MOSERS Bonuses Revisited

June 25, 2009

MOSERS Bonuses Revisited

Jim Winkelmann — who was mentioned recently on this blog for his pithy letter to the Post-Dispatch arguing against the Clayton smoking ban — has had another letter to the editor printed in that paper. This one addresses the contentious topic of bonuses for Missouri public pension managers.

I wrote about this topic before, contending that criticism of the bonuses didn’t make sense given that the fund was (at least on paper) not losing value as fast as the rest of the market. I am now reconsidering, given Winkelmann’s clever point that the MOSERS employees were the ones assigning value to the investments that they reported as having lost less value than the market.

Here is a relevant quotes from the letter:

The MOSERS website reports that its investment policy is to have 25% of the pension portfolio invested in “alternative investments” in the published annual report they are referred to as “limited partnerships”. Even though the balance sheet in the annual report uses the term “fair market value” assigned to these limited partnerships by definition there is no ready market for these investments. [...]

With no market for these limited partnerships where do these fair market valuations come from?

I ran into Winkelmann at lunch yesterday, and he commented to me that the problem is similar to that of assigning “market value” to a house appreciating or depreciating … before it’s sold. The fact is that the true market value of a thing is never the amount that you expect to receive — instead, it is the amount that somebody will actually pay.

I don’t agree with the argument that the MOSERS employees’ bonuses were unearned just because the plan lost money. However, the more subtle yet very relevant point that the MOSERS valuation was totally subjective, and assigned by the very people who stood to gain by inflating the number, smacks of perverse incentives.

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Also I and others would take the position that the Investment Allocation Policy determines the outcome. The manager has little if any way to affect outcome past what the policy produces. Wouldn’t it make more sense to give a bonus based on attendance rather than investment outcomes? At least their behavior and decisions could influence their attendance record!

Comment by Jim Winkelmann — June 25, 2009 @ 5:22 p.m.
In Jim Winkelmann’s recent letter to the editor titled Missouri pension bonuses don’t add up, he questions how fair market value is determined for the System’s illiquid assets. To provide some background, MOSERS invests in a diversified portfolio of asset classes ranging from common stocks to securities issued by the U.S. government. Most of the System’s investments trade on a public exchanges or have a liquid market among the broker dealer community. MOSERS does invest in segments of the market where there is limited or no liquidity. Examples would include private equity partnerships, real estate partnerships timberland and hedge funds. MOSERS is a long-term investor given that it needs to fund benefit payments far into the future. As a long-term investor MOSERS has the ability to be patient, supply capital to those who seek liquidity and take advantage of the opportunities associated with inefficient markets. In other words, MOSERS is in a position to capture a return premium available from illiquid assets.

Mr. Winkelmann’s letter references MOSERS’ alternative investment allocation and asks the following question. “With no market for these limited partnerships where do these fair market valuations come from?” The alternative investment portfolio consists of several sub-asset classes. MOSERS’ investments in exchange traded commodities and other publicly traded assets within the real estate and timber portfolios. These investments are liquid and are priced each trading day. Other alternative assets held in the private investments, real estate and timber portfolios do not trade everyday. Just because they are not priced daily does not mean that the valuation process is suspect. MOSERS invests with a number of external investment managers who have expertise in these illiquid markets. Each manager is charged with valuing these assets according to Standards set forth by the Financial Accounting Standards Board (FASB). FASB’s Fair Value Measurements Standard defines fair value and establishes a framework for valuing the assets in accordance with generally accepted accounting principles. Typically each manager has established a policy regarding their valuation process. This process is further reviewed and scrutinized at least annually by their external accountants during the audit process.

Just as importantly, the internal investment professionals at MOSERS to which the bonuses were paid play no role in the pricing of these illiquid assets, therefore the possibility that MOSERS staff was in a position to game the benchmarks as implied by Mr. Winkleman is simply wrong.

To clarify another misconception raised by Mr. Winkleman, the losses resulting from investments in Madoff Securities were the result of funds MOSERS placed with Silver Creek Investors, not Silver Lake. Over the time period mentioned by Mr. Winkleman, MOSERS paid no fees to Silver Creek. While MOSERS does employ Silver Lake and paid them $2.6 million in fees as reported in the most recent consolidated annual financial statements Silver Lake has no affiliation with Silver Creek.

Comment by Rick Dahl, CIO MOSERS — June 29, 2009 @ 10:08 a.m.
Rick

Thanks for your thoughtful rebuttal. So what you are saying is that the market values are supported by accounting standards? So when there is no readily available market for 25% of the portfolio we should just ask the accountants what something is worth. Since when do accountants set values? Aren’t these types of valuation methodologies one of the key reasons behind the global financial crisis? Can there ever be a substitute for a willing buyer? Are these accountants willing to give MOSERS a “put option” on 25% of the “fair market value” of the portfolio? Do you think there should be a margin of error on the fair market value determinations? Who pays these accountants? Maybe I can get one of those accountants to give buy my house for $650,000 for my house!

This reminds me of an old joke: A business man asked a famous valuation expert what two plus two equals? His response; “How much do you want it to equal?”

Comment by Jim Winkelmann — July 1, 2009 @ 2:10 p.m.
Mr. Winkleman

Below I have attempted to answer your questions and want you to know this will be my last post. I do hope that interested parties like yourself will be fair and reasonable in your judgement of MOSERS. Our policies and procedures for asset valuation have been scutinized by numerous parties over the years with no negative findings. With that said, we will always continue to strive for improvement. We take our responsibility of managing our members assets very seriously and strive for excellence as an organization.

1. estimates of fair market value are made by the investment professionals charged with managing the investments, not the accountants/auditors. The auditors responsibility in the process is to make sure that the managers are following policy guidance established in FASB 157.
2. the percentage of the portfolio in illiquid securities is about 18%, not 25%. Once again, we are not asking the accountants to value the assets, that is the responsibility of the managers. I would add that the managers do not receive performance pay based on the marks they place on the portfolio. They are paid based on realizations, therefore, they have no conflict in valuing the assets.
3. they don’t
4. the key reason behind the global financial crisis was that for the last twenty five years we (households, government, business) have spent beyond our means. This spending was accomodated by the cheap money policies of Mr. Greenspan and the Federal Reserve. The process of mark to market accounting exposed the unacceptable amount of borrwing that was being done by our financial institutions.
5. No.
6. There are no put options in our manager contracts and I have no interest in selling our illiquid assets where they are currently being marked. The will be worth considerably more when economic conditions improve, and because MOSERS is not over-indebted we are not forced sellers.
7. Not sure what good it would do.
8. The investment managers are paid by MOSERS as a limited partner. The auditors are paid by the partnership which is a collection of limited partners and the general partner.

Comment by Rick Dahl, CIO MOSERS — July 8, 2009 @ 12:06 p.m.
Again – if there is no market for 18% of the portfolio, what is would be the margin of error?

Comment by Jim Winkelmann — September 23, 2009 @ 6:03 p.m.

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Also I and others would take the position that the Investment Allocation Policy determines the outcome. The manager has little if any way to affect outcome past what the policy produces. Wouldn’t it make more sense to give a bonus based on attendance rather than investment outcomes? At least their behavior and decisions could influence their attendance record!

Comment by Jim Winkelmann — June 25, 2009 @ 5:22 p.m.

In Jim Winkelmann’s recent letter to the editor titled Missouri pension bonuses don’t add up, he questions how fair market value is determined for the System’s illiquid assets. To provide some background, MOSERS invests in a diversified portfolio of asset classes ranging from common stocks to securities issued by the U.S. government. Most of the System’s investments trade on a public exchanges or have a liquid market among the broker dealer community. MOSERS does invest in segments of the market where there is limited or no liquidity. Examples would include private equity partnerships, real estate partnerships timberland and hedge funds. MOSERS is a long-term investor given that it needs to fund benefit payments far into the future. As a long-term investor MOSERS has the ability to be patient, supply capital to those who seek liquidity and take advantage of the opportunities associated with inefficient markets. In other words, MOSERS is in a position to capture a return premium available from illiquid assets.

Mr. Winkelmann’s letter references MOSERS’ alternative investment allocation and asks the following question. “With no market for these limited partnerships where do these fair market valuations come from?” The alternative investment portfolio consists of several sub-asset classes. MOSERS’ investments in exchange traded commodities and other publicly traded assets within the real estate and timber portfolios. These investments are liquid and are priced each trading day. Other alternative assets held in the private investments, real estate and timber portfolios do not trade everyday. Just because they are not priced daily does not mean that the valuation process is suspect. MOSERS invests with a number of external investment managers who have expertise in these illiquid markets. Each manager is charged with valuing these assets according to Standards set forth by the Financial Accounting Standards Board (FASB). FASB’s Fair Value Measurements Standard defines fair value and establishes a framework for valuing the assets in accordance with generally accepted accounting principles. Typically each manager has established a policy regarding their valuation process. This process is further reviewed and scrutinized at least annually by their external accountants during the audit process.

Just as importantly, the internal investment professionals at MOSERS to which the bonuses were paid play no role in the pricing of these illiquid assets, therefore the possibility that MOSERS staff was in a position to game the benchmarks as implied by Mr. Winkleman is simply wrong.

To clarify another misconception raised by Mr. Winkleman, the losses resulting from investments in Madoff Securities were the result of funds MOSERS placed with Silver Creek Investors, not Silver Lake. Over the time period mentioned by Mr. Winkleman, MOSERS paid no fees to Silver Creek. While MOSERS does employ Silver Lake and paid them $2.6 million in fees as reported in the most recent consolidated annual financial statements Silver Lake has no affiliation with Silver Creek.

Comment by Rick Dahl, CIO MOSERS — June 29, 2009 @ 10:08 a.m.

Rick

Thanks for your thoughtful rebuttal. So what you are saying is that the market values are supported by accounting standards? So when there is no readily available market for 25% of the portfolio we should just ask the accountants what something is worth. Since when do accountants set values? Aren’t these types of valuation methodologies one of the key reasons behind the global financial crisis? Can there ever be a substitute for a willing buyer? Are these accountants willing to give MOSERS a “put option” on 25% of the “fair market value” of the portfolio? Do you think there should be a margin of error on the fair market value determinations? Who pays these accountants? Maybe I can get one of those accountants to give buy my house for $650,000 for my house!

This reminds me of an old joke: A business man asked a famous valuation expert what two plus two equals? His response; “How much do you want it to equal?”

Comment by Jim Winkelmann — July 1, 2009 @ 2:10 p.m.

Mr. Winkleman

Below I have attempted to answer your questions and want you to know this will be my last post. I do hope that interested parties like yourself will be fair and reasonable in your judgement of MOSERS. Our policies and procedures for asset valuation have been scutinized by numerous parties over the years with no negative findings. With that said, we will always continue to strive for improvement. We take our responsibility of managing our members assets very seriously and strive for excellence as an organization.

1. estimates of fair market value are made by the investment professionals charged with managing the investments, not the accountants/auditors. The auditors responsibility in the process is to make sure that the managers are following policy guidance established in FASB 157.
2. the percentage of the portfolio in illiquid securities is about 18%, not 25%. Once again, we are not asking the accountants to value the assets, that is the responsibility of the managers. I would add that the managers do not receive performance pay based on the marks they place on the portfolio. They are paid based on realizations, therefore, they have no conflict in valuing the assets.
3. they don’t
4. the key reason behind the global financial crisis was that for the last twenty five years we (households, government, business) have spent beyond our means. This spending was accomodated by the cheap money policies of Mr. Greenspan and the Federal Reserve. The process of mark to market accounting exposed the unacceptable amount of borrwing that was being done by our financial institutions.
5. No.
6. There are no put options in our manager contracts and I have no interest in selling our illiquid assets where they are currently being marked. The will be worth considerably more when economic conditions improve, and because MOSERS is not over-indebted we are not forced sellers.
7. Not sure what good it would do.
8. The investment managers are paid by MOSERS as a limited partner. The auditors are paid by the partnership which is a collection of limited partners and the general partner.

Comment by Rick Dahl, CIO MOSERS — July 8, 2009 @ 12:06 p.m.

Again – if there is no market for 18% of the portfolio, what is would be the margin of error?

Comment by Jim Winkelmann — September 23, 2009 @ 6:03 p.m.

June 25, 2009