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Trailing returns

It takes some doing to rank as one of the very worst performing public pension funds in America. But the $28 billion Maryland State Retirement & Pension System has managed to earn that unhappy distinction.

It takes some doing to rank as one of the very worst performing public pension funds in America. But the $28 billion Maryland State Retirement & Pension System, the country's 11th-largest public fund, has managed to earn that unhappy distinction. For the fiscal year ended June 30, 2001, the fund lost 9.4 percent, placing it in the 100th, or lowest possible, percentile of Wilshire Associates' widely respected Trust Universe Comparison Service of the nation's biggest public pension plans.

The fund's five-year ranking is only slightly better, putting it in the 92nd percentile. But go back another two years, and Maryland brings up the rear once again, ranking in the 100th percentile, with a 10.3 percent average annual return for the seven years through last June 30. The TUCS Universe is not all-inclusive, of course. The New Jersey Division of Investment, for example, reported a worse return than Maryland last year.

Still, no one in the state of black-eyed Susans is thrilled about the laggard performance. Laments William Donald Schaefer, the state's comptroller and acting chairman of the pension plan's board of trustees: "Nobody likes coming in last. It's a matter of pride and an insult to the leadership."

It's costly, too, and Maryland is paying a steep price. The state system provides retirement plans to nearly 300,000 employees and retirees. Last year it paid out $1.4 billion in benefits, up from $1.1 billion in 2000, though it still offers one of the least generous public sector benefit packages in the country. Even so, the plan's subpar returns mean Maryland will likely hike contributions to the fund by $40 million in fiscal 2003, the biggest increase in a decade. It's certainly not what legislators, or taxpayers, want to hear as they wrestle with a $500 million deficit in the state's $22.2 billion budget.

Now Maryland faces the daunting task of turning itself around in a tough time. Major markets are in disarray - offering no clear direction for asset allocation. And the state's plan lacks a leader following the sudden resignation in February of state treasurer Richard Dixon, who served as chairman of the pension plan's board of trustees. Nancy Kopp, chosen by the state legislature in a special election for trea-surer, is widely expected to succeed Dixon as the plan's overseer, but the trustees are not scheduled to elect a new chairman until June, leaving the plan rudderless for several months. And although the budget shortfall is creating political pressure for quick solutions, pension plan leaders and state officials are split on what needs to be done.

Where did Maryland go wrong? Start with a big bet on international equities. Under Dixon, a 26-year Merrill Lynch & Co. broker, Maryland stuck with an aggressive and ill-timed bet on global stock markets. In 1996, when he was elected state treasurer and joined the board as vice chairman, the fund's allocation to international stocks was a high 20.5 percent, which included a 3.5 percent allocation to emerging-markets equity (at the time the average large public fund held 9.9 percent in international stocks). By 2001 the allocation had crept up to 21.3 percent in international stocks with nothing in emerging markets. Remarkably, the plan's cap for international stocks got as high as 30 percent in March 2000. Last October the international equity allocation stood at 18.7 percent, still well above the industry average of 12 percent.

With international stocks volatile for the past five years, Maryland's returns suffered despite the fact that the plan's portfolio actually beat its Europe, Australasia and Far East index benchmark by a wide margin. Maryland's average annual returns of 6.5 percent in its international equity portfolio for the past five years surpassed EAFE's 2.9 percent but lagged behind the 14.5 percent for the Standard & Poor's 500 index and 7.48 percent for the Lehman Brothers bond index. "If you want to dissect it, our bigger international equity allocation is a fair explanation for our underperformance versus TUCS," says Peter Vaughn, the Maryland system's executive director.

Some critics believe the plan's problems extend beyond a losing asset allocation. Maryland, unlike most public pension plans, has not traditionally used an outside investment consultant as a check on its performance. And Dixon actively encouraged fund trustees to judge his performance on the actuarial goals of the fund - that is, the returns needed every year to assure that the fund could meet its liabilities - rather than the investment performance measures generally favored by the money management world.

Indeed, the trustees told the staff in 1996 to stop presenting the TUCS data to the board. "I was very unhappy with the staff not sharing that information with us," says Schaefer, the state comptroller who didn't join the board until 1999. "That was a terrible mistake, and it was just stupid."

That Maryland should have found itself in such a mess is deeply ironic. Until last fall Dixon was being hailed - not least by himself - as a quasisavior responsible for having turned the state fund around. In fact, Dixon, who attributed his February resignation to a worsening case of diabetes, did push through some important changes. A tough taskmaster, he insisted that active money managers give the state its money's worth and aggressively fired big name organizations, including Alliance Capital Management and Putnam Investments, when they failed to beat their benchmarks. And by encouraging the plan to dramatically hike its equity allocation in the middle of the bull market, Dixon helped erase the plan's unfunded liability, which stood at $4.8 billion when he joined the board in 1996, leaving the plan 80 percent funded. By 2000 the state had a $369 million surplus, putting it in the black 20 years ahead of schedule.

That quick turnaround led Dixon, who ruled with a brash self-confidence that inspired resentment as well as respect, to proclaim to a Baltimore Sun reporter in 2000 that he was the "best treasurer in the country." Says Schaefer, Maryland's governor between 1987 and 1995: "He was a little domineering. Dixon is smart as hell - a little egotistical - but smart as hell."

Then those peer comparison numbers that Maryland's trustees didn't see burst into the public eye last October, when the Sun broke the news that Maryland's performance ranked it in the basement. That information infuriated state legislators and blindsided fund trustees, who said they had never seen the TUCS report before reading about it in the Sun. The Baltimore paper followed up with a series of scathing reports on the fund and its management, and in November leaders of the Maryland state senate summoned Dixon to a tense meeting, where they demanded answers on the fund's performance. It didn't help that the fund's poor showing in 2001 meant that the legislature had to find millions to make up for investment losses and that the fund had once again fallen into deficit.

Climbing back out again won't be easy, but some changes are already in the works. In December the General Assembly's Joint Pension Committee, which regulates the plan, voted to require the fund to hire an external investment consultant. But here, too, Maryland will go its own way. Although the vast majority of pension funds keep their consultants on retainer, the Maryland State Retirement & Pension System will hire on a project-by-project basis.

And Kopp, a 30-year veteran of the state assembly who is known for her deliberate, circumspect style, will move slowly if she does take charge in June. She is clear about the need for change. "I think the performance can and should be improved," she says. "I'm still learning how we can do that."

She may want to encourage her colleagues at the pension plan to take some refresher courses. Not everyone there sees the need for changes. Says Arthur Caple Jr., the trustee who chairs the board's investment committee: "If we had stuck with our higher allocation to fixed income, would the unfunded liability have disappeared 20 years ahead of schedule? No." Adds executive director Vaughn, who advises the trustees on investment strategy: "I don't think our asset allocation will change dramatically. Last year the market did everyone dirty."

Vaughn is echoing the thoughts of Dixon, who says he doesn't believe any change in asset allocation or plan administration is required. "Of course not," he scoffed, the day before he left office. "You can't argue with success."

The son of a janitor, Richard Dixon grew up in Maryland's segregated Carroll County in the 1950s. He won a Bronze Star as a captain in Vietnam, then joined Merrill Lynch as a broker in the firm's Baltimore office in 1970. Five years later he received an MBA from his alma mater, Morgan State University.

Between 1983 and 1996 Dixon served as a state legislator, and in 1996 his former colleagues elected him state treasurer, making him the first black to hold a constitutional office in the state. As treasurer Dixon claimed one of three votes on Maryland's powerful Board of Public Works, which approves all large state contracts. (The governor and the state comptroller cast the other two votes.) As treasurer he also became one of 14 trustees on the pension fund's board. He claimed the top job two years later after the chairman, Louis Goldstein, Maryland's legendary state comptroller and a veteran force in state politics, suffered a fatal heart attack.

When Dixon joined the board, the plan was still struggling, a legacy of Maryland's historical underweighting of equities. In the 1980s the fund kept roughly 30 percent of its assets in stock, compared with an industry average of about 55 percent. By 1986 the plan had an unfunded liability of $8 billion.

Under Goldstein's leadership, and at the urging of Baltimore venture capitalist Howard (Pete) Colhoun, one of the three unpaid publicly appointed investment advisers used by the trustees, Maryland began boosting its stock exposure dramatically - from 35 percent to 54 percent between 1991 and 1996, with more than half of the equity portfolios indexed.

Maryland also began its fateful push into international waters. In 1995 it hiked its allocation to this asset class from 5 percent to 13 percent, in good measure at Colhoun's urging, recalls money manager Frank Cappiello, a fellow Maryland adviser. "Pete spearheaded the move into international equities," Cappiello says. "At the time, the U.S. represented around 30 percent of [worldwide] gross domestic product, so this was a way of participating in a big part of the global economy that we were missing out on."

At first the changes worked like a tonic. The fund's an-nual returns climbed to 11.9 percent, and its unfunded liability had narrowed significantly by the time Dixon join-ed in 1996. He was a proponent of boosting the equity allocation even more and increasing the focus on international stocks.

By 1997 the fund was investing 62 percent of its assets in stock. Three years later, the fund's equity portfolios represented 72 percent of total assets. Though the international portfolio was invested by active managers, about 65 percent of the fund's U.S. equities were indexed to the S&P 500.

The more muscular strategy worked. The fund's total assets jumped from $20.6 billion in 1996 to $33.1 billion in 2000, while the $4.8 billion unfunded liability had become a $369 million surplus. Not only that, but in 2000 the Maryland fund produced returns of 11.7 percent, putting it in the second quartile of all large public funds, according to TUCS. The strong returns enabled the state legislature to slash Maryland's annual contributions to the pension fund from 12.9 percent of workers' salaries in 1996, or $721 million, to 7.98 percent, or $682 million in 2000. Dixon and his colleagues were heroes, celebrated in the press.

"We've saved the state hundreds of millions of dollars," Dixon says. "Hundreds of millions of dollars."

Dixon made his presence felt in many ways. Under his guidance Maryland increased its permitted ceiling on stocks to 80 percent, and he carried through on his promise to dump underperforming managers. Typically he gave a manager three years to perform. "There are thousands of money managers out there," Dixon says. "Why should we be paying for underperforming money managers?"

In 1999, just a few months after Dixon became chairman of the board, the fund initiated its largest shake-up ever, firing three money managers - Alliance Capital, Putnam and Mercantile-Safe Deposit & Trust Co. - which together handled some $350 million in assets, and accepting the resignation of a fourth, Investment Counsellors of Maryland, which managed $103 million. In 2000 Maryland fired eight managers that ran a combined $2.6 billion in domestic equity portfolios. A good portion of those assets were redirected to international stock portfolios. In 2000 the plan's trustees raised the ceiling on foreign stocks from 20 percent to 30 percent. The trustees also eliminated the plan's exposure to emerging markets.

But in the end, Dixon's demanding management style didn't bring home the bacon. The outsize bet on international stocks turned ugly. "We had a position in international equity before I joined the board," Dixon says. "The allocation grew because the investments grew, and we chose not to rebalance it." Bank of Ireland Asset Management ran the biggest chunk of Maryland's international portfolio, and Dixon says the firm's success convinced him that Maryland shouldn't reduce its international exposure. "They were doing a great job. Why would you take money away from a manager doing a great job?"

Dixon and the Maryland trustees did respond to the market reverses, lowering the cap on international stocks in May 2001. But by then significant damage had been done.

Maryland also suffered closer to home. From 1996 to 2001 its now $11.6 billion U.S. large-cap portfolio produced average annual returns of 11.6 percent, versus 14.5 percent for the S&P 500. The plan lagged behind the S&P in part because more than $2 billion in assets was placed in a passively managed State Street Corp. growth fund that suffered a 32.2 percent loss in 2001. The plan's asset allocation as of October 31, 2001: 43.1 percent in domestic stocks, 18.7 percent in international stocks, 1.7 percent in convertibles, 27.5 percent in domestic investment-grade bonds, 3.4 percent in domestic high-yield bonds, 5.3 percent in real estate and 0.2 percent in alternative investments.

How much of the blame for Maryland's problems belongs to Dixon? Critics say that his style of management brooked little dissent but offer scant evidence that anyone on the investment staff of the state plan or among the trustees or outside advisers wanted to adjust the plan's asset allocation.

The biggest problem appears to be how insular the plan was. Maryland investment policy is determined by a nine-member investment committee of the 14-person board of trustees, together with the board's three public investment advisers, the fund's executive director, Vaughn, and its chief investment officer, Carol Boykin. The investment committee reviews proposals by the advisers and the staff and makes recommendations to the entire board of trustees, which then votes on those recommendations. "The investment committee sets investment policy," says Dixon, who was a member.

But the board didn't filter the opinions of trustees, including Dixon, or staff through an external investment consulting firm. Presumably, outsiders might have served as a check on such ideas as dramatically overweighting international stocks and would have embraced peer review performance numbers.

Instead, the fund relied on the advice of its unpaid board advisers. Dixon and his allies argued that the fund had enough expertise in-house, but by the 1990s this was a very unusual approach to pension fund management.

And, say critics, Dixon tended to run roughshod over opponents. His role as one of three members of Maryland's Board of Public Works, they say, gave him enormous leverage in getting his way with the other plan trustees, several of whom worked for other state agencies.

"He's a bully," says Colhoun, who served as an adviser to the plan for 18 years before Dixon forced him out in 2000 by opposing his renomination. "Everybody was afraid of him."

Dixon rejects that notion out of hand. "That shows how little he knows about state government," Dixon says. Adds executive director Vaughn: "No one man rules the board. It takes a consensus."

As long as the fund continued to meet its internal actuarial hurdle of 8 percent, the rate at which it projected liabilities would grow, Dixon had free rein. But when the news broke last October of how poorly Maryland had ranked in Wilshire's TUCS survey, he found himself in the middle of a firestorm of criticism that only intensified when Maryland's Joint Committee on Pensions informed the legislature last fall that it would need to kick in an additional $55 million in pension payments, about $30 million of which was directly related to the 9.4 percent decline in the fund's investments. (In March the legislature decided that a $40 million hike would suffice.)

The raft of negative local coverage got so intense that the board of trustees in November sent state employees and retirees a special bulletin assuring them that "this is a very solvent and well-funded retirement system." The bulletin included this dig: "It is inconceivable that we could be the worst-performing pension system while achieving full funding 20 years ahead of the legislative deadline."

In an interview with Institutional Investor days before he resigned, Dixon offered a characteristically stirring defense, arguing that the Wilshire report is irrelevant. "My objection is that we don't know who the peers are," Dixon says. "What are their risk parameters? How much did they invest in fixed income? Do ten of the 38 have $1 billion in assets? We've got $30 billion." (Wilshire Associates declined to comment on Dixon's criticisms.)

Dixon insists that pension funds should be judged by how they perform against their actuarial hurdle rate. The fund exceeded it in six of the past seven years. "If we are meeting and exceeding our actuarial assumptions, we are exceeding our goals," he says. "If we make 6 percent [in a given year] and somebody else makes 7 percent, what difference does it make?"

The actuarial argument infuriated state legislators. "This is absurd," wrote Barbara Hoffman, a state senator, and Howard Rawlings, a state delegate, in a stern December 21 letter to Dixon and his fellow trustees. "The State of Maryland's pension system does not exist in a vacuum. Any agency of state government could declare itself successful if it were to self-designate benchmarks and refuse to engage in comparison. The Board's investment performance and strategies must be compared to other plans to analyze whether the Board's strategies are the appropriate ones."

The Joint Committee on Pensions urged the fund to hire an outside investment consultant to help devise a more appropriate asset allocation. The committee also recommended that the plan drop its "self-designated benchmark" of 8 percent and devise a more realistic method of evaluating its investment performance.

In December the trustees reduced the 80 percent cap on equities to 70 percent and established a target goal of 60 percent. The board also approved a plan to hire an investment consultant by May. But since the consulting firm will work on a project basis and will not be on retainer, which is the arrangement of most public funds, its influence will be constrained by the board of trustees.

"We are looking at the categories in which we might use a consultant," says trustee Caple, who is also the director of the state's Supplemental Retirement Programs. "It would be ludicrous for us to say we're going to use a consultant for everything if we've got the internal capabilities gratis."

Maryland House Speaker Casper Taylor Jr. says that kind of attitude "could be" a cause for concern. Taylor, for one, was surprised to find out that Maryland's longtime disdain for consultants was "the exception, not the rule" for other public plans. Schaefer, the state comptroller, thinks the retirement system must hire an investment consultant, if only to restore confidence in the system among voters, public employees and retirees. "Psychologically, it is crucial that we do so," he says.

Adds treasurer Kopp, "A consultant will give us more capacity and flexibility in our decision making. I thought it was a good idea when I was a legislator, and I think it is a good idea now."

Both Kopp and Schaefer believe that Maryland should directly measure its performance against other funds - a clear break with Dixon's policy. "It is one more piece of information that we should add to the mix," Kopp says. "Peer comparisons can be extremely useful in raising red flags."

Certainly a red flag has already been raised over Maryland's subpar performance. It's also clear that Dixon's successor will bring substantial changes to the state pension fund, though it remains to be seen what specific form they might take. Will they be enough to pull Maryland up in its peer rankings? Taxpayers and state workers can only hope so.

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