West Virginia's state pension funds began investing in stocks just three years ago. They proceeded with native caution - which turned out to be a good thing.

By Justin Dini
August 2001
Institutional Investor Magazine

Change comes slowly to West Virginia. The ground is still pitted with coal mines, the Appalachian air echoes with the twangy sounds of string music, and last year voters elected 83-year-old Robert Byrd to an eighth consecutive six-year term in the Senate, a record in U.S. history.

Until four years ago this conservatism also reigned at the state's public pension funds. Operating under 19th-century guidelines, they were prohibited from owning any stock or non-investment-grade bond. The result was disastrous. Missing out on the long-running bull market in equities, West Virginia posted among the worst returns of any public funds in the country. As the weakest link in the state retirement system, the teachers' fund held just a fifth of the assets it needed to meet its obligation to retirees, forcing the state to pump in millions.

Finally, in 1997 the funds won the right to buy stocks, but Craig Slaughter, the executive director of the West Virginia Investment Management Board, moved with typical caution. By early 2000 he had put 40 percent into stocks, mostly indexed in large-cap domestic shares, with the rest tucked into value plays. After years of being eclipsed by more aggressive funds, Slaughter had finally gotten a break. Though he got caught in the market downdraft, his value stocks rallied, and his substantial bond holdings soared as rates dropped, strengthening the state's returns.

The results were startling. With the Standard & Poor's 500 index down nearly 10 percent, the Nasdaq composite index off 39 percent and the median return among the nation's big pension funds off 2.54 percent, the West Virginia Investment Management Board delivered a total return of 4.1 percent in 2000. That figure made the state last year's top-performing fund among all public plans, with more than $1 billion in assets, according to Wilshire Associates Trust Universe Comparison Service.

It's a far cry from the fund's past performance. The plan recorded an average annual return of 9.33 percent between 1987 and 1997, versus a median return of 12.5 for large public funds. The five years ending December 31, 1997, were especially dismal, as the fund returned 7.36 percent annually compared with a peer group median of 13.3 percent. For both periods the pension plan ranked at the lowest end of the bottom quartile of all big public funds, according to TUCS.

"It doesn't hurt to have a little bit of luck," says Slaughter. He adds that the fund's stock allocation has goosed returns as well. "Within our equity portfolio, we are probably more diversified than most public funds; half of our equity is large cap, the other half is mid- to small-cap," Slaughter says.

For the West Virginia native, who has been fighting to broaden the fund's investment mandate since he joined in 1989, the results are sweet satisfaction. In 1993 the fund, still reeling from a derivatives debacle that predated Slaughter, briefly dabbled in the market after winning approval from the state legislature. It bought a few stocks, but they had to be sold when the state supreme court ruled the move unconstitutional.

Voters kicked off West Virginia's pension fund revival in 1997, when they passed a referendum amending the state constitution to allow the plan to invest in equities. That year the state legislature lifted the 125-year-old ban against stocks, although it simultaneously passed a law limiting the plan's equity exposure to 60 percent.

Taking up their new mandate, the board of trustees at the start of 1998 placed 3.5 percent of plan assets in an S&P 500 index fund, upping the ante to 20 percent by year-end. Returns lagged, mostly because of subpar performance in the fund's fixed-income portfolio. In 1999, with equities up to 40 percent, the plan returned 6.7 percent, weighed down by then-beleaguered value stocks.

Today the equity allocation is up to 60 percent (still below an industry average of 65 percent); half of the shares are in domestic large-cap stocks, with 75 percent indexed. The rest of the equities are divided equally between international stocks and small- and midcap domestic stocks. To manage them West Virginia favors boutiques like the $1.9 billion Bellevue, Washington-based Mastholm Asset Management, which runs a $220 million international stock portfolio for the state.

"We consciously choose small managers," Slaughter says, mostly because the fund prefers nimble stock pickers who can move quickly in response to changing markets. "We believe the core strategy we have in place" - a heavily indexed large-cap portfolio and active management in mid- and small-cap stocks - "makes for a very strong, very stable portfolio."

Roger Hunter, the Charleston, West Virginia, attorney who chairs the investment committee of the board of trustees, goes a step further: "We would like to be the best public fund in the country."

They've got a ways to go. The West Virginia plan is essentially an amalgam of 11 different state funds, including the state workers, teachers and police plans; the Workers' Compensation Fund; the Pneumoconiosis - or "black lung" - Fund; the West Virginia Tobacco Settlement Fund; and the West Virginia Prepaid Tuition Trust Fund, a tax-advantaged educational savings vehicle. The funds report combined assets of $7 billion, including $5.5 billion in pension funds, and fall under the supervision of the WVIMB.

Despite the recent performance boost, the West Virginia retirement plans remain underfunded by some $4 billion. Almost all of the trouble comes from the $1.05 billion teachers' fund, which in July 2000 was just 21.4 percent funded, with an unfunded liability of $3.8 billion. The system faces its shortfall largely because of decisions made in the late 1980s by the state legislature and governors to shortchange the pension fund far below what actuaries said was necessary to keep it stable. The state used the money to cover holes elsewhere in its budget, whose deficits swelled through the 1980s. In 1987 West Virginia contributed just $16 million to the fund, and in 1988 state officials tried to avoid making any contribution to what was already an underfunded plan, until the state supreme court forced them to make some payments to the plan. At the same time, the legislature bent to the state's influential teachers' union and approved several pay hikes between the mid-1980s and early 1990s, which further increased the liabilities of the teachers' fund.

Beyond the $3.8 billion unfunded liability for its teachers' system, West Virginia faces a $276.5 million shortfall in its state troopers' retirement fund and $40.2 million in the judges' retirement fund. In the next year or so, the state must float a $4 billion bond issue to help bolster the funds.

The $2.7 billion Public Employees' Retirement System, the other big fund under the WVIMB's umbrella, has managed to stay fully funded because the state has maintained a 9.5 percent annual contribution rate to that system for years, and salary increases for state employees have been less generous. Many other states have reduced state contributions to their pension systems in the past four or five years, some below 1 percent, because the bull market has made them flush with cash; West Virginia's mediocre returns made that impossible.

Still, the state has come a long way since the grim days of 1987. That year the retirement system and the state's $2.4 billion operating budget lost more than $287 million in a bond trading debacle that led the state to sue Morgan Stanley & Co., Salomon Brothers and Goldman, Sachs & Co., among other Wall Street firms. The last dispute was not resolved until 1996. The losses forced out the state treasurer, who quit after he was impeached by the legislature.

Soon after the bond trading fiasco, a new governor, Gaston Caperton, took office. As he moved to shore up the state's fiscal straits, raising taxes and cutting government spending, he also took steps to reform the management of the pension funds.

Until 1990 the West Virginia Board of Investments - made up of the governor, the treasurer and the state auditor - oversaw the state's pension funds as well as its operating fund. Under this arrangement the treasurer served as the de facto chief investment officer for the state, and he and his staff ran the day-to-day investment operations. After the scandal the legislature pulled the investment management function out of the treasurer's office, creating an independent staff for the West Virginia Board of Investments, of which Slaughter was named chief of staff. In addition, the board was expanded to include four more members. Today 13 trustees oversee the WVIMB.

Slaughter has honed his political and financial skills over the years to keep his critics at bay. An avid cyclist and a graduate of Cornell University and West Virgina University College of Law, Slaughter carefully cultivates the different constituencies that the fund must address: the state legislators, local government representatives and the public workers themselves. "He's doing everything he needs to do," says Patti Hamilton, executive director of the West Virginia Association of Counties, a group that represents some 400 local government officials and is a reluctant supporter of the move into stocks. Hamilton says that Slaughter has kept her group informed about the WVIMB's performance and potential shifts in investment strategy. Says Slaughter, "We're in a fishbowl, and that's a good thing."

In 1872 West Virginia lawmakers added a provision to the state constitution that prohibited public funds from owning stock in any company or association. Many states had similar taboos in place, but West Virginia saw itself as particularly vulnerable to the vagaries of market forces, given the state's dependence on the coal industry.

"This is a big company state," says Robert Plymale, the state senator who played a crucial role in the 1997 reform. "Coal companies owned most of the land, and they pretty much ran the store. There's been a historic distrust among West Virginians that said if you allow the government to buy into those companies' stocks, the companies would own the state."

By the 1960s most public funds nationwide placed at least a small portion of their assets in equity markets. By the mid-1990s only three states prohibited pension fund investment in stocks: Indiana, South Carolina and West Virginia. (Today all three can invest in equities.) In the early 1990s staffers in the West Virginia treasurer's office began muttering about trying to lift the ban, but before that could happen, the state was forced to clean up one very messy financial scandal.

Historically, West Virginia's state treasurer had wielded enormous power over the state's finances. In early 1985 state treasurer A. James Manchin and two of his deputies moved to boost returns through trading in long-term U.S. Treasury bonds - trading that a later report by special prosecutor James Lees found to be "extremely speculative."

For two years the approach did in fact goose returns as interest rates fell, but the strategy began to unravel in March 1987 when rates spiked higher. Suddenly, West Virginia faced a $22 million trading loss.

Rather than eat the loss, West Virginia tried to claw its way back into the black. Much later the state, citing the legal doctrine of "know your customer," alleged in court that Morgan Stanley and Salomon Brothers, among other Wall Street firms, had used illegally "aggressive" sales tactics to persuade the state treasurer and his staff to try to trade their way out of the shortfall. But that only exacerbated an already ugly loss. "What they were essentially doing was day trading," says Slaughter. "The problem wasn't that big until they tried to day trade out of it."

The treasurer's office negotiated reverse repurchase agreements with some of its investment banks, which essentially allowed the state to stall for time in the hopes that interest rates would turn back in its favor. They didn't, and West Virginia continued to get hammered. Within months the initial $22 million deficit mushroomed into a $287 million loss.

The debacle became public in late 1988 following an independent audit of the treasurer's office. The news broke soon after Caperton, a Democrat, had won the race for governor but before he took office. It emerged, too, that the treasurer had not just been playing around with the state's retirement portfolios, but was also investing the government's $2.4 billion operating budget. Most of the trading losses, in fact, came from the state's operating fund.

Not surprisingly, state treasurer Manchin took a direct hit. In June 1989 the state legislature voted to impeach him, and he resigned that July after 41 years in state government. (In 1998, Manchin was elected to the state's House of Delegates.)

In 1989 the state sued the Wall Street firms that had encouraged the bond trading. Seven years later all the suits had been settled out of court, with West Virginia recovering a total of $55 million. Morgan Stanley, which was alleged to have orchestrated most of the losses, coughed up $20 million.

"This was a state in real distress. We could ill afford a scandal like this," says attorney Thomas Heywood, who first served as Caperton's legal counsel and later as chief of staff.

Through the late 1980s West Virginia, like most of the Rust Belt, suffered the effects of deindustrialization - widespread factory closings, bankruptcy filings and a sharp decline in tax revenues. In 1988 the state's unemployment rate reached 9.2 percent, second only to Louisiana's 9.6 percent, and well above the national average of 5.6 percent. The state's fiscal deficits swelled, reaching a high of $500 million in 1989.

That same year, as a first step toward reforming the state pension system, governor Caperton recommended adding four additional members to the Board of Investments, stipulating that the new trustees should come from the private sector.

The governor appointed Thomas Loehr, then a state senator, to serve as interim treasurer. In August 1989 Loehr tapped Slaughter, whose law firm had worked for Loehr's investment company, to be the treasurer's chief of staff. Then in 1990 the legislature voted to split the treasurer's office from the Board of Investments. The WVIMB assumed oversight responsibility for the operating fund, and Slaughter became the board's chief of staff.

After instituting other controls - mandating independent annual audits, hiring an internal auditor who reported directly to the newly constituted board - Slaughter began to think about buying stocks. "It was a no-brainer," Slaughter says.

But West Virginians weren't so sure. "Our retirees were just scared to death about investing in equities," Slaughter says. With fresh memories of the 1987 bond trading scandal, voters also wanted to be sure that the fund's managers acted responsibly. "People wanted safeguards put in place," says Marie Prezioso, a fund trustee since 1995 and an executive at regional investment bank Ferris, Baker Watts. "They wanted a highly independent, professional board and staff."

When the legislature voted to put the stock investment referendum to a vote, newly elected Republican governor Cecil Underwood was determined to get the measure passed. With the help of a $330,000 advertising campaign, the amendment's supporters made a strong case for portfolio diversification.

Boosting returns took on added urgency since several of the system's plans, primarily the teachers' retirement fund, had become severely underfunded. The inevitable fallout from decisions by the legislature in the 1980s and early 1990s served to dramatically reduce state contributions to the pension funds. Under then-governor Arch Moore, the state, wrestling with budget deficits, used those scheduled contributions to the teachers' fund to cover shortfalls elsewhere in the state budget.

Although fewer than 10 percent of eligible voters showed up at the polls, in September 1997 the Modern Investment Management Amendment passed overwhelmingly, with 78 percent of voters supporting the measure.

Newly empowered, Slaughter went to work.

His first move was both predictable and sensible - he hired a consulting firm, St. Louis-based Summit Strategies Group, to recommend an asset allocation strategy. Its thrust: moving steadily toward West Virginia's new 60 percent stock cap; indexing the vast majority of large-cap domestic equities; and hiring boutique asset managers to handle the remaining portfolios. The firm also endorsed Slaughter's instinct to manage none of the fund's assets in-house and to overweight the actively managed stock portfolios with value names. Says Slaughter, "We thought that value would prevail in the long run."

By February 1998 West Virginia had shifted nearly $20 million of its assets into an S&P 500 index fund run by State Street Global Advisors, selling bonds to finance the move. "We wanted to get equity exposure just as quickly as possible and right off the bat," says Stephen Holmes, president of Summit. "The strategy was to begin with index funds and build out from there."

Acting on Summit's advice, the state adopted a performance-based fee arrangement instead of the more traditional asset-based compensation. (According to a recent Institutional Investor survey of public and private plan sponsors, 38.1 percent have some form of performance-based fee arrangement in place with their managers.) By the fall the fund had hired all of its 16 active and two passive managers. The roster that WVIMB installed by September 1998 has remained mostly intact.

Just as he settled into his new post, Slaughter was nearly shown the door. In May 1999, as his three-year contract was about to expire, the trustees began a nationwide search for Slaughter's replacement, thinking that the fund would be better served by a more experienced administrator. "At the time, we really wanted someone who had a financial background but who also had administrative experience," says trustee Prezioso.

Slaughter applied for his own job, and by September the trustees had whittled the candidates down from 57 contenders to five finalists, including Slaughter. That month the board voted to offer his job to Joseph Markus, West Virginia's secretary of administration and an aide to governor Underwood, who was working on West Virginia's $4 billion pension bond proposal (which is still pending). Markus accepted the offer but a week later withdrew his name from consideration when his insistence that he continue to oversee the bond offering sparked criticisms from public interest advocates. They argued that for Markus to do both jobs would be a conflict of interest. A week later the board offered Slaughter his job back, and he took it.

By early 2000 Slaughter decided that he needed a chief investment officer to help monitor the roster of money managers, as well as someone who could help the fund diversify into alternative asset classes. In May the fund hired as its first CIO Timothy Carlson, a 34-year-old former Marine who served in the Gulf War. Carlson left a job as a senior investment officer at the Iowa Public Employees Retirement System for the new job in Charleston, and his timing proved impeccable.

He joined Slaughter just as the Nasdaq was imploding - and West Virginia was consequently reaping the benefits of a 50 percent allocation to fixed income. "We weren't fully exposed to stocks in April 2000, so we did a lot of our buying after the markets dropped," Slaughter notes. By the end of the year, fixed income was down to 45 percent and equities represented 55 percent of fund assets.

Slaughter notes proudly that 16 of the fund's 18 managers beat their benchmarks last year. Santa Monica, California-based Dimensional Fund Advisors, which runs 50 percent of the small- and midcap portfolio using a modified value approach, fell short as did Los Angeles-based Capital Guardian Trust Co., which runs an emerging-markets equity fund. New York's Silchester International Investors turned in the most impressive performance, delivering a return of 15.9 percent on its international equity portfolio, versus a 14 percent loss for the Morgan Stanley Capital International Europe, Australasia and Far East index.

Altogether West Virginia's equity investments declined 3 percent in 2000, versus the 6.8 percent loss produced by the fund's benchmark, a blend of the EAFE, Russell 2000 and S&P 500 indexes.

The fund's large-cap investment of $1.5 billion fell 7.9 percent, net of fees, versus the 9.1 percent decline in the S&P 500. This was a real achievement given that 75 percent of the portfolio was passively invested. West Virginia's $780 million small- and midcap equity slice doubled up the Russell 2000, rising 8.6 percent versus 4.3 percent. Among the fund's holdings: St. Jude Medical, a medical equipment maker; financial services firm MBIA and natural gas distributor Peoples Energy Corp. The fund's $811 million international portfolio declined 4.2 percent. Its benchmark was down 14 percent.

"I didn't know what to expect when West Virginia hired us in July 1998," says Theodore Tyson, the chief investment officer of Mastholm Asset Management, one of the fund's international stock managers. "My fear was that they'd be overwhelmed because they were dealing with all these new asset classes for the first time. But they cleared up that concern in a nanosecond."

The fund's $2.8 billion fixed-income portfolio, comprised mostly of investment-grade corporate and U.S. Treasury bonds, gained 13.1 percent, versus an 11.6 percent return for the Salomon broad investment grade index. West Virginia's active bond managers are Pasadena, California-based Western Asset Management Co., which manages 45 percent of the fixed-income portfolio using a core strategy; and Austin, Texas-based Hoisington Investment Management Co., which handles 10 percent of assets using a macroeconomic approach.

"I think the incentivization of the managers was a key part of how well we performed," says trustee Hunter. "If they perform well, then we're willing to pay them for that."

If West Virginia is to keep up its winning streak, it will almost certainly have to raise or eliminate its cap on equity investments and dabble in alternative assets, says Slaughter. After all, the average public fund has 65 percent of its investments in public stocks, with at least a few percentage points worth of private equity. Will the 60 percent cap be eliminated? If CIO Carlson had his way, it would disappear tomorrow. "Academically, I don't think we should have a cap. By having artificial restrictions like a 60 percent cap in place, I think it really closes off your access to the entire universe of investments," he says.

Still, in a state that wrestled with the issue for years, there is nothing academic about the debate over the cap on equities. State Senator Plymale introduced legislation last year that would have eliminated the cap, but it died in the state's House of Representatives after the Senate passed it overwhelmingly, 32 to 2. At this point, at least one of the trustees wants to keep the restraint. "I personally think 60 percent is a good number because we're still new at it," says trustee Patrick Kelly. "I don't think we should stay at 60 percent forever, but in the near term, I think that's plenty."

"That cap, to many of my constituents, is very much a comfort level," says lobbyist Hamilton, whose West Virginia Association of Counties was a reluctant supporter of the referendum in 1997. Slaughter and Carlson must also persuade their board to venture into private equity. The WVIMB is permitted to invest in alternative investments under the 60 percent cap, and Carlson says he has begun to look into expanding the fund's equity investments. "I think it is something to keep an open mind about," he says. Earlier this year the trustees authorized investing in corporate bonds with a B rating. "But," cautions trustee Kelly, "this is still a fairly conservative board."

Many in West Virginia say that the board is especially cautious because West Virginia is one of the few states that makes its trustees and staff personally liable "for any losses resulting from a breach of duty imposed by the act." Says Kelly: "The personal liability aspect certainly clarifies our decision-making process. That gets your attention."

This is a state that harbors sour memories of failed investing ventures. "The first two years after we were hired, all I heard were two words: James Manchin," says Summit's Holmes. Adds trustee Hunter, "I think, given our state's unique history, we do feel a heavy sense of responsibility to be extra cautious and extra prudent."

And well they might: Just such a cautious streak propelled West Virginia to the head of the pension pack.