becoming the only member of the committee with any actual investment experience. It was an experiment in fiduciary responsibility that ended badly. “I started asking questions when things weren’t sounding right,” Tobe said. “And a secret session was held where they voted to kick me off.”
Several weeks after he was removed, the remaining members of the committee approved a $200 million investment in a hedge fund called Arrowhawk Capital Partners. Tobe, though he remained a trustee, only learned about the deal after the fact, while reading the magazine Pensions & Investments.
The Middle Man
Tobe had never heard of Arrowhawk, and he quickly figured out why: Arrowhawk was a new fund whose first investor was the Kentucky Retirement Systems, or KRS. During his tenure as a trustee, KRS staff had proposed moving 5 percent — roughly $650 million — of the pension’s total holdings, then invested almost entirely in a mix of stocks and bonds, into large, established “funds of funds” — vehicles that allow investors to buy a basket of hedge funds, rather than risking everything on a single fund. Instead, the staff had steered the investment committee in 2009 to a startup fund with no track record. Tobe pressed the issue at several public meetings of the KRS board and eventually, in 2010, an internal audit revealed that Arrowhawk paid more than $2 million to a middle man named Glen Sergeon to land Kentucky as a client. KRS’s chief investment officer resigned during the course of the investigation (only to land a private-sector job as a managing director at a giant investment consulting firm). “Bad publicity, along with mediocre performance, sealed the fate of Arrowhawk,” Tobe wrote in his self-published book, “Kentucky Fried Pensions.” Two and a half years after Kentucky selected the firm for its first-ever hedge fund investment, Arrowhawk shut its doors.
Yet Kentucky’s heavy reliance on alternatives has come at a steep cost. Hedge funds and private equity typically charge “2 and 20” – 2 percent of every dollar invested, plus a 20 percent share of any profits. That works out to fees roughly 10 times what a pension fund would pay to invest in a plain vanilla stock fund. In 2009, the year it began investing in hedge funds, KRS paid $13.6 million in annual management fees. Five years later, that figure had ballooned to $126 million, according to a study KRS itself commissioned — more than twice as much as it had publicly disclosed in its 2014 filings. And that higher figure still didn’t capture all the millions of dollars in those 20 percent “performance fees” that hedge funds and private equity collect — sometimes many years into the future, after the sale of a successful venture — before distributing profits to investors. That same study underscored a second cost: Kentucky’s gamble on alternatives has proven a lousy investment. Had KRS simply matched the performance of the median pension fund in the five years ending in December 2014, the pension would have produced an additional $1.75 billion in earnings. If it had invested in a basic index fund matching the Russell 1000 (the country’s 1,000 largest public companies), KRS would have earned another $9 billion. Even investing the entire pension fund in a long-term bond fund — as safe an investment as there is, short of leaving it all in cash — would have meant hundreds of millions of dollars in additional profits during those five years.
It’s a damning story of gross mismanagement. Combine that with a General Assembly that didn’t regularly meet obligations, and it’s not difficult to see why there’s a crisis of sorts now.
Here’s what else is clear: The teachers and public employees who paid (and still pay) into this system are not at fault. They didn’t make these decisions and they did meet their obligations.
Sorting out a path forward should be done out in the open with the transparency that has been lacking in the pension system for far too long.
For more on education politics and policy in Kentucky, follow @KyEdReport