Wall Street secrets pit $75B pension plan against trustee tasked with protecting it

(Bloomberg) — When State Senator Katie Muth joined the board of the Pennsylvania teachers’ pension fund last year, she knew she had a lot to learn: With a college degree in athletic training, her financial education consisted largely of paying off her student loans. But she saw the unpaid trustee position at the $75 billion Public School Employees’ Retirement System as a way to protect teachers and state taxpayers — and an extension of her job as a lawmaker.

Little did the 38-year-old know she was about to get a crash course in high finance and sharp-elbowed pension politics. Or that she would be forced to sue her own fund to get access to internal documents.

The Pennsylvania teachers’ fund is a microcosm of the problems at many public pension plans — and why some retirement experts believe more bad news could be coming as markets continue their gyrations and pension plans try to amplify declining returns with riskier investments. The $5 trillion mountain of money in public pension coffers has enriched many a Wall Street firm. Yet millions of retired school teachers, firefighters and other civil servants must get by on modest monthly checks that critics say are made even smaller by some asset managers’ hefty fees.

It was at Muth’s first board meeting in March 2021 when the pension system’s executive director revealed in a memo that the fund had erred in reporting its average investment returns over several years. The mistake, for which a consulting firm has accepted blame, turned out to be a small yet politically explosive overstatement. It meant nearly 100,000 educators would have to contribute up to several hundred dollars more into the fund annually.

Muth soon learned that the fund’s professional staff, without informing the board, had set up holding companies to acquire land near the fund’s Harrisburg headquarters. She was also troubled by reports that some staff had been taking what she considered lavish trips arranged by money managers who competed to invest the pension fund’s assets.

Two months after Muth joined the 15-member panel, the retirement system confirmed it was the subject of a public-corruption probe by the US Justice Department, first reported by the Philadelphia Inquirer. In September, the Securities and Exchange Commission opened its own inquiry. Both probes are ongoing. Neither the fund nor any current or former officials have been accused of wrongdoing.

As one of the few trustees who hadn’t been around when the incidents under investigation occurred, Muth considered it her duty to get answers. And that’s when she discovered how secretive and dysfunctional the public pension system really is.

“The reaction has been horrifying,” said Muth. “They treat me like a little girl who needs to watch her Ps and Qs, but transparency is important here. People’s lives are on the line. It’s their retirement security, for crying out loud.”

The fund’s spokesperson, Evelyn Williams, said a board-directed investigation by an outside law firm, paid for by the retirement system, found no wrongdoing by the fund or any of its current or former officials. She said the staff travel was necessary for a pension fund with global investments and didn’t violate any laws or policies in place at the time. The fund board last year adopted new travel rules. The board and staff, Williams said in an email, are “committed to encouraging and fostering a culture” of transparency and accountability.

Glen Grell, the retirement fund’s former executive director, informed the board and other top officials of the performance reporting error promptly after learning of its implications, said his lawyer, Marc Raspanti, in a letter. Grell, who retired in February, cooperated fully with the internal investigation and ”has earned his stellar reputation after honorably serving the citizens of Pennsylvania for decades in various roles,” Raspanti said.

PSERS, as it’s called, is significantly underfunded with just 60% of the assets it needs to meet commitments in coming years. The shortfall is due to increases in pension benefits that have outpaced contributions into the plan, combined with a costly investment program that has failed to narrow the gap. Like many of its peers, the plan had been counting on alternative sources — private equity, real estate, hedge funds and even loans to finance oil fields controlled by Iraqi Kurds  — to help boost returns.

Such investments can lift performance beyond what stocks and bonds can deliver, but come with heightened fees and risks. They’re also cloaked in secrecy, which can hide conflicts and self-dealing. Such problems have gotten other public pensions into trouble and are among the reasons for the PSERS investigations, including whether asset managers did favors for, or provided gifts to, fund officials in order to win business.

Governance, too, is fraught: The PSERS board is composed of active and retired teachers, state officials and lawmakers. Some have little or no financial training and can be outgunned by professional staff and the asset managers they select to invest the money, critics say. The state officials frequently send designees to meetings instead of attending themselves.

“Many board members haven’t mastered the complicated math involved in supervising in-house staffs or negotiating with the likes of PE giants like Apollo,” said Jeff Hooke, a finance lecturer at Johns Hopkins University, referring to one of the US’s largest private equity firms. “It’s obvious what happens next: The pension fund beneficiaries get eaten alive by fees,” said Hooke, who wrote “The Myth of Private Equity.”

Fund spokesperson Williams said it’s wrong to assert that firms like Apollo can take advantage of its board. “PSERS investment professionals negotiate the fees and present their recommendation” to the board for approval, she said. The teachers who serve as board members “have all taken the needed time out of their busy schedules to educate themselves.” Apollo, through a spokesperson, declined to comment.

Before joining the PSERS board in February 2021, Muth had already made national news as a reformist crusader. She grew up in the Western Pennsylvania town of Delmont, population 2,700. Her father sold drill bits to coal mines and her mother was a nutritionist and part-time waitress before passing away from a brain aneurysm when Muth was 11. She was attracted early on to health care but found traditional medicine depressing and opted instead to earn a degree as an athletic trainer. Before she was elected, she interned as a trainer with the Pittsburgh Steelers.

After volunteering for Hillary Clinton’s presidential campaign in 2016, Muth launched a shoestring run for the state senate in hopes of unseating a Republican who had represented her suburban Philadelphia district for 16 years. With husband Trevor dialing for dollars, Muth and volunteers knocked on thousands of doors, hearing frequent complaints about how teachers’ pension costs were driving up property taxes.

At the height of the #MeToo movement in 2018, she won the seat in part by openly discussing the gender battles she had fought and a sexual assault she had suffered as a college student. The first piece of legislation she drafted sought to abolish the time limit that rape victims have to bring cases to court.

In Muth’s stately, wood-paneled capitol office, campaign signs tout clean water, higher wages and animal rights. Dangling from a chandelier above her desk is a miniature pair of boxing gloves, given to her by a legislative staffer.

With over 500,000 active and retired members, PSERS pays out $7 billion in benefits annually, with the average retiree receiving $26,000. About 44% of its money was invested in private equity and other alternatives in fiscal 2021, which ended last June. That’s well above the public-fund average and it means that PSERS spent $584 million on outside asset managers last year, more than what Pennsylvania budgeted for health, conservation and environmental protection combined.

Total returns of 8.04% in the decade through June 2021 put PSERS in the bottom half of its peers, according to Aon Investments USA, the fund’s adviser. Aon, the firm that accepted blame for the performance calculation error, declined to comment through a spokesperson.

Williams, the fund spokesperson, said that in fiscal 2021 PSERS received about $3 in net returns for every $1 spent in fees. She also said the fund beat its overall benchmark. Yet PSERS decided last year to reduce the size of its alternative-investment portfolio and eliminate the “absolute return” portion that included many hedge funds. Over the previous five years, PSERS paid the managers of those funds $653 million in fees. The system’s new goal is to cut alternatives to 30% of its holdings.

Bridgewater Associates LP, whose former chief executive, David McCormick, recently conceded defeat in the Republican US Senate primary in Pennsylvania to celebrity physician Mehmet Oz, was the retirement plan’s biggest outside investment manager. Bridgewater took in $610 million in fees from PSERS between 2008 and 2021 before seeing its role drastically cut last year.

The hedge fund became an issue in the Senate race in the spring when Oz declared that McCormick “ripped off the teachers’ pension fund when he was at Bridgewater.” Bridgewater and McCormick spokespeople declined to comment. During the campaign, a McCormick spokeswoman told Bloomberg Businessweek in a statement that the firm’s “conservative approach reflected the risk PSERS wanted to take for its retirees and delivered results in line with expectations.”

As a pension trustee, Muth helps decide whether to put hundreds of millions of public dollars into private equity and other alternatives, based on staff and fund consultants’ recommendations. She said the staff usually provides directors with briefing books a few days before a vote. She’s found them long on upbeat summaries but short on details about where the money is going. When she sought more information, she got the brush-off, she said.

“We’re putting all this money into private equity and I don’t know what they’re doing,” she said. “I just want to be able to tell teachers, ‘Here’s where your hard-earned dollars went.’”

Given their high fees, PE investments must soundly beat the stock market for investors to do as well. The typical 2% management fee is close to 200 times the negligible cost of index funds. Most PE funds also lop off another 20% from investment returns in the form of carried interest. In fiscal 2021, PSERS paid private equity funds a 1.54% management fee and 18.6% in carried interest — less than the industry standard.

The details are so complex and closely guarded that investors often don’t know how much they’re paying. The expenses that pensions and other big investors list in annual financial statements at best capture half the actual costs, according to CEM Benchmarking, which tracks institutional investment performance.

Private equity fund managers often declare virtually every aspect of their operations “trade secrets” to maintain confidentiality. At most retirement systems, trustees aren’t privy to fund contracts, known as limited partnership agreements. In Pennsylvania, a state law shields from public disclosure partnership records or anything that would be “detrimental” to fund investments.

Muth said the state law shouldn’t apply to her as a trustee. To help her pierce the secrecy, she hired Terry Mutchler, a lawyer who specializes in obtaining public records. With her help, Muth last June sued the fund, executive director Grell and the board chairman, Christopher Santa Maria, to obtain the documents she felt she needed to do her job as a fiduciary.

Muth’s case is supported by two other PSERS directors — state Treasurer Stacy Garrity and Garrity’s predecessor, Joseph Torsella. Both declined to comment. A three-judge panel in Commonwealth Court of Pennsylvania rejected PSERS’s preliminary objections to the case, which is still pending. Grell, through his lawyer, said it’s without merit. Santa Maria didn’t respond to requests for comment.

Williams, the PSERS spokeswoman, said some documents had been withheld until the completion of the internal investigation and that Muth has now been given everything she requested. Muth said she’s yet to see any partnership agreements. “If PSERS had done what Senator Muth is asking for five years ago, it might not be facing two federal investigations,” Mutchler said.

Over the last 15 months, Muth said she’s learned not to take anything she’s told at face value. She recounted how the staff last September recommended making a direct investment of about $25 million in YES Communities, a trailer park operator. Speaking on behalf of YES at the meeting was an official from San Francisco-based private equity firm Stockbridge Capital Group, a co-investor in the venture.

But Muth wondered why YES operated mostly in the South and Midwest and not in Pennsylvania. She called state officials and discovered the lending practices used by YES’s loan originators weren’t permitted in Pennsylvania. She shared this with the board, which rejected the staff proposal 14-1. “You have to dig out information like you’re carving for fossils,” she said. YES didn’t respond to a request for comment. A Stockbridge spokesperson declined to comment.

Muth also dug into the Harrisburg land deal, the subject of the federal criminal probe involving public corruption. At least four senior PSERS officials have received grand jury subpoenas regarding the matter, including then-executive director Grell, according to documents reviewed by Bloomberg.

At a meeting last spring, a lawyer PSERS hired to look into land purchases said his firm was investigating what role pension staff played in the deal. That, said Muth, is when she held up an IRS tax form showing three of the five officers and directors of a holding company that owned the property were senior PSERS executives. One was the chief investment officer, James Grossman Jr., whose $485,000 compensation last year made him Pennsylvania’ highest-paid employee, earning more than double Governor Tom Wolf’s $201,000 salary. Grossman, who retired in May, declined to comment through his lawyer.

The holding company, 812 Market Inc., is one of at least five entities listing Grossman and other PSERS officials as directors, documents show. Although the board was supposed to be notified of the proposed acquisition at a 2017 meeting, the Harrisburg property isn’t mentioned in any board meeting minutes and no directors recall discussing it prior to the purchase, according to the outside law firm’s report. The report, however, also states that the creation of a holding company was discussed — without specifying by whom — as a way to limit transfer taxes without addressing why no board member could recall that.

“As is common practice, PSERS has holding companies on which PSERS staff serve,” spokesperson Williams said in an email. “PSERS staff receive no payment for such service.” Williams also said the formation of the holding company “was advised by counsel, and does not require Board approval.” Grell, through his lawyer, said holding companies are used to limit the fund’s legal exposure and that all the property acquisitions were board-approved.

In September, the SEC subpoenaed the teachers’ fund for information on possible securities law violations. The document shows that the agency is seeking details on the performance error and any so-called pay-to-play exchanges of money, gifts, trips or anything of value between the fund or state officials and dozens of investment managers and consultants.

Pennsylvania’s pension problems aren’t isolated, but it’s not often that trustees go to the mat like Muth to obtain documents. Six years ago, Joseph John Jelincic, a director of the US’s largest public pension fund, the California Public Employees’ Retirement System, pressed to see a partnership agreement with a private equity fund managed by Advent International. CalPERS’s staff reluctantly complied, he said. The contract, he found, stated that its general partners were not fiduciaries, were indemnified against certain criminal conduct and could charge the fund for an office in the Cayman Islands. Spokespeople for Advent and CalPERs declined to comment.

A decade ago, South Carolina Treasurer Curtis Loftis pushed his state’s retirement system to reveal more details on payments to money managers than what was in public reports. Loftis wanted, for example, to disclose performance fees and organizational expenses. The results were stark: In 2011, the system’s annual report listed $69 million in money management fees. The next year, with new disclosure rules in place, the figure jumped to $296 million.

“If you don’t have access, you’re not trying hard enough,” he cautions fund directors. “You can’t be afraid of losing your job. You have to pound the table and scream. Billions are being siphoned off working people and given to the richest people in the world.”

An even simpler solution, said Johns Hopkins’s Hooke, would be for retirement systems to focus on low-cost index funds. That’s what the Public Employees’ Retirement System of Nevada has done with its $58.5 billion in assets. With 6% of its money in private equity, 6% in real estate and most of the rest tracking public market indexes, its travel costs are minimal and its investment staff now stands at two, compared with about 60 at PSERS. Over 10 years, Nevada’s 10.1% return on its investment portfolio is 25% higher than PSERS’s.

Washington has also taken note. In February, the SEC proposed strict new disclosure requirements for private equity and other alternatives. They reflect concerns expressed by Chair Gary Gensler that fees are opaque and too high — and put investors at greater risk.

The SEC proposal would require alternative funds to report their performance quarterly, and to account for all the costs passed on to investors. The fund industry quickly expressed its opposition. The SEC is required to hold a public comment period and a second vote before any new rule takes effect.

“The truth is important,” said Muth. “In its absence, how do we know what’s going on and how the money’s spent? This isn’t a private bank. This is public money.”

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