A recent article in the New York Times outlined an F.B.I. investigation into a Pennsylvania pension plan that took some BIG risks in alternative investments. In this podcast, Tom and Tim break down where the trustees went wrong, and why alternative investments can be so dangerous.
‘F.B.I. Asking Questions After a Pension Fund Aimed High and Fell Short’ – The New York Times
The Risks with Alternative Investments – Transcript
DISCLAIMER: Tom Mullooly is an investment advisor representative with Mullooly Asset Management. All opinions expressed by Tom and his podcast guests are solely their own opinions and do not necessarily reflect the opinions of Mullooly Asset Management. This podcast is for informational purposes only, and should not be relied upon as a basis for investment decisions. Clients of Mullooly Asset Management may maintain positions in securities discussed in this podcast.
Tim Mullooly: Welcome back to the Mullooly Asset Management podcast. This is episode number 355. Thanks for tuning in. This is Tim Mullooly, and with me today is Tom Mullooly. How are you doing?
Tom Mullooly: Good. Hello everyone.
Tim Mullooly: There was an article in the New York Times. If you tuned into the Mullooly Asset show this week, we touched on a couple of points from this article, but honestly, there was so much to talk about in this that we wanted to take time on the podcast and really dive into things that we couldn’t discuss fully in a short video.
Tom Mullooly: I’ll start out by saying that if you’ve got time, please take a look at this article. We’ll link to it in the show notes, but I’m amazed someone hasn’t been arrested.
Tim Mullooly: Yet.
Tom Mullooly: Yet.
Tim Mullooly: Looking at the details in this article, it’s probably coming. So it has to deal with a Pennsylvania public school employees retirement system. So it’s the pension fund for public school teachers in Pennsylvania.
The trustees of the account, which they’re supposed to be acting as fiduciaries, and we’ll get into that, they decided to put a majority of the money in the pension fund into extremely risky speculative alternative investments. Some of them will leave you scratching your head. And now the FBI is investigating the pension fund because these people clearly were not operating under the fiduciary responsibility that they had to all of the participants.
Tom Mullooly: So the article started out by talking about some of the different investments that are being held by the Pennsylvania public school employee retirement system. So it’s not just teachers. These are anybody who’s employed by the public school system in the state of Pennsylvania. They’ve got money invested in trailer park chains, in pistachio farms, in payphone systems for prisons. I mean just weird stuff. I mean, it’s not like they’re buying the NASDAQ index or Apple.
Tim Mullooly: Right. Yeah. They’re not buying the typical blue chip name stocks that you would think, or even just any kind of stock or bond or any type of more traditional investment. I think one of the last things they pointed out there was that they’re making some kind of loans or some kind of investment to the people-
Tom Mullooly: To the Kurds.
Tim Mullooly: … the Kurds in Iraq.
Tom Mullooly: That’s right. But hey, it pays 12%.
Tim Mullooly: Right. So where do you want to start with this article? Where should we dive in?
Tom Mullooly: The first thing I just want to get out of the way is they mention near the top of the article that the decisions that brought the fund to this point are by now commonplace in the world of public pensions. I completely disavow and find that hard to believe because I don’t think you’re going to find other public pensions that have 51% of their assets in alternative non-traded investments. That’s reckless.
Tim Mullooly: That’s what I was going to say. I feel like pension funds, you do hear that they have some sort of exposure to alternative investments, but not 51%. That’s a controlling stake of their allocation being dished out to pistachio farms, et cetera.
Tom Mullooly: Now it’s not as large as some other state retirement plans around the country. The Pennsylvania plan is $62 billion, but that’s a lot of money for retirees.
Tim Mullooly: Right, exactly. And for the people that are counting on that money, it means the world to them.
Tom Mullooly: Right. There’s 500,000 participants across the state of Pennsylvania.
Tim Mullooly: That’s a lot of people.
Tom Mullooly: Yeah. Now of the half a million participants, half of them are still working and they’re contributing to this plan. So money from every paycheck is going into this pension plan. The other half of the participants are retirees who are getting a check every month. Now think about your checking account at home.
You’ve got some money that you want to earmark for that project that you’ve got coming in two or three or four months, but then you’ve also got money that has to be paid out this week. You’ve got to pay the electrical bill. You’ve got to pay your cable bill. You’ve got to do some food shopping. So you need to have cash on hand.
If 51% of your assets are tied up in alternative non-liquid investments like pistachio farms, how can you get money from that? You’ve got to have the rest of the money or a large chunk of that money available in something that you can sell very quickly so you can get a check out every month. I don’t know how they arrived at this asset allocation, but it is, the second time I’m going to say it in five minutes, reckless.
Tim Mullooly: I was going to say, I was actually going to ask, how do you think they got to where they are today? I mean, in the article, they walked through what’s happened in this plan over the last, I think like 20 years. They went back to the last couple bear markets, drops in the market and what happened to this pension fund. And I feel like they just kept doubling down on their mistakes, and it’s just compounded and grown and they’ve needed to take more and more risk to make up for the bigger and bigger losses.
Tom Mullooly: That’s a pretty succinct summary of what they did. Every time that the market would turn down, they would panic, they would sell at the bottom and they would get involved in riskier things to try and make the money back. I’m using air quotes. I’m using air quotes because I’ve heard this over 30 plus years of people telling us we’ve got to make that money back. Well, you didn’t lose it all at once, you’re not going to make it all back at once either. If you try and do that, you’re taking a hell of a risk.
Tim Mullooly: Right. And they outlined how, when the market dropped, I think it was in 2008 or around that time when they sold out of stocks. They sold out of the S&P 500 or one type of broad index and went into more of these alternative investments. I mean, if they just didn’t panic and held onto the indexes compared to what they ended up getting, they would have made way more money just by staying in stocks.
Tom Mullooly: I think that we’ll hear more and more details as the months and years go by. We’ll hear leaked depositions and testimony in court about how things went. But if you just think about what Tim said, they appeared to have bailed out on a large portion of their stock allocation in 2008, 2009. Now think about this.
The market bottomed in March of ’09, the S&P famously bottomed at 666, not a good number, but for the better part of November through February, the S&P traded between 700 and 800. And it also on the way back up in March and into April, it traded between 700 and 800. So if you got out of large cap stocks at that level, I cringe to tell you that today S&P 500 is trading above 4000. That’s five times more than where it was when you decided to sell.
Tim Mullooly: As I was reading the article, I was trying to think where the problem started for them. And I think it’s a little different than just a regular investor with a pension, because these people have more of an urgency to make money for the next quarter or the next half of a year, because they have obligations to pay out money to people that are collecting these checks. Like you said, half of the people are paying into the system and half of the people are now taking money out of the system.
So with all of these outflows, and other pensions across the country probably find themselves in this situation too, but it could almost be too late. The amount that they told people they were going to be getting for the rest of their lives was just not realistic. It wasn’t sustainable and they forced themselves into needing to take more risk. So I feel like that’s where the whole thing started with them. They forced their hand into taking more and more risk and getting more and more reckless with it.
Tom Mullooly: Now, an interesting twist in this, by comparison, the Pennsylvania State Employees Pension plan is the money that goes into, those pension plans for the state workers, that comes through their operating budget. That money’s budgeted every year. But the money for the public school employees retirement system, that comes from only two sources. It comes from the teachers kicking in their own money and it comes from property taxes. So now everybody is getting dragged into this.
Tim Mullooly: Yeah. Whether you’re a participant in that plan or not, you’re going to be feeling the pain of these losses, of these risky investments that these people are trying to make.
Tom Mullooly: So as Tim alluded to a few moments ago, it seems like about 20 years ago, around 2000 or 2001, the trustees realized that they’re not going to meet their obligations, and so they started tapping into increasing property taxes across the state. Now property taxes affect you whether you’re a renter or a homeowner because if your rent goes up, a lot of that covers increased expense like property taxes.
So everybody’s in on this, including businesses. So they started seeing more taxpayer contributions come in from 2001 through 2008. Then the market collapsed in 2008. And what really I found stunning was that, I’ll just use this line right here from the article, “The fund emerged from the great recession with even less money than it had in 2001.”
Tim Mullooly: Imagine you’re a taxpayer that had seen your property taxes increase for almost a decade to pay for this fund, and then they end up with less money, their problem is bigger.
Tom Mullooly: Yeah, really bad. So then they-
Tim Mullooly: What are you guys doing?
Tom Mullooly: Yeah. Then doubled down on their risks. And so after 2008, they started moving into these alternatives. And now these alternatives make up 51% of the $62 billion asset. But that’s the problem with this, is that when you turn money over to someone who’s managing money or handling the alternative sleeve, if you want to call that, of your investment portfolio, you don’t really know what’s going on.
And so now I’ve got to believe that these trustees are pretty red faced right now, because they’re discovering that the money that they turned over to a money manager to manage the alternatives for them is now winding up in Kurdistan, in pistachio farms, in payphone systems in prisons, things that they didn’t really expect and are completely illiquid. You can’t call up and say, “Hey, how’s pistachios doing today. Can we sell our share?” It doesn’t work that way. These are 20 year investments and you don’t get your money out until it’s sold. Hopefully at a higher price, but-
Tim Mullooly: Who knows.
Tom Mullooly: Who knows is right.
Tim Mullooly: These trustees, even though they passed the torch to the alternative fund managers that are picking these alternative, it’s still on the trustees to find managers or find alternative products or investments that are suitable, so it doesn’t wipe their hands clean of it. Like, oh, we weren’t the ones managing the pistachio farm investment. They’re the ones who turned over the reins to the alternative managers, and their trustees of the pension have fiduciary obligation to that plan.
Tom Mullooly: So, the trustees need to do some due diligence and they have a fiduciary obligation. It’s not like, as Tim said, you’re not going to go, “I have to leave early today because I have to hoe the south field for pistachios,” it’s, “Hey, we need to know, how do we” … I think that’s the most important question to ask when you’re talking about alternative investments. How do I get my money back? Or how do I get my money out? Or when do I get my money out?
Tim Mullooly: Yeah. How liquid is it? How do they value it? Because I think that’s a big one too, along the way. How do you value something like a pistachio farm? You don’t really know. It’s not constantly being bought and sold.
Tom Mullooly: Right. So they’re cranking out these quarterly reports and they get the information from, or the prices from the alternative investment manager, whoever that is. They don’t know. They’re guessing what the value is.
Tim Mullooly: Yeah. It’s a little bit better than just a blind guess. They probably have some sort of an educated guess, but at the end of the day-
Tom Mullooly: I hope they do.
Tim Mullooly: … it’s still a guess. To me, that’s like when you go on Zillow and you’re looking at the price of your house or someone else’s house and they give you the Zestimate, that’s great, but the house is worth whatever someone’s going to pay for it whenever you choose to sell it.
Tom Mullooly: 100% right. And so that’s why when you’re managing money, it’s really optimal if you deal in things that are liquid, that have prices, that have active markets that you can buy and sell in all the time and you know the price. So they quoted a former trustee for the plan.
He said, “Putting money into private investments could be dangerous, in part because the extent of the fees are poorly misunderstood.” Incidentally, pretty fat fees in alternative placements. So we get cold called every day, not every day anymore, but we-
Tim Mullooly: Calls or emails.
Tom Mullooly: … all the time from folks trying to get us to show their alternative investments to our clients. We delete their emails, we block them. And we hang up on the people who call. It’s just not something that we’re going to get mixed up in. But this past trustee goes on to say, “Private valuations are very susceptible to manipulation.” If you’re listening to this podcast, that is very, very, very, very, very important. Private valuations are very susceptible to manipulation.
They can put down whatever they want. So I’m going to just go off on a sidebar here. Early in my career, in the ’80s as brokers, we used to buy CDs for our clients. They’re called brokered CDs. So you could be sitting at an office in New York City and a client says, “I want to put my money into CDs,” and they’ve got an account with you at a big brokerage firm. So what you’re actually buying is a CD from Wells Fargo or the Bank of Louisiana, or the First National Bank of Paducah, wherever. You’re buying all these different CDs.
When the statements would come out, they would show, hey, you put $50,000 into this CD. It’s worth $50,000. That’s not true. That’s not even accurate. We don’t know what it’s worth because it’s actually an investment. There’s no liquid market for it. And so they had to make an estimate. There was a big lawsuit about this. And all of the big brokerage firms had to change how they valued these CDs on the statement because they were carrying them at face value.
Now, if interest rates go down, you could actually sell that CD and make a couple of bucks. The reality is that most of the time, if rates stayed the same, there was a sales charge in there, and the market changes. And so it’s probably going to be worth a little less than what you paid for it. But they had to change the way that they priced these things on the statements, because the system was not working the way it should have. They were just carrying them at face value.
I would venture to say that most alternative investments are completely mis-marked on your individual statements. That’s why we don’t get mixed up in alternatives.
Tim Mullooly: Yeah. It’s hard to know all the specific details about any of these investments. And whenever that’s the case, it’s just something that we tend to stay away from. But for this pension plan moving forward, unfortunately I think, in my opinion, the way to get themselves out of this hole now is to reduce what they’re paying out to people. I don’t know how they can do that.
Or maybe it’s just people that are already collecting will continue to collect, but maybe for people who haven’t yet started collecting, when they do file to start getting those checks, it’s going to be less than they thought. Otherwise, they backed themselves into a corner by continuing to double down on their mistakes. And that’s something that we say all the time here, that it’s okay to make a mistake, but don’t repeatedly make the same mistake. You have to change what you’re doing to fix the problem.
Tom Mullooly: The corollary to what Tim said is it’s okay to be wrong, not okay to stay wrong. There’s a lot of folks that will own an investment. It’ll go down in value. And they’re like, “I’m not selling this until it comes back.” And if it does come back, they’re going to say, “Why would I sell it? It’s up 40% in the last couple of months.” Did you forget what you told me, just not very long ago that I’m not selling this until it gets back to even. Well, here we are. It’s stunning to see this kind of mismanagement in some big bucks, really with a lot of responsibility tied to it.
Tim Mullooly: Yeah. Over $60 billion for half a million people. That’s a lot.
Tom Mullooly: Yeah, it really is. I think we ought to just quickly mentioned a thing about the Kurds. They invested through an outside money manager into an alternative investment. They basically bought into oil wells overseas. Now, they probably didn’t have all the details when they plowed their money into this, but the promised return was 12% yield on a note on a bond that was going to come due in 2022.
This involved placing money with the Kurds, who were trying to carve out their own nation in Iraq called Kurdistan. Obviously things are pretty volatile over there. When Iraq found out what the Kurds had planned, Iraq sent its army in to recapture the oil fields that were backstopping the debt. They basically said, “No, sorry, we’re nationalizing that. It’s ours. No more income.”
But through that story came an even more sensational fact, sensational in the pension world is somebody sneezed, but they talked about how they expected a 12% income, or a 12% yield on this investment. Obviously something that’s paying 12%, it’s got a lot of risk. But they said that would easily help them hit their target, annual return target of seven and a quarter percent. Stop the presses. This fund is trying to hit an annual target of seven and a quarter percent. That is super aggressive.
So I sit on the board, an advisory board that oversees a pension here in New Jersey, and we’re trying to get them to lower their target from six and a half to six, because we feel six and a half is too aggressive. They have to take too much risk to do that. We just don’t know from year to year what the market’s going to give us.
So it’s better to use a lower number and be surprised on the upside. As we’ve said on many podcasts and videos, we’re optimistic people. We’re also people-pleasers. So we want to give people good outcomes, but we have to plan pessimistically, even though we live optimistically. We want to plan for the worst case scenario.
Tim Mullooly: Yeah. And even taking out the fact that this was an investment overseas with oil in Iraq, there were a handful of red flags there that would apply to almost any other investment as well. The fact that there’s 12% returns coming to them and they didn’t know all the details yet before they piled their money into it. Stop right there. It doesn’t matter if it’s a stock or a bond or something overseas in Iraq, if you don’t understand what you’re putting your money into, don’t pile a lot of money into it. It’s simple as that.
So there was a lot to digest there in that article. Good stuff to break down on the podcast. That’s going to wrap up this episode of the Mullooly Asset podcast. Thanks for listening, and we’ll see you next time.
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