Dr. Rudy Fichtenbaum: How We Can Restore the COLA and Reduce Member Contributions
Cindy Murphy
How We Can Restore the COLA and Reduce Member Contributions
Dr. Rudy Fichtenbaum, STRS Ohio Board Member-Elect
STRS needs to reduce its expenses and increase its returns without increasing market risks. In the most recent Board meeting, Governor appointed investment expert Wade Steen, indicated such a solution exists but he also told us that the senior management staff are preventing the Board from even discussing the solution. The solution that Mr. Steen alluded to would result in STRS earning an additional $4 billion per year. For perspective, $4 billion is more than the current employee (14%), employer (14%), and healthcare contributions- combined. It is easily enough money to restore the COLA for retirees and cut contributions for active employees and begin rolling back some of the other cuts that came with pension reform.
What is the proposed solution? Let’s think for a moment about banks, the building block of our financial system. What is a bank? A bank is a business that accepts deposits and makes loans. Pretty simple right? Traditionally banks made money by making loans and charging borrowers more in interest than they paid to depositors. When you make a loan, you are a “taker” or an “investor” who takes risk and hopes to make money when interest is paid on the loan. Banks can reduce their risk by selling the loans they make. Each time they make a loan they charge a small fee and when the loan is sold the bank has the money to make new loans. So today banks make most of their money not from the interest they charge on loans but from the fees of making loans. If a borrower defaults the bank is protected because they don’t own the loan. In this case the bank is acting as a “maker.”
STRS current investment strategy is to be a taker. The investment staff take risk by trading and investing in non transparent alternative investments (hedge funds, private equity, and venture capital) and thus, implicitly believe they are smarter than Wall Street. The graphs below show the odds of beating the market.
Think about it this way, beating the market means that you are above average. In a zero-sum game, half will earn a gross return above the market and half will earn a gross return below the market. But investing is not free and once trading costs and investment expenses are deducted there is automatically less than a 50/50 chance of earning a return that is above average. If we were in Lake Woebegone things might be different, but we live in Ohio.
What is the alternative? Combining passive investing and being a maker allowing STRS to earn fees by using its balance sheet will dramatically increase returns and reduce risk. This is precisely what the Healthcare of Ontario Pension Plan has done for more than twenty years.
Unlike a bank, a pension has a permanent capital base which means there are no depositors who can withdraw their money and pensions are not subject to the same types of restrictions as banks when it comes to managing their balance sheet. This allows a pension to partner with banks as a maker and collect fees by helping banks better manage their balance sheet.
STRS has assets. To become a maker, STRS will exchange its risky assets like stocks for safe assets like Treasuries. STRS will then use a portion of the Treasuries to buy the rights to the returns (or losses) of an index (for example the S&P 500), which amounts to passive investing. STRS can then take the remaining Treasuries and exchange them with a bank for stocks the bank wants to get off its balance sheet for a fee. STRS will in effect be creating a warehouse for these stocks and can lend them out for additional fees. STRS will still get the interest from the Treasuries, and the bank continues to get the capital gains (losses) and dividends from the stocks. Each time the stocks come back they will be lent out again for another fee. So, because STRS will get the S&P 500 returns (or losses) plus the fees it earns for warehousing and the fees for lending its inventory, it will always be able to beat the market. This strategy, of being a maker and getting the benefits of passive investing, also lowers risk because fees, associated with warehousing operations, are negatively correlated with stock market returns.
Are there risks with this strategy? The two major risks are counterparty risk i.e., the bank you are dealing with goes bankrupt and operational risk. Counterparty risk can be managed by only engaging with banks that are ‘too big to fail’. Operational risk is keeping track of all the transactions, so you know who has the stocks from your warehouse. This type of risk can be mitigated using advanced technologies.
So why are STRS senior staff standing in the way of this solution that could restore the COLA, reduce member contributions, and potentially restore other pension cuts? The answer appears to be that senior management seems to care more about the well-being of the investment staff than it does about STRS members.