Reviving a pension plan

At the start of 1995, Connecticut’s $12 billion public pension plan ranked dead last among the nation’s large public pension funds. Despite half its assets being invested in stocks, the fund’s 10-year annualized return was just 10 percent – about the same as the average bond fund and a whopping 139 basis points behind the average public pension plan’s return.

In January 1995, a new team took over the fund’s management and began one of the largest public pension fund restructurings in history. The turnaround began when a blue-ribbon panel of investment experts was convened to assess the fund’s problems and determine appropriate corrective action. Additionally, the state hired a pension consultant to help select investment managers and monitor performance. Following are examples of key problems identified by the team and the steps taken to solve them.

* The state was allocating assets without a clear understanding of the pension fund’s long-term liabilities. Minimizing the fund’s long-term liability was as much a priority for the new management team as was maximizing returns. The team analyzed the impact different asset allocations and market conditions had upon the fund’s asset growth and unfunded liability, and the findings provided the basis for a more rational asset-allocation strategy.

* As they expanded the fund into new asset classes, the former administrators failed to rethink their investment strategy. However, guided by the asset-liability study, the new team analyzed how each available asset class would fit into a prudent investment strategy. That analysis prompted a decision to eliminate international fixed-income securities as an asset class since such securities were more volatile than domestic bonds, without superior returns.

The team also separated the equities that performed best with active management from those that lent themselves to passive management or indexing. As a result, investment management costs declined, risks were reduced, and the fund’s performance picked up. * Under the previous management, the number of investment managers increased while performance decreased, yet accountability was virtually nonexistent. By contrast, the new team introduced quarterly performance reviews and rated managers’ performance against newly implemented benchmarks. Managers that under-performed or failed to follow agreed-upon strategies were disciplined and/or fired.

The new team reviewed a total of 70 investment managers, told them their contracts were under review and invited new managers to compete for the fund’s business. (Nearly 400 investment managers responded.) The management team fired all but six of its investment managers and ultimately settled on a staff of 30.

* Despite its poor performance, the fund had been paying exorbitant management fees. To reward success and punish failure, the new team introduced performance-based fees, making clear to investment managers the link between their performance and fees. Performance-based fees saved the fund $11 million in the first year.

* Over the years the fund had become thoroughly politicized, with investment managers being chosen more for their political connections and contributions than for their performance. At the team’s urging, Connecticut’s legislature passed a law that forbids contributions to political campaigns by companies doing business with the state. The law freed the pension plan to focus on doing what is best for the people of Connecticut and for the 52,000 people who depend on the fund for their benefits.

In less than three years, the transformation was complete. By mid-1997, a year after restructuring concluded, the fund ranked in the top quartile of all large pension funds.