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The retired firefighters, police officers, teachers and other state and municipal employees of Wisconsin are set to suffer yet another reduction in their monthly pension checks. On May 1, for the fifth year in a row, many of the 168,000 retirees and beneficiaries in the Wisconsin Retirement System (WRS) will begin receiving payments that are as much as 13 percent smaller than in 2012.

But it’s not just retirees who will have more trouble making ends meet in the Badger State. The 256,000 active employees in the WRS have been taking home smaller paychecks since July 2011. That is when Governor Scott Walker and the state legislature, as part of an effort to close a $3.6 billion state budget gap, mandated that public workers split the required contributions with their employers. Before that Wisconsin municipalities picked up most or all of their employees’ share of pension contributions.

At first glance, these reductions look similar: Both retirees and active employees will take home or receive less money than in years past. But there is a key difference. While current employees have recently begun to share their pension contributions with their employers, the retiree reductions are a direct result of a well-­constructed pension machine that increases or decreases payouts in tandem with the gains and losses in the WRS’s investment portfolio, which now has $84.6 billion in assets. Designed decades ago and unique among the 50 states, the ninth-largest public pension system in the U.S. features a mechanism that insulates Wisconsin from wide swings in funding by balancing both cost-sharing and risk-sharing between employers (that is, taxpayers) and employees.

Wisconsin’s multilevered retirement machine also awards pensioners an annual “bonus,” or dividend, when asset prices are rising that has reached as high as 17 percent (during the bull market in 1999). Retirees can also rest assured that their pensions are secure for the long haul despite any short-term gain or pain, because the adjustability feature keeps the WRS close to 100 percent funded. For their part, taxpayers can take comfort in knowing they won’t get hit with an increase because of a shortfall in the pension trust fund. Although the investment portfolio lost 26 percent of its assets in 2008, when the financial crisis exploded, taxpayer savings have been impressive: At the end of the 2013–’14 pension calendar year, the state will have shaved total pension benefits by $4 billion over five years.

“The Wisconsin Retirement System is fully funded, and the explanation is largely based on the design of the system,” says David Villa, who joined the Madison-based State of Wisconsin Investment Board (SWIB) as its first chief investment officer in June 2006. Villa is responsible for ensuring that the WRS achieves the top returns needed to deliver its 76 percent share of the system’s contributions (employers and employees split the rest).

It turns out that the Midwestern state best known for cheese and beer also has the best-designed and best-governed pension system in the U.S. The WRS’s ability to balance employer and employee gains and losses has sheltered Wisconsin from the pension problems that are running rampant in other states. Neighbor Illinois has only about 45 percent of the assets needed to meet future pension liabilities in its state employees’, teachers’ and university systems. In total, U.S. public pensions have a $757 billion underfunding hole, according to a June 2012 report by the Pew Center on the States.

The WRS was not immune to the financial crisis, losing $22.7 billion in 2008. So it’s a little ironic that although former Wisconsin public employees are still feeling the pain in the form of payment reductions, these very payment reductions are the reason state retirees are likely to continue to receive their benefits in the future.

The Wisconsin pension machine aligns the interests of its employees, taxpayers and investment office. Beyond the adjustable gears and switches that pass on investment gains and losses to Wisconsin retirees and tax savings to citizens is a system of governance that ensures employers and employees make every required contribution, in up and down markets. The third critical element is a bulletproof trust fund that prevents poaching by state officials in search of extra revenue. On top of it all is an investment process that is akin to the more risk-based investing used by top educational endowments and foundations.

“It’s one of the best-run, best-funded public pension plans in the country,” says Dale Knapp, research director of the Wisconsin Taxpayers Alliance, one of the WRS’s vigilant watchdogs. “It’s not something the legislature can get its hands on.”

“This is a good demonstration that defined benefit plans can work and they should not be written off,” adds Peter Gilbert, former CIO of the Pennsylvania State Employees’ Retirement System and the current investment chief for the endowment at Pennsylvania’s Lehigh University. “It’s critical to have the right design, and it’s critical that the employer funds the plan.”

In the wake of the financial downturn, state retirement systems have come under increasing attack by governors and legislatures desperate to balance budgets and stave off tax increases. Kansas, Louisiana and Virginia have replaced their defined benefit plans with cash balance or hybrid plans for new employees. Alabama closed its plan at the end of 2012 and replaced it with a new defined benefit scheme that will weaken future retirement benefits. Since 2000 nine state legislatures, including Florida, New York and Ohio, have enacted optional defined contribution plans for their public servants. Last year New York State Comptroller Thomas DiNapoli had to push hard to keep the new plan optional.

With so many states jeopardizing their retirees’ futures, it was little wonder that, in a bid to close a $3.6 billion budget hole in early 2011, then newly elected Wisconsin governor Walker successfully ended collective bargaining rights for unionized state workers and doubled their pension contributions, while cutting the pension cost to taxpayers in half (by requiring a 50 percent contribution by employees that had previously been bargained away). Although the budget gap was unrelated to the retirement system, which was fully funded, Walker set his cost-cutting sights on the defined benefit pension. In June 2011, under the governor’s direction, the Republican-led legislature ordered a yearlong study of the retirement system to determine whether a defined contribution plan for public employees would better serve the state’s needs. The legislature also wanted to examine whether employees should be permitted to opt out of making contributions.

“We have obviously in the past two years been pretty willing to be bold — that’s an understatement — about tackling issues out there,” Walker told Institutional Investor in December. “One of them we looked at was, could we change from a pension to a 401(k) system?”

In fear of losing their promised benefits, a record 15,265 WRS participants retired in 2011, nearly double the number that had retired the previous year. Their worries, however, proved unfounded. The pension system study, released last June, made a thorough accounting of all the ways in which the WRS was a model of excellence. Says Michael Huebsch, whom Walker appointed as secretary of the Department of Administration, the second-most-powerful role in Wisconsin government: “I summed it up to the governor: The system isn’t broken, and there’s no reason for us to tinker with it. And we’re not going to.”

In the midst of the ongoing political wrangling, which led to Walker’s June 2012 recall election and subsequent second victory, SWIB CIO Villa has been working hard to grow the WRS for its members. After all, their dividends depend on it.  Villa took aim at portfolio risk, earning a top-quartile ranking from San Francisco–based investment consulting firm Callan Associates. Calling himself the “chief risk guru,” Villa says, “If you can earn 50 basis points more on $80 billion while taking less risk, that pays a lot of $2,100 [monthly pension] checks.”

As a result of the devastating 2008 loss, the nine SWIB trustees, including Huebsch, in 2010 approved a new strategic asset allocation to reduce investment risk. This initiative lowered the fund’s reliance on equities and added a “best ideas” portfolio — a sort of internal hedge fund; SWIB launched a direct hedge fund portfolio in February 2011. With all the complex alternative-asset additions to the portfolio, and looking to cut costs, Villa has expanded the rigorously trained internal investment team to bring more investment duties in-house. Since 2007 in-house assets have grown from 21 percent to 55 percent; two thirds of that is in public market assets.

But Villa’s vision for his role goes beyond risk management and fund performance. The CIO, who comes from a family of teachers, has established a relationship with the nearby University of Wisconsin to draw upon the institution’s considerable resources. He established internships that make use of both the business school and its Applied Securities Analysis Program. An internal education program motivates investment staff to pursue a life of learning through academic research. “We’ve worked hard to strengthen the relationship with the university,” says Villa, who also set up weekly “office hours” visits from two economics professors.

Despite the success of Wisconsin’s pension system, some fear that the state’s progressive culture will be stamped out with the enthusiastic aid of out-of-state conservatives, some of whom helped Walker build a $30 million war chest in the recall election. Although the governor has said he is leaving the WRS alone for the time being, it is still an open question whether the nearly 500,000 Wisconsin public service employees, along with many millions more across the U.S., can count on receiving the benefits they were promised.

THE WISCONSIN LEGISLATURE CREATED THE state’s first public employee pension funds in 1891 with plans for Milwaukee’s police and firefighters. A teacher’s plan followed in 1909. Through the 1930s and ’40s, more pension funds were established for municipal and state employees. By the late ’40s the state had accumulated a $30 million surplus in pension assets in non-interest-bearing accounts. The legislature began working toward a consolidation of these funds following World War II, culminating with the formation of the Wisconsin Retirement Fund, which included all public employees with the exception of teachers and Milwaukee workers.

In 1951 the legislature created SWIB to actively invest and optimize the state pension assets and ensure financial security for public servants. The Department of Employee Trust Funds was founded in 1967 to administer the pension system. Teachers joined the system in 1975; by 1982 all workers, save Milwaukee city and county employees, had been merged into WRS.

The “formula option,” which adjusts the amount of a retiree’s annuity up or down based on the performance of the assets managed by SWIB, was adopted in 1965. Under the formula the fixed portion of a retiree’s pension check may never go lower than the initial amount at retirement.

In 1983, when SWIB began investing for the modernized WRS, then valued at about $6.7 billion, fixed income still accounted for the lion’s share of the portfolio, at 60 percent. U.S. equities were 30 percent, with a 10 percent allocation to real estate. The fund earned 12.5 percent that year, and retirees got a 5 percent dividend on top of their fixed payment. WRS retirees continued to receive dividends every year until 2008, when the 26.2 percent decline triggered a five-year smoothing of portfolio losses. Dividends dropped to –2.1 percent in 2008; –1.3 percent in 2009, thanks to smoothing, despite a strong full-year performance of 22.4 percent; –1.2 percent in 2010; and –7 percent in 2011. At the same time dividends were falling, contributions increased, from 10.4 percent of employees’ salaries in 2007 to 13.3 percent this year.

SWIB was early to invest outside the U.S., beginning in 1990 with a 6 percent allocation to international equities and 4 percent to international fixed income. The group was well into risk measurement by that time, calculating volatility and various risk exposures, like credit and industry risk, according to Ronald Mensink, now head of analytics and fund management, who joined SWIB in 1991 to oversee asset allocation. Until 2006, SWIB was organized by asset-class heads who worked with an outside consultant and reported to an executive director; it did not have a central chief investment professional.

In 2001 the SWIB board hired McKinsey & Co. to assess its alternative investments, which then comprised a 5 percent allocation to real estate and 4 percent to private equity. McKinsey recommended that SWIB no longer need board approval to make investment decisions that required fast action. “It moved the ball forward in terms of empowering the staff investment committee,” explains Charles Carpenter, who has overseen alternative investments since 1988.

Given its asset size, Wisconsin was late in hiring a chief investment officer. In 2005, in an effort to reinvigorate internal asset management, then–­executive director David Mills began to woo Villa to fill the new CIO role. At that time, Villa was investment chief at Florida’s State Board of Administration in Tallahassee, responsible for $137 billion in more than two dozen state funds, including the $100 billion Florida Retirement System.

“I was very happy in Florida,” says Villa. “But when [Mills] explained I would be chair of the investment committee, I was right there.”

Raised in Albuquerque, New Mexico, Villa was inspired early by educators. His father’s family had taught in El Paso, Texas. His first mentor was his high school principal, who encouraged the student’s goal of starting an experimental school. But when Villa got to Princeton University in 1972, he pursued an economics degree. He earned an MA in economics and Latin American studies from Stanford University before picking up an MBA in 1979 at Northwestern University, where he studied accounting and finance and also met his wife, Jane.

Villa began his career as a certified public accountant and auditor in the financial services division of Arthur Andersen in Chicago. From there it was on to First National Bank of Chicago for a decade that included a four-year stint as London-based head of the Europe, Middle East and Africa audit group. In 1992, after earning his certified financial analyst designation, Villa was hired by Chicago-based Brinson Partners as global operations manager, with the promise of future work in asset management. A few years later the firm, which was acquired by Swiss Bank Corp. in 1994, made good on its word, assigning Villa to a role in asset allocation, then client relationship management.

“That’s what makes me dangerous,” quips Villa. “I’ve done it all.”

In January 2004, Villa traded bitter Chicago winters for sunny Tallahassee. But after two years as CIO of Florida’s SBA, he moved back to the Midwest. Working so close to a major university has allowed Villa to fulfill his early goal of educating others. “I feel like I’m running my school, dedicated to knowledge,” he explains. “I’ve built an environment that encourages people to stretch and learn.” Last summer Villa brought in 17 interns from the University of Wisconsin. “Interns are fun to have around because they make you think,” he says. “They bring enthusiasm and brand-new knowledge and challenge our investment professionals.”

Within his agency — packed with 151 highly credentialed professionals, some with multiple degrees, including 52 MBAs, 42 CFAs, 24 CPAs, five attorneys and three Ph.D.s — Villa has instituted a policy of “no paper, no promotion” as a way to ingrain a culture of learning. Each member of the investment team is required to write a paper; the more senior the staffer, the more complex and in-depth the paper must be. “It’s about intellectual property,” says Villa. “You have to continually refresh. It’s about a lifelong commitment to learning.”

For Villa earning the highest returns possible for the WRS is job one. In 2012 the core fund was up 13.7 percent, the fourth year in a row with a positive return. The CIO defines investment risk as “the risk of not achieving our investment objective.” For active members the goal is a return of 4 percent plus wage growth; for retired members it’s 5 percent plus inflation. Annual retirement benefits are calculated so that whatever the fund earns beyond 5 percent plus the consumer price index is the pensioner’s dividend adjustment. If performance falls below that bogey, a retiree receives lower payments, down to a floor equal to the amount of his or her first pension check.

While Villa works with an expected return assumption of 7.2 percent — within the typical 7 to 8 percent range for a public fund — the WRS uses that number only to value contribution rates for active participants in the pension plan, not as the discount rate used to project future liabilities, as other state funds generally do. Wisconsin’s 5 percent discount rate is the most conservative among U.S. public pensions, contributing to its well-funded status.

Despite the heavy loss in 2008, the pension payouts have exceeded inflation since 1982 and work out better than the cost-of-living adjustments other retirement systems distribute, reports Robert Conlin, secretary of the Department of Employee Trust Funds. This is true in spite of a 7 percent reduction in pension checks last year and as much as 13 percent for some workers in 2013, the final year of the five-year smoothing of the 26.2 percent loss of 2008. Next year, when the 2008 loss drops out of the smoothing, retirees should begin to see a raise in their checks, explains Conlin — especially if  Villa can work investment magic.

IT WAS A FEW DAYS BEFORE CHRISTMAS, and the late-afternoon light was flickering out over Lake Mendota, a large gray expanse behind the Wisconsin governor’s mansion. The white-columned building, nestled within the posh precincts of Maple Bluff, just outside the state capital, was designed in the classical revival style in 1920 and sold to the state by a local banker in 1949. Its current tenant, Scott Walker, was nursing a cup of hot tea and a scratchy throat when he took a seat in the Nutcracker Room to talk pensions with II.

Born in Colorado Springs, Colorado, in 1967, the son of a Baptist minister, Walker arrived in Milwaukee in 1986 as a freshman at Marquette University. Although he attended Marquette for four years, he never graduated. Instead, he turned to politics, launching his political career in 1990, when he won the Republican nomination for Milwaukee’s Seventh District seat in the Wisconsin State Assembly, though he lost the election. At 22 he was already on a path to shake up the state’s long-held progressive tradition.

Much of Wisconsin’s history is rooted in the progressive movement. But don’t confuse the term with liberalism, warns Dennis Dresang, professor emeritus at the Robert M. La Follette School of Public Affairs at the University of Wisconsin. Its historical meaning is “anti–political machine,” he notes. Ironically, the movement began in Wisconsin in 1854 with the birth of the Republican Party. Early Republicans were abolitionists who had migrated from the East, mostly from New York and Massachusetts, for economic opportunity. Six years later Abraham Lincoln, a neighbor from Illinois, won the party’s first presidential nomination.

Wisconsin’s progressive legacy was further forged by Robert (Fighting Bob) La Follette. After winning the state gubernatorial election in 1900, La Follette oversaw a slew of social reforms that were later adopted nationally, including workmen’s compensation insurance, unemployment insurance and the progressive income tax. He went on to serve as a U.S. senator from 1906 until his death in 1925. Early in the La Follette era, Wisconsin produced two thirds of the cheese made in the U.S. and exported it globally, even to the cheese-loving citizens of France; today it is still the leader in U.S. cheese production.

In the Nutcracker Room of the governor’s mansion, a cozy, wood-paneled space packed with dozens of the iconic wooden figures in all sizes, Walker explained his history with public pensions. In April 2002, following a pension scandal, he won a special election as the first Republican Milwaukee County executive. In 2000 his predecessor Tom Ament had approved a costly lump-sum “backdrop” pension bonus to system retirees. (Milwaukee is the only jurisdiction in the state that does not participate in the WRS.) Ament resigned in the wake of the scandal. “I had to fix all that,” Walker says. “We got the biggest settlement against an actuarial firm at that time,” he adds, referring to the $45 million that consulting firm Mercer paid the county in 2009 after being sued for $100 million.

Walker won the gubernatorial election in November 2010 on a platform of job creation and tax cuts for small business and the highest-­earning state residents. In the first few weeks of   2011, he pushed Act 10 through the legislature despite a group of 14 Democratic lawmakers decamping to Illinois in an effort to make the governor negotiate provisions of the legislation. Among its more controversial features: an end to union collective bargaining and a requirement that state employees pick up half of the pension contribution formerly made by employers, as well as a portion of their health care insurance costs.

For many lower-level employees, the increased pension and health care costs equal a 13 percent reduction in their pay, explains David Stella, SWIB board member and the recently retired secretary of the Department of Employee Trust Funds, which manages the pension system. This comes on top of the 13 percent reduction in pension checks that begins May 1. For the average employee it equals between 8 and 9 percent. Stella, who has an MSW degree from the University of Wisconsin, asks, “Why do corporations, when faced with fiscal crisis and needing money or to be competitive, put pensions on the block?” His answer: “The reason you are able to use pensions to reduce immediate costs is because there is very little immediate impact and you can deal with it later.”

But Walker and his successors are unlikely to try poaching from the pool of pension assets. That’s because it was tried before, by former governor Tommy Thompson in 1987, with a devastating result. One of the major causes of pension underfunding is state legislatures and governors “borrowing” tens of millions of dollars in retiree assets to plug nonpension-related budget gaps. In Wisconsin’s case the Employee Trust Fund Department took $84.7 million from the funds they oversaw to pay a special investment performance dividend to a certain group of annuitants — monies that were supposed to come from the state’s general fund. A class-action lawsuit resulted, led by state engineers and teachers. It took a decade for the state supreme court to rule that the assets belonged to the retirees and had to be returned to the WRS account. The court also ordered that an additional sum be returned to make up for lost investment earnings. The total bill after attorneys’ fees: $206 million.

Aside from knowing that their assets are secure, Wisconsin public employees have always been able to count on regular contributions paid into the system. “It’s one of the hallmarks through thick and thin: We pay the contributions that are due,” notes ETF Secretary Conlin, who succeeded Stella. “It’s great to take time off when markets go up, but then they go down and you take more pain,” he adds. Starting last October, Wisconsin employees began putting in their share, about 6 percent of pay, alongside their employers.

When Walker took office in January 2011, along with 50 new legislators (out of 99), his administration confronted a $3.6 billion budget deficit. At that time, Walker tapped Huebsch, a 16-year Wisconsin assemblyman from La Crosse County, to be secretary of the Department of Administration. Huebsch is also the governor’s representative on the nine-member SWIB board. As secretary of the 900-employee Administration Department, Huebsch oversees the state budget, finance and comptroller’s offices, as well as the budgets of all other state agencies. “We can and will oversee any part of state government,” he explains. “All requests to the legislature and budget submissions come through me.”

Huebsch was first elected to the legislature in 1994 and served with Walker. A national sales director for a wholesale printer, “I always had the political bug,” he admits. After becoming governor Walker sought a quick solution to the budget deficit, but he didn’t want to continue furloughs (which had been implemented at every Wisconsin state agency save the WRS in the wake of the financial crisis), raise taxes, order layoffs or take money from other pots, Huebsch says. Although some people were caught off-guard by the swiftness of Walker’s actions, others were not surprised that the governor chose public employees as a source of funds.

Walker’s solution was announced on February 11, 2011. In a bill called Act 10, Wisconsin eliminated union collective bargaining rights and moved a percentage of pension and health care costs from taxpayers to employees. The move was all the more startling considering that Wisconsin was the first state to grant these rights to public employees. “By the weekend of the 19th and 20th, tens of thousands of people, union workers and people from all walks of life,” had begun protests in the state capitol building, recalls Huebsch.

James Palmer was among those speaking to a crowd of 100,000 protesters at the capitol in early 2012. “The wholesale nature of the measures [Walker] passed were extraordinary,” says Palmer, who wears two hats: executive director of the Wisconsin Professional Police Association, a labor union representing 10,000 uniformed officers, and president of the watchdog Wisconsin Coalition of Annuitants, a 150,000-member, nonpartisan retiree group. Palmer, whose coalition members meet monthly with WRS and SWIB officials, including CIO Villa, appreciates the opportunity to work with, not against, state officials.

“There’s a very intimate relationship between ETF, SWIB and the participants,” agrees Villa. “If I’m able to communicate to constituent groups what we need to be successful, they will support us.”

Although Act 10 did not affect safety workers — police and firefighters — they realized they could be next, Palmer says. “The private sector started bargaining away pensions from pay deals,” he says. “People use the public pension benefits to drive a wedge between the haves and have-nots. It becomes a race to the bottom.”

Some Wisconsin taxpayers view this differently. “There was a feeling of resentment among a lot of people that the taxpayer is paying the entire contribution,” says the Wisconsin Taxpayers Alliance’s Knapp. “The retirement system is viewed by many people as fairer now.”

“There’s no question the pension plan is the thing [teachers] care about most,” adds David Bennett, executive director of the 15,000-member Wisconsin Retired Educators’ Association. More than 90 percent of lifetime educators do not receive Social Security. “We’re very, very vigilant as an organization to make sure nothing negative happens to the WRS and that no one at the capitol does anything they shouldn’t do,” Bennett says.

SWIB executive director Michael Williamson, who returned to Madison last June after more than a decade as director of the North Carolina Retirement Systems, prefers to focus on more-congenial relations between the agency and the executive and legislative bodies. “The governor and the legislature have given us the flexibility to manage our budget, to hire positions we need to manage increasingly complex portfolios and set salaries that allow us to be competitive in the marketplace,” he says. “They understand we are not a typical state agency. We’re in a different ballpark. We’re not even playing the same game.”

On June 5, 2012, Walker became the first governor in the U.S. to survive a recall election with a higher percentage of the vote than in his first victory. “Every time we talk about something, the presumption is the worst,” sums up Huebsch. “But with budget problems and furloughs, we had very few choices.”

IT TAKES A BIT OF ALCHEMY to produce a state-of-the-art investment portfolio within a public pension fund. In Wisconsin the mixture starts with Villa’s asset management experience, his role as head of the SWIB fund investment committee and a strong commitment to staff learning. Add to that SWIB’s history as an investment leader, a smart and focused board, and the hands-off approach taken by the state legislature, and the result is a potent brew.

One of  Villa’s early accomplishments was redesigning the fund as a unified, global, internally managed platform rather than as a collection of separate asset classes. In late 2006, soon after he arrived, the CIO began work to combine the U.S. and non-U.S. equity portfolios. At that time, the resources required to implement this plan were dependent on 2007–’09 budget approval. Then in 2007 the legislature passed Act 212, better known as the investment modernization act, which allowed SWIB to make its own investment decisions rather than following a legal list of approved investments.

“We allowed SWIB to bring more of their investment decisions in-house,” explains Huebsch. “One of the things that makes SWIB stronger than other states is that they’re buffered from the legislature. There’s a pretty strong fire wall between political and fiduciary influences that must oversee the success of the pension fund.”

No sooner did SWIB adopt the prudent-expert standard than the financial markets fell apart. But increased investment flexibility would be key to Villa and the board’s strategy to prevent another huge loss like the one the fund was dealt in 2008.

Before Villa’s arrival there had been managing directors in charge of each asset class, overseeing both internal and external managers. In Villa’s view that structure prevented investment staff from managing assets holistically. He created a new fund management group to oversee external managers. “Now we manage all of the managers as one big active fund of funds,” Villa says.

The new structure has fostered collaboration across asset-class portfolios. “We don’t fire people for using the term ‘asset class,’ but it has a connotation that is very different from what it was six years ago,” the CIO notes. A big benefit, he says, is doing away with the need to fill asset buckets with substandard external managers just because a preset allocation requires it. “We think of them as one big group of managers and rank them,” he explains. That means, for example, that three small-cap equity managers might be hired instead of three large-cap ones, without regard to their dollar weights in the total portfolio. Risk-weighting is what counts now.

“The very positive thing that David has done is tear down the silo mentality,” says Barry Dennis, co-founder and chairman of San Francisco–based Strategic Investment Solutions, one of SWIB’s nine specialty investment consultants. “He has the entire organization moving toward a total fund result.” Dennis, who has worked with Wisconsin for the past 15 years, points to the incentive compensation plan Villa developed, which is tied to the performance of the total fund rather than to each person’s own portfolio. And, he notes, Villa has given analysts money to run in their own sectors. It’s very unusual to allow analysts alpha-generating opportunity, the consultant points out. “The board focuses more on compensation than other boards I work with,” he adds.

The emergence of a unified asset management team spawned the creation of a best-ideas portfolio. It works along the same lines as the central book in a multistrategy investment firm. “It encourages innovation when you can express an investment idea that didn’t fit in the portfolio before David arrived,” notes managing director Mensink, who is responsible for overseeing hedge fund and risk parity managers. The best-ideas portfolio resides within a larger multi-asset-class portfolio, now 4 percent of the total fund. “The multiasset is my hedge fund,” explains Villa; he and his senior managers are its collective portfolio managers.

After some eight years of debate among its trustees, SWIB finally launched a true hedge fund portfolio in February 2011. “Let’s face it, hedge funds are not a well-known investment offering; they don’t like to show what they do,” says board member and former Wisconsin Employee Trust Fund head Stella. “The concern is that hedge funds are risky.”

To help mitigate that risk, SWIB hired Marina del Rey, California–based hedge fund consulting firm Cliffwater, as well as Dominic Garcia, who had built a fund of hedge funds as deputy CIO of New Mexico’s Public Employees Retirement Association. Wisconsin has investments that range in size from $50 million to $200 million in 11 hedge funds, on its way to its goal of about 15. Among the managers: BlueCrest Capital Management, Capula Investment Management, Claren Road Asset Management, MKP Capital Management, Scopia Fund Management and Winton Capital Management. SWIB has also allocated $1.6 billion to two risk parity portfolios run in roughly equal amounts by Connecticut-based AQR Capital Management and Bridgewater Associates.

The Wisconsin CIO has his own idea on how to compensate hedge fund managers. “He’s interested in the fee split of the profits — how much gross alpha is being generated,” says Cliffwater CEO Stephen Nesbitt. “He’s not interested in a hedge fund where half the alpha is going to the manager and half to him. He wants 70 percent going to him and 30 percent to the hedge fund manager.”

“We don’t really negotiate fees,” Villa adds. He has observed that managers who are willing to take a 30-70 alpha split tend to have traits that he finds attractive, including their compensation structures, standards of care and loyalty, and willingness to be fiduciaries. “That surprised us — the correlation between passing the screen and having cultural attributes we want,” says the CIO. “These nonfinancial characteristics line up nicely if they can get through the screen.”

After the financial crisis SWIB put a greater focus on risk management. Its board created the position of director of enterprise risk and compliance, filling it with the previous head of internal audit, Brandon Duck. “In the context of risk management, we found out how bad bad was in 2008, and it was very bad,” says Stella. The desire to take down the risks inherent in a 53 percent equity position and a low-interest-rate environment caused Villa to consider using both a risk parity strategy and leverage on its lowest-return and least-volatile assets.

In February 2009, after the completion of a study by Strategic Investment Solutions, the board approved the use of as much as 20 percent leverage on low-risk assets. But “leverage caused great anxiety to the members,” notes Stella, and the board hit the brakes. It hired investment consulting firm NEPC to perform a second study, which agreed with SIS’s recommendation that as much as 20 percent leverage was necessary to help shrink the outsize equity allocation. SWIB hired Minneapolis-based Clifton Group in 2010 to manage the leverage overlay program.

“The concept is, if I have an asset that has a stable and predictable cash flow and isn’t high risk, I can apply some leverage to it,” explains Villa, who wants to set the record straight on the sensitive issue. The media, he says, have incorrectly turned this into a story about leveraging fixed income to increase returns. The correct story, he contends, is that by selling equities SWIB is diversifying away from risky assets and replacing them with lower-risk, lower-return ones.

For now, however, Villa has temporarily halted the leverage program. “Because of historically low interest rates, we’re in uncharted waters,” he says. “We’re waiting for interest rates to normalize and for the fiscal situation to be resolved in Europe and the U.S.” Only 4 percent of WRS’s equity portfolio has been replaced, half with hedge funds and private equity and half with levered fixed income.

While Villa and his team strive to keep up the ten-year annualized return of 8.4 percent as of December 31, 2012 — compared with the 7.96 percent median annualized return earned by “megaplans,” according to Wilshire’s Trust Universe Comparison Service — the broader issue of the value of defined benefit pensions for public employees continues to roil the industry. Between 1999 and 2008 the overall funding of public pensions dropped from an average 102 percent to 84 percent, a decline of $452 billion, according to a February 2010 report from the Pew Center on the States.

Currently, the Florida legislature is considering replacing its defined benefit pension, despite its 86.9 percent funded status and good financial condition. As with many states that have used their pension funds as ATMs, the Florida legislature in 2011 reduced compensation for public employees by 3 percent, supposedly to fund retirement. But rather than reducing the unfunded pension liability, lawmakers used those dollars to balance the state budget.

Wisconsin is not alone in conducting a study of its retirement system with an eye toward moving to a defined contribution plan. The Pew report highlighted results from other studies. For example, last year Minnesota released a study by Mercer that found the ongoing cost of its existing defined benefit plans would be less than the cost of a replacement 401(k)-type plan with a funding structure of 5 percent each from employers and employees. The transition cost of a defined contribution plan was estimated at $2.76 billion. The higher investment costs and lower returns to participants were cited but not estimated.

A 2011 report, ordered by New York City Comptroller John Liu in partnership with the National Institute on Retirement Security and the New School’s Schwartz Center for Economic Policy Analysis, found that defined benefit pensions can deliver the same retirement income as defined contribution plans at 40 percent less cost thanks to superior investment returns, better-managed longevity risk and portfolio diversification. The California Public Employees’ Retirement System published a report in March 2011 suggesting that closing the defined benefit plan and replacing it with a defined contribution plan would cost employers more and offer employees lower benefits.

Villa is concerned about the movement to close defined benefit pensions and shift public employees to defined contribution plans. He reviews the advantages of defined benefits: pooled risks, professional and lower-cost investment management, participant access to alternative investments. “If the cost of the benefit is too high, lower the benefit,” asserts the CIO. “Don’t throw it away, because defined benefit pensions are so much more efficient.”

There will be an economic price to pay if pensions go away, Villa says. “In terms of having robust capital markets, you need a long-term horizon,” he notes. “Pensions are long-term pools of capital willing to take risk through time.”

For his part, Governor Walker likes to point out the differences between the Illinois and Wisconsin retirement systems. Early last year he spoke to the Commercial Club of Chicago, less than a three-hour drive from Madison, and he found the members very concerned about their state’s massive underfunded pension obligations. “They’re just scared to death,” Walker asserts. “I walked them through what we do as a state, not just what we did in the spring of 2011. I told them it’s going to be hard but maybe not as hard as they think if they move toward a system like ours, which is kind of a hybrid — the best of many worlds.”

Regardless of their politics, legislators in states with underfunded pensions would do well to borrow a page from Wisconsin and its well-functioning retirement machine.

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