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Cypen & Cypen
February 23, 2012

Stephen H. Cypen, Esq., Editor

1.     CALLAN PERIODIC TABLE OF INVESTMENT RETURNS: Callan Associates Inc. annually publishes its Table of Investment Returns, showing annual returns for key indices, ranked in order of performance over the past twenty years (see C&C Newsletter for February 3, 2011, Item 2).  Here are the numbers for 2011, in which only three-out-of-nine categories are in positive territory: 
BC AGG                                                                         7.84%
S&P/CITI 500 GROWTH                                              4.65%
S&P 500                                                                         2.11%
S&P/CITI 500 VALUE                                                 -0.48%
RUSSELL 2000 GROWTH                                        -2.91%
RUSSELL 2000                                                           -4.18%
RUSSELL 2000 VALUE                                             -5.50%
MSCI EAFE                                                                  -12.14%
MSCI EMERGING MARKETS                                   -18.17%
Some other observations: 

  • Stock markets around the world suffered through a year of incredible volatility, as fear gripped investors faced with uncertainty in the European debt markets, negative prospects for Japan following the tsunami and nuclear disaster, the U.S. budget fiasco and Treasury debt downgrade and seeming unraveling of growth of global economy. 
  • For only the third time in thirteen years, small cap (-4.18%) trailed large cap (2.11%) stocks in 2011.  Small cap growth (-2.91%) outperformed small cap value (-5.50%) for the third year in a row. 
  • Fixed income (7.84%) generated the highest return among asset classes in 2011.  Fixed income performance surprised on the upside.  At the start of 2011, yields were exceptionally low, and economic growth was expected to lead to inevitably higher interest rates, and therefore weak performance for fixed income.  However, interest rates declined as investors flew to quality, driving up bond prices and total returns.  Ironically, one of the major flight-to-quality events of 2011 was the downgrade of the very instruments that investors use to effect this flight to quality. 

How public pension plan assets should be invested is an important but unsettled question.  Some observers endorse the standard practice of investing heavily in higher yielding but riskier equities, reasoning that the higher average returns will reduce future required tax receipts and also help to reduce underfunding over time.  Others advocate a more conservative approach that reduces volatility of funding levels and likelihood of severe shortfalls during economic downturns when government resources are already constrained.  A research paper from Columbia Business School says accounting rules for public pensions create a perverse incentive to invest in stocks:  since projected liabilities are discounted at the expected return on assets rather than at a rate that reflects the generally lower risk of liabilities, investing assets in the stock market leads to a higher allowed discount rate for liabilities, which in turn lowers the accounting-based measure of liabilities and lowers required pension contributions.  This choice of discount rate contradicts the valuation principle that risk of the quantity under consideration determines the appropriate discount rate.  Determining optimal asset allocation requires specification of who bears the risks and returns and how risks and returns are traded off, that is, a budget constraint and an objective function.  The authors solve a simple model that illustrates the asset allocation problem facing a public fiduciary that seeks to minimize the welfare cost of distortionary taxes, subject to a funding constraint.  They demonstrate that there is a trade-off between the higher average return on equities that lowers average taxes and the greater risk of equities that increases expected tax distortions.  The authors also incorporate the idea that if there is a positive correlation between stock returns and pension liabilities over longer horizons, then holding some equities can serve as a partial hedge against liabilities, providing an additional reason for equity holdings.  They consider sensitivity of conclusions about optimal asset allocation to the degree of initial underfunding, to the expected level of future taxes, and to the stochastic properties of pension liabilities.  Although the authors do not model them formally, they do discuss other considerations beyond minimizing tax distortions that can influence the optimal asset allocation in State and Local pension plans, which together seem to point toward a policy of matching pension assets and liabilities.  
3.      COSTS OF SWITCHING INVESTMENT MANAGERS:  Institutional investors spend a great deal of time addressing their strategic choices and investment managers in order to maximize portfolio returns relative to risk taken.  This review process, according to, leads to periodic changes in investment manager lineups and transitions to new managers from legacy mandates.  Too often, though, investors do not spend enough time understanding and managing the transition costs and risks.  These costs are not easy to identify (especially in advance), and, as is said in so many business contexts, what is difficult to measure tends not to get managed. However, there is no question that firing one manager and hiring another will incur expenses -- with some expenses being a lot less visible than others.  Specifically, there are some transition cost issues you should consider, for both equities and fixed income, before making a manager change.  As institutional investors know, no two actively managed portfolios are exactly alike.  Even two passively-managed portfolios can have differences.  Inevitably, security purchases and sales will form part of a transition, and central to that process is market liquidity, or ability of assets to be bought or sold without causing a significant movement in price and with minimum value loss.  The basic challenge in a transition is how to move from the current allocation to a new investment structure while minimizing costs incurred and managing risks involved.  So, it is worth reviewing how trading costs could be divided into direct, indirect and other components: 

  • Direct costs are visible components of a transfer, and include brokers’ agency fees (commissions) and any fee paid to a specialist transition manager (normally charged on a project basis). 
  • Indirect costs are less obvious but typically exceed direct costs, often by a substantial margin.  Main examples are bid/offer spreads and market impact.  The latter occurs because the very act of trading large quantities of a particular asset in a short period -- or even showing the intent to do so -- can have a detrimental effect on market prices.  
  • Opportunitycosts are degradation of prevailing prices caused by actions of other market participants.  If exposure risks are not managed adeptly, unpredictable losses or gains can occur, especially if trading takes place in volatile markets.  
  • Administrative costs include time spent by fiduciary committees working through merits of a manager search, adviser fees to assist in the process, negotiation of new contracts (including legal fees), rewriting of fund documents and marketing materials, communicating to third parties about the change and custodial fees associated with securities movements.  

Volatility of today’s markets, together with availability of dedicated transition management services, means that, even for small plans, engagement of a specialist manager will frequently be worth considering.  A transition manager’s role is to take responsibility for coordination and execution of the entire process and the results, achieved by adopting a project management approach that includes procedural safeguards and employs specialized risk-monitoring tools during the trading process.  Guess what the authors of this piece do for a living? 
      DEVELOPING PENSION FUNDING POLICY FOR STATE AND LOCAL GOVERNMENTS:  Over the past decade, the Annual Required Contribution as described in Governmental Accounting Standards Board’s Statements No. 25 and No. 27 has become a de facto funding policy for many public-sector retirement systems.  A Research Report from Gabriel Roeder Smith & Company reminds that GASB is currently revising public pension accounting standards and has communicated an important message in the process: accounting standards are not funding standards.  In the Exposure Drafts of the new Statements No. 25 and No. 27, GASB has removed all references to ARC.  At the same time, the EDs require disclosure of elements of a plan’s funding policy and the actual funding pattern must be taken into account to determine the plan’s financial disclosures.  Now more than ever, public retirement systems need to have a sound, written funding policy to secure member benefits -- and a strong funding policy may improve a plan’s financial disclosures as well.  The report concludes that, in funding defined benefit pension plans, governments must satisfy a range of objectives.  In addition to the fundamental objective of funding long-term costs of promised benefits to plan participants, governments also work to (1) keep employer’s contributions relatively stable from year to year; (2) allocate pension costs to taxpayers on an equitable basis; and (3) manage pension risks.  Developing a written funding policy can help decision makers understand tradeoffs involved in reaching these goals and document reasoning that underlies their decisions.  By clarifying funding policy, decision makers can come to a better understanding of the principles and practices that produce sustainable benefits. 
5.      SUMMARY OF 2010 ANNUAL SURVEY OF PUBLIC EMPLOYEE RETIREMENT SYSTEMS:  STATE-ADMINISTERED PENSIONS:  A just-released report is part of a continuing series designed to provide information on the structure, function, employment and finances of the United States’ nearly 90,000 state and local governments.  The United States Census Bureau produces data quinquennially as part of the Census of Governments in years ending in “2” and “7.”  The surveys provide a wealth of information on state and local government employment and financial activity.  The data collected are for defined benefit plans only, and do not include data for defined contribution plans or other postemployment benefit plans.  This survey covers the following retirement system activities: revenues by state; expenditures by state; cash and investment holdings by state; membership information by state; and liabilities information by state for state-administered retirement systems only.  For Census Bureau statistical purposes, a public employee retirement system is one that is financed by a separate accounting fund of the administering government, excluding pay-as-you-go insurance plans. It must have some type of assured revenue stream or dedicated revenue source other than appropriations from the administering government.  Other criteria exist for membership, such as funding and organization.  A public pension system’s members must consist of current or former public employees.  A retirement system must have at least one separate identifiable fund within a recognized government unit, and it must be funded completely or partially with public contributions.  A retirement system must also be recognized as a government unit that provides revenues, expenditures, financial assets and membership information for public employee retirement systems.  Each state-administered retirement system is considered an agency of the corresponding state government; however, the information in the publication reflects only the retirement system portion of revenues, expenditures and assets: 

  • State-administered pensions showed positive earnings on investments in 2010, after two consecutive years of losses on investments.  Earnings on investments totaled $289.6 Billion in 2010, $112.7 Billion below the 2007 earnings on investments of $402.3 Billion, the most recent year with an increase in earnings on investments.  Losses on investments totaled $511.5 Billion in 2009 and $71.7 billion in 2008.  The 2009 fiscal year was greatly affected by the market decline of 2008, since it covers the period from July 1, 2008 to June 30, 2009.  The total of “net earnings” is a calculated statistic, and thus can be positive or negative.  The total of “net earnings” equals the sum of earnings on investments plus gains on investments minus losses on investments.  
  • State-administered pension systems accounted for 83.8 percent of total holdings and investments for all state-and locally-administered pension systems.  While the report encompasses data for only state-administered pension systems, the state data show a very large part of the financial activity for public pensions. 
  • Total cash and investment holdings for state-administered pension systems rose 10.7 percent, from $2.0 Trillion in 2009 to $2.2 Trillion in 2010, the first year-to-year increase since 2007. Total holdings and investments consist of cash and short-term investments, governmental securities, nongovernmental securities, foreign and international securities, mortgages and other investments. 
  • The three largest investment categories, corporate stocks, foreign and international securities and corporate bonds, made up two-thirds of total holdings and investments in 2010; respectively,  34.6 percent, 16.3 percent and 15.8 percent. 
  • Most investment categories showed increases from 2009 to 2010, with few exceptions:  cash and short-term investments, mortgages and real property.  Combined, these categories composed 8.0 percent of total holdings and investments in 2010. 

One thing that we have never seen before:  the overall unit response rate and total quantity response rate were 100%.  The Census Bureau must be doing something right. 
State and local pension systems have received significant attention in the last few years.  Changes to state pension systems have been taking place in response to increased attention and concerns.  A new brief from National Association of State Budget Officers examines a number of pension issues from a budgetary perspective.  A budgetary perspective considers long term pension funding adequacy and the financial cost of promised benefits in relation to the rest of current state spending.  Sufficiently budgeting for public pension systems can help states resolve pension funding issues over time without disrupting current appropriations for public services.  Pension contributions currently represent a small percentage of states’ operating budgets (but funding requirements could increase, as demographics change and new pension fund accounting rules gain traction).  States are taking great steps to limit future budgetary impacts of pension plans by enacting reforms that reduce liabilities and promote funding adequacy.  In fact, 40 states made significant revisions to at least one state retirement plan in 2010 or 2011.  As tax revenues slowly increase, states will also have the option to allocate more funds to build stronger pension systems. However, such allocation may entail real budgetary trade-offs between alternative state services or more robust pension systems. Gradual plan and funding changes can allow states to match contributions with future obligations over time, without drastically reducing services or undermining retirement security of other employees or retirees. 
7.      SHERIFF ENTITLED TO QUALIFIED IMMUNITY FOR DISCIPLINE OF LIEUTENANT:  The day after his scandal-ridden third election to the position of Orange County Sheriff-Coroner, Carona placed on administrative leave Hunt, former lieutenant officer with the Orange County Sheriff’s Department, who had dared to enter the race and campaign against Carona’s alleged culture of corruption. Carona then demoted Hunt, an action that prompted Hunt to file a 42 U.S.C. § 1983 suit claiming that his placement on administrative leave and subsequent demotion were in unconstitutional retaliation for exercise of his First Amendment rights.  The federal district judge concluded that Hunt’s campaign speech was not protected by the First Amendment because, based upon specific factual findings by a jury, Hunt fell into the narrow “policymaker” exception to the general rule against politically-motivated dismissals.  The federal court of appeals determined that the district court erred in this conclusion, but agreed with the district court’s alternative ruling that Carona was entitled to qualified immunity because a government official in his position “reasonably but mistakenly” could have believed that political loyalty was required by someone with Hunt’s job responsibilities at the time he ran against Carona.  In affirming, the appellate court said even if Carona engaged in the appropriate analysis and wrongly concluded that Hunt was a policymaker such that demoting him was constitutional, it cannot be said that he acted objectively unreasonably in concluding he could demote Hunt without violating his constitutional rights.  Hunt v. County of Orange, Case No. 10-55163, (U.S. 9th Cir., February 13, 2012). 
8.      GOLF WISDOMS:   Never teach golf to your wife.  
9.      PARAPROSDOKIAN:  (A paraprosdokian is a figure of speech in which the latter part of a sentence or phrase is surprising or unexpected in a way that causes the reader or listener to reframe or reinterpret the first part.  It is frequently used for humorous or dramatic effect.):  “She got her good looks from her father; he's a plastic surgeon.” -- Groucho Marx     
10.    QUOTE OF THE WEEK:   “Living is a thing you do, now or never – which do you?”  Piet Hein 
11.    ON THIS DAY IN HISTORY:  In 1974, Patty Hearst, daughter of publisher Randolph Hearst, kidnapped by SLA. 
12.    KEEP THOSE CARDS AND LETTERS COMING:  Several readers regularly supply us with suggestions or tips for newsletter items.  Please feel free to send us or point us to matters you think would be of interest to our readers.  Subject to editorial discretion, we may print them.  Rest assured that we will not publish any names as referring sources. 
13.    PLEASE SHARE OUR NEWSLETTER:  Our newsletter readership is not limited to the number of people who choose to enter a free subscription.  Many pension board administrators provide hard copies in their meeting agenda.  Other administrators forward the newsletter electronically to trustees.  In any event, please tell those you feel may be interested that they can subscribe to their own free copy of the newsletter at  Thank you.


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Items in this Newsletter may be excerpts or summaries of original or secondary source material, and may have been reorganized for clarity and brevity. This Newsletter is general in nature and is not intended to provide specific legal or other advice.

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