Florida’s juicy fruit
The fourth-largest public pension fund in the U.S. is adding a defined contribution plan.
The fourth-largest public pension fund in the U.S. is adding a defined contribution plan.
By Justin Dini
Institutional Investor Magazine
The fourth-largest public pension fund in the U.S. is adding a defined contribution plan. It will begin life with $13 billion , and money managers are licking their lips.
Florida has been the butt lately of a lot of jokes about counting. Here’s a number that adds up fast: $101 billion.
That’s the size of the state’s pension fund, and the fight for its future has been as fierce as any battle over ballots. Thanks to the state government’s desire to limit future liabilities, the Florida Retirement System is about to metamorphose from a traditional behemoth of a defined benefit plan , the fourth-largest public plan in the country, in fact , to one that also features a defined contribution plan, complete with mutual fund menus and Internet access.
The creation of the new plan, the largest such undertaking ever, is slated for the summer of 2002 and has stirred up a firestorm of controversy, with financial services companies, local politicians, bureaucrats and labor leaders jockeying to shape the plan’s final form. Even after an 11th-hour compromise, critical questions remain unanswered: How many asset managers will be hired? Which will be chosen?
Money managers are fighting hard to pick their share of Florida’s tempting fruit. “This is the biggest pot of money of its kind, ever,” says Curt Kiser, a former Republican state representative who now works as a lobbyist for Houston-based insurer Variable Annuity Life Insurance Co., or Valic, a unit of American General Financial Services. “We’re going to do our damnedest to be competitive.”
Elected in 1998, Governor Jeb Bush targeted pension reform as a top priority of his administration, and the Republican-dominated legislature duly pushed through a bill authorizing a defined contribution component to the state’s retirement plan, which the governor signed into law last June. The new law will immediately and dramatically reduce the state’s liability for future benefits , as the government intended , while shifting some of the burden for retirement savings from the state to individual workers. The change may also help the state attract job seekers looking for portable retirement benefits.
“With a traditional defined benefit system, if there’s a shortfall, the taxpayers are left holding the bag,” sums up Tom Feeney, the Republican speaker of the Florida House of Representatives. “With a DC plan, there is no shortfall.”
Under Florida’s legislation, state employees must choose whether they want to participate in the defined benefit or the defined contribution plan, technically a 40l(a). (A 401(a) differs from a 401(k) in that only the employer contributes to the plan.) Florida’s defined benefit plan functions along traditional lines; employees, who will now vest after six years, get a pension that is based on a percentage of the average salary of their five highest-paid years, derived by multiplying their years of service by 1.6 percent. An employee with 30 years of service, for example, would receive 48 percent of the average salary of his five highest-paid years. If employees elect to join the new 401(a), the government will contribute 9 percent of their salaries to their retirement funds each year. Current workers will have a three-month window in the summer of 2002 to decide whether to move their balances into the defined contribution plan.
Surveys show that of the 660,000 employees who now work in Florida’s 801 state agencies, half will opt for the new plan. Overwhelmingly, say consultants advising the state, those joining the 401(a) will be new workers and ones with the fewest years of service. As a result, these advisers project that the plan will begin life with a hefty $13 billion, instantly ranking as the 11th-biggest public or private defined contribution plan in the U.S.
To be sure, these surveys were taken before the bear market began, and employees may well opt for the security of the defined benefit plan. In Michigan, for example, only 6 percent of existing workers chose the new defined contribution plan option when it was introduced in 1996. (All new workers were required to do so.)
What Florida’s plan will actually look like remains unclear. Although Florida’s State Board of Administration has been charged by the legislature with designing and administering the fund, the ultimate approval for all policy decisions lies with the trustees. The three-member board includes Governor Bush, state comptroller Robert Milligan and insurance commissioner Thomas Gallagher.
Over the past nine months, the agency has alarmed and upset major financial companies as it waffled on one critical issue: whether to give retail money managers , like Citigroup’s Travelers Life & Annuity unit, American Insurance Group’s SunAmerica Retirement Markets and TIAA-CREF , an equal chance to compete against their institutional rivals. Initially, the SBA favored institutional, or “unbundled,” providers because it concluded that they would manage the money at a much lower cost to participants.
The Florida legislature set the stage for a battle when it wrote a statute that requires the SBA to hire different vendors to handle each of the three functions , administration, education and investment management , typically offered by defined contribution providers. Most companies hire a single firm to act as a “bundled” provider of those three services for their 401(k)s. Florida’s legislators argued that this policy would prevent potential conflicts of interest that could arise if, say, one firm was educating state employees about the pros and cons of switching from the defined benefit to the defined contribution plan while earning asset management fees from the latter. The statute, though, confused many by blurring the traditional definition of bundled providers. “We thought the legislation itself was fundamentally flawed, in that it lays out far too specifically how the DC plan should be structured rather than letting the SBA work out the details,” says Thomas Hughes, a senior vice president at Fidelity Investments Tax-Exempt Services Co., the arm of the mutual fund giant that offers retirement savings plans to tax-exempt organizations and the public sector.
Despite the fact that the investment function was split from bookkeeping and education, annuity giants such as ING Aetna Financial Services still assumed they could compete for a slice of Florida’s investment management business by offering their traditional products. The statute reads: “The [SBA] shall select one or more providers who offer multiple investment products when such an approach is determined by the board to afford value to the participants otherwise not available through individual investment products.”
Then, last summer, the SBA issued an investment policy statement that emphasized the need to hire low-cost money managers and made no mention of bundled providers. Retail operators, especially those that feared that their annuity products would be would be shut out of an important new market, went on the attack. TIAA-CREF and Valic filed separate legal challenges seeking to invalidate the SBA’s statement. Legislators, who accused the SBA of acting mainly to protect its own turf, championed the cause of retail money managers. Mike Fasano, Republican majority leader of the Florida House of Representatives, introduced a bill in February that would force the SBA to hire at least five different bundled providers.
“A lot of people were running around like their hair was on fire,” recalls state comptroller Milligan.
“We knew the SBA policy statement would be disappointing to much of the industry,” acknowledges Tom Herndon, the agency’s executive director and a onetime chief of staff for former governor Lawton Chiles. “But we were surprised at the vehemence. We underestimated the intensity of the sentiment.”
Last month, under mounting pressure from politicians, the SBA revised its policy; it will now hire “one or more bundled providers” to act as investment managers. Among those clamoring for a piece of the action: SunAmerica Retirement Markets, Nationwide Financial, Horace Mann Insurance Cos. and ING Aetna Financial Services. Fidelity, the biggest player in the 401(k) industry, competed for the role of third-party administrator of the entire plan, a job that ended up going to CitiStreet, a joint venture of Citigroup and State Street Corp.
Fidelity hasn’t given up on the honey pot, though. “We’re interested in both [the institutional and retail money management mandates],” says Hughes. “They’ll need to clearly spell out what the restrictions are.” The SBA says money management firms will be free to compete for both types of mandates.
It’s no surprise that firms are vying so fiercely for the business. After years of astounding growth, the defined contribution market is nearing saturation. Some 97 percent of big companies (those with 5,000 employees or more) now have 401(k)s, and smaller company plans tend to be less profitable to run. Not only is Florida’s $13 billion a huge prize, the state’s switch could blaze a trail for other public pension funds to follow. Ten states , Indiana, Michigan, Montana, Nebraska, North Dakota, Ohio, South Carolina, Vermont, West Virginia and Washington , now offer their workers some form of a defined contribution plan, and that number is sure to grow. Public pension plans now manage roughly $2.4 trillion nationwide , an enormously appetizing sum to defined contribution players.
The SBA will hire between 26 and 28 managers to oversee 12 unbundled investment options: five equity, three balanced and four fixed-income or money market funds. These will range from a large-cap U.S. value fund to a Russell 3000 index fund to a high-yield bond fund.
To determine which managers it will hire, the SBA is considering everything from experience to assets under management to historical performance to fees. The agency says it will rely heavily on the expertise of its investment consulting firm Callan Associates. The SBA issued requests for information in mid-February and hopes to wrap up its search by the end of the year.
If Florida’s SBA has taken a conservative approach, it’s understandable. Nothing on this scale has been attempted before. Shifting $13 billion in funds from one plan to another is an administrative challenge for even the most sophisticated fund managers.
“Every other state, as well as the George Bush administration, is watching what happens in Florida,” says majority leader Fasano. “We’re one of the first big funds to make this change, but we certainly won’t be the last. If we make a big mess of it, no one else is going to want to deal with it.”
Florida’s flirtation with pension plan reform dates back to 1984. The concept of a defined contribution plan had only been around for eight years when the state legislature passed a bill introducing this option for thousands of college and university employees as a supplement to their defined benefit plan, which was created in 1970. In the mid-1980s Florida also began to offer a deferred compensation plan to a limited number of senior state executives. Valic and Aetna Insurance Co., among others, received state contracts to offer annuities as part of the two new plans (a fact that the insurance companies have repeatedly pointed out in the current debate). Despite these additions, the idea of extending a defined contribution option to all state employees failed to advance; the legislature was not inclined to tinker with the pension system. In fact, it took four years of heavy lobbying by the state university system’s board of regents to convince the legislature that the state needed a defined contribution plan to keep its professors in Florida.
In 1992 then,lieutenant governor Kenneth (Buddy) Hood Mackay, under pressure from insurance lobbyists, approached Andrew McMullian, who headed the Florida Retirement System, about the possibility of introducing defined contribution options for all state workers. McMullian says he also had heard from the lobbyists, so he wasn’t surprised by the push. (McMullian was asked to resign last year by Jeb Bush’s administration, in part because he opposed aspects of the defined contribution plan.)
But because it never had a sponsor in the legislature, which was more concerned with fully covering what was then an unfunded liability, the issue lay dormant. In 1996 Michigan became the first big state fund to launch a defined contribution plan as an alternative to its $8.8 billion defined benefit program. All employees hired after the new program was first offered must use it. At the time the plan was created, existing workers were given a brief period in which to select between the two. (According to the most recent figures available, the defined benefit plan now has $11 billion in assets and the defined contribution plan $1.5 billion.) The topic was revived in Florida , most visibly and noisily by lobbyists for financial services firms.
The immediate inspiration for the new Florida law came from a 1998 conference sponsored by the American Legislative Exchange Council, a Washington-based conservative think tank that had begun to push the notion of portable defined contribution plans for state employees. The group disseminated model legislation to further the cause. Debby Sanderson, a Republican Florida state representative, attended the conference as the state chairwoman of ALEC.
“The seed was planted there,” recalls Sanderson, now a state senator whose district includes parts of Broward and Palm Beach counties. “I thought the idea of a DC plan was perfectly logical, and I just got so excited. I thought, Why shouldn’t we take the liability off Florida taxpayers? Why shouldn’t we teach people how to invest?” In mid-1998 Sanderson introduced a bill, based on the ALEC template, that authorized the conversion of the Florida plan. The House agreed to create a committee to study the idea, but the session ended before the Senate could act.
Then Jeb Bush was elected governor and made a mandatory defined contribution plan for state employees a priority in his 2000 budget. The proposed reform got a jump start. “The time has come for Florida to develop and implement a modern retirement system that addresses the needs of both the state and its employees,” Bush said in his January 2000 budget message.
Says Valic’s Kiser, “The governor’s support was like throwing gasoline on the fire. That got people to get serious about it.” Adds House speaker Feeney, “The governor certainly helped put it over the top.”
It wasn’t all smooth sailing. The chairman of the House budget committee, Ken Pruitt, initially opposed the bill, convinced that the movement was being driven solely by investment industry interests and that employees did not want a defined contribution option.
“We’ll write a bill based on what employees say they want, not what vendors tell us they do,” he told reporters in January 2000. He commissioned Watson Wyatt Worldwide to conduct a survey of state employees. The results surprised him. More than 40 percent said they would pick a defined contribution option if one were offered. Persuaded, Pruitt led his committee to produce a bill that the House and Senate passed last May. One month later Bush signed the Public Employees Optional Retirement Plan into law.
Under Florida’s defined benefit plan, government agencies make a fixed contribution that varies from year to year (in 2000 it was 9 percent of a worker’s annual salary; this year it’s 8.21 percent), covering retirement, survivors’ and disability benefits. The state will kick in a 9 percent contribution to the defined contribution plan. In the defined benefit plan, most employees vest after six years , the new legislation lowered the vesting period from ten years , and employees can begin collecting their full benefits at 62. Workers who leave government employment before the end of the six years forfeit their benefits.
Under the new law, which takes effect June 1, 2002, current employees will be able to transfer their accrued benefits into individual accounts. A significant difference between Bush’s original proposal and the final legislation: The defined contribution plan is optional for new workers , at the insistence of the state employees’ union.
As politicians, bureaucrats and industry executives have wrangled over the terms of Florida’s new plan, insurance companies and retail money managers have campaigned to protect their prospects of managing this new pool of assets.
The battle lines were drawn last July, when the SBA released the first draft of its investment policy statement. The board advocated three tiers of investment options , core, balanced and specialty , to be managed by what it described as low-cost institutional money managers. As a group, money managers charge an average of 22 basis points annually to run Florida’s defined benefit plan. The SBA wanted to be sure that it got similar institutional pricing, not retail rates, for its defined contribution participants. The SBA statement specifically excluded annuities, infuriating the insurers that had been such strong and early advocates of a defined contribution plan for Florida.
The board’s critics argued that the agency was essentially creating “an SBA mutual fund” that would merely duplicate the existing defined benefit plan. “No one ever really envisioned when this bill passed last year that we would only have one choice, and that choice would be a state-run mutual fund,” says Fasano.
Not that duplicating the SBA’s results would be such a bad thing. Florida’s pension fund, like many of its counterparts around the country, rode the 1990s bull market, turning an unfunded liability that at one point reached $16 billion into a $9 billion surplus. Last year the SBA produced a negative return of 2.4 percent, easily besting its benchmark, which produced a negative return of 3.9 percent. Over the past five years, the fund has averaged annual returns of 13.5 percent; over the past ten, 13.7 percent. That places it in the second quartile of pension funds, according to Wilshire Associates’ Trust Universe Comparison Service. The fund has stuck to the same asset allocation since 1999: 55 percent U.S. equity, 25 percent fixed income, 12 percent international equity, 4 percent real estate, 2.5 percent alternative assets (primarily private equity) and the remainder in cash.
Executive director Herndon says that under the new Florida statute, the SBA is obligated to protect the interests of state employees by hiring low-cost money managers, whatever their affiliation. “To us, the legislation is pretty clear,” Herndon notes. “It doesn’t say that you select multiple investment product providers first. It says you select them if you can show added value. It clearly contemplates that there’s a role for them if certain circumstances come to pass.”
In a letter to Governor Bush in late January, Pruitt, the author of the legislation, agreed. “Institutional-priced investment products should be the primary offering and ‘bundled providers’ secondary, and only then if they add value,” he wrote.
Part of the problem for would-be managers is Florida’s terminology, which tends to lump all retail fund managers under the bundled label. Florida has concluded that the best way to get low-cost managers is to separate administrative support services from portfolio management. In many plans, high management fees subsidize the onerous recordkeeping that bundled providers “throw in,” or offer as an inducement to hire them.
But the bundled providers think they can compete, even if they are forced to do so in unbundled fashion. “How do you know if we can add value unless you let us bid for the business?” says Valic lobbyist Kiser. “You shouldn’t make that judgment until the bids come in.”
State comptroller Milligan agrees: “I would suspect that if they are interested in getting into the $13 billion pot, they’ll work pretty hard to be competitive in an economic sense.”
Throughout this battle, Jeb Bush has managed to remain above the fray. He has expressed no preference for one approach over the other in the public meetings Herndon has had with the fund’s board of trustees.
In light of the SBA’s recent policy turnabout, it seems clear that retail money managers have won their battle: The SBA promises them a place at the table. Says Milligan, “I would certainly think that bundled providers, as long as they really scrub their costs, will get a piece of the business.”
Creating a defined contribution plan involves a host of new administrative challenges. The February selection of CitiStreet as the plan administrator was just the first obstacle cleared.
Last summer the SBA commissioned studies from consulting firms Ennis, Knupp & Associates, Milliman & Robertson and William M. Mercer to determine the amount of assets that it would likely have to transfer from the defined benefit plan to the defined contribution plan. All three firms settled on the figure of $13 billion (estimates ranged from a low of $8 billion to a high of $32 billion). “Let’s hope that the three actuarial firms are right, that it is only $13 billion,” says Herndon. “If it winds up to be $30 billion and all we’re ready to do is $13 billion, then we’ve got a problem.”
The SBA will soon hire a brokerage firm that will advise the agency on how to go about liquidating a $12 billion portfolio (some $1 billion of the transferred assets will be in cash). “It is a complicated endeavor,” Herndon says."We’re probably going to approach this on some sort of pro rata share of our various asset classes here at the board,” he says. “That presents some problems. Almost 8 percent of the board’s assets are in real estate and private equity. [The proportion has risen as the stock market has fallen.] What if you can’t sell the building you want to sell at a particular time? What if you can’t get out of a private equity contract because it has a ten-year life span?” Reasonably, the SBA early last year halted new private equity investments. “We have not wanted to incur additional liquidity constraints on any of our portfolios,” Herndon notes.
There are other issues: Who will pay what Herndon estimates will be millions of dollars in transaction fees once the defined benefit fund starts liquidating? “Is it fair to saddle the DB plans with those costs? Probably not,” he says. “Those are not the folks who are moving , they shouldn’t have to pay those costs.”
The SBA is asking vendors if they will take in-kind transfers from the defined benefit to the defined contribution portfolios. “It is a hell of a lot cheaper if we don’t have to pay the round-trip cost to sell something, only to turn around and have them buy the exact same stock for their portfolios,” Herndon says. “How we move 1 million shares of General Electric Co. from the board account to, say, T. Rowe Price is an interesting question. A lot of mutual funds don’t want to do that. They want to take cash and just start from scratch. We have some real concerns about that. There are a lot of nuances that nobody has a lot of experience dealing with.”
The legislature will have to create a trust fund in which the assets can be placed while they’re between plans. Predictably, perhaps, Fasano is already threatening to use the trust fund legislation as a means to keep a tight leash on the SBA.
Says Fasano: “To ensure that our choices are being implemented, the trust fund bills will come due prior to the [new plan] being implemented. If we see any problems or if all sides are not coming to their agreement, we can stop it.”
After all, it was Florida’s legislators who created the new 401(a) in a bid to substantially reduce a major government obligation. Now they want to be sure that the government agency handling the assignment gets the job done.