Thursday, December 3, 2009

Risking the state retirement system

The News Observer reports on a new in-state investment pool for the state retirement system.
State Treasurer Janet Cowell is starting a $250 million equity fund to invest in North Carolina companies with two goals in mind: make money for the state pension fund and create jobs in North Carolina.

Cowell's office is scheduled next week to announce the investment firm that will manage the fund.

The legislature this year passed a law, at Cowell's request, giving her more flexibility in managing pension fund investments so she could establish the Innovation Fund. The fund is set up to invest up to $250 million in companies that have "significant operations in North Carolina," according to the request for proposals from investment firms.
Before posting further, I should disclose that I am currently enrolled in the state pension system, so I've got a dog in this particular fight. However, anyone who is a North Carolina taxpayer also has a stake.

At first glance, the proposal looks great. Investments inside North Carolina offer a potential two-fer in that the retirement system could reap the investment returns, while the investments themselves add to the state's economy and tax base.

However, a closer examination reveals serious downsides.

The primary goals of the pension fund manager should be to maximize the fund's returns while minimizing risks associated with those returns. Prudent fund management provides security to current and future retirees who depend on the fund. It also reduces costs to taxpayers who are ultimately on the hook for the obligations of the fund.

Absent this special fund, nothing prevents the Treasurer from investing in North Carolina companies and projects--so long as they meet the retirement system's other objectives. If an investment, inside or outside North Carolina, can yield a competitive return, the Treasurer should be on it.

However, by setting a firm dollar amount of $250 million, the state is indicating that the Treasurer wouldn't have found this many worthwhile in-state projects through its normal procedures. This suggests that the state is going to invest in at least some in state projects with returns that are less than competitive. Either the policy is pointless ($250 million would have been invested anyway) or it results in over-investing.

Besides possibly failing to maximize its returns, the state is also going against the other principle of sound investment, which is to diversify risks. The retirement system is funded through individual deductions, taxpayer contributions, and investment returns. In times when the state economy hits a bad patch (and what are the chances of that ever happening?), the revenues available from taxpayers dry up. However, the investment returns available elsewhere might not decline or at least not decline by as much. By investing more within the state, the retirement fund ties its returns more closely to the state economy, reducing the opportunities for diversification and increasing risks and volatility. A fund manager should want these revenue streams to be less correlated, not more correlated.

A cautionary example of the dangers of correlated risks is an employee whose stock is entirely or mostly invested in the company that she works for. If the company goes bust, the worker not only lose her job but also her investment. Ask a former employee of Enron whether he or she is happy that so much of the employees' retirement funds was tied up with that company.

The policy also sends a bad message to other states, which might also be encouraged to concentrate their investments at home. If additional states pursue these types of approaches, the funds available to North Carolina companies from other states could be reduced.

Finally, the approach is ripe for abuse. North Carolina elects its Treasurer. Companies and workers who might directly benefit from the retirement system's investments would have the opportunity to contribute to the Treasurer's election. The Treasurer should face political pressure to make the best investments; however, she should not be beholden to particular groups.

My hope is that this is indeed a pointless policy and that the Treasurer is just trying to get good P.R. for investments that she would have made anyway. Unfortunately, her description of this plan doesn't sound that way.