HONOLULU - Trustees of the $7 billion Hawaii Employees' Retirement System "failed to properly manage the beneficiaries' assets" and employs a consultant that may have conflicts of interest in selecting money managers, the state auditor said in a report.
Fund executives and trustees criticized the audit, saying in a written response: "The report is based on many factual errors and appears to lack due diligence." The response also notes the consultant that assisted in the audit, New England Pension Consultants Inc., Cambridge, Mass., lost out in a bid to replace the Hawaii ERS' longtime consultant, Callan Associates Inc., San Francisco.
The 56-page audit, overseen by Marion M. Higa, state auditor, said investment performance is "poor." "ERS performed dismally," the audit also stated The audit placed the fund "below the bottom 15% nationally when compared with other retirement systems" during the five-year period ended June 30.
The Hawaii Legislature, in commissioning the audit, was anxious about whether or not ERS' assets are managed and invested competently" and "expressed concerns regarding ... the board's unwillingness to terminate" 3Bridge Capital LLC, San Francisco, "an underperforming investment manager that employs the former administrator of the ERS," the audit notes. The former administrator is not named in them report. The audit and the auditor office's written response to the ERS rebuttal also found:
* "The ERS' investment consultant's objectivity could be suspect, since the consultant disclosed financial relationships with the majority of investment managers it has recommended to the board. These financial relationships can include providing consulting services to money managers on strategy and marketing/sales implementation, software and database information on money managers' performance..." Callan is not named in the audit.
* "...the delayed decision by the board to terminate 3Bridge resulted in the potential loss of $128 million in assets."
* "Delays in contracting for bank custodian and securities lending services, which placed ERS assets at risk for five months and contributed to lost income of approximately $1 million."
Further conflicts alleged
In its 35-page response, the fund's board questioned the credibility of New England Pension Consultants, the audit's consultant. Not only did it lose to Callan in 2000, the response said, but it also "regularly competes with our investment consultant for other engagements with other public pension funds. Does that fact suggest that the auditor's consultant has a potential undisclosed `conflict of interest?'..."
The audit was also critical of the ERS reporting structure. Its chief investment officer, who is selected by the board, reports to the ERS administrator. At most other state pension funds, the CIO reports to the board of trustees, the board's investment committee, the board's chairman, or an executive director who reports to the board.
Hawaii's reporting structure, the audit found, is "fundamentally unsound," since the administrator is responsible for ERS operations, and not investments. The audit suggests the CIO should report directly to the board, chairman of the board, the board's investment committee or an executive director, who reports to the board.
The response from trustees and management states, "The report demonstrates a lack of understanding of the complexity of the ERS' systems, processes and procedures." The audit "unfairly fails to acknowledge positive trends in ERS performance..."
In referring to Callan, the audit said: "The selection process for investment managers relies too heavily on recommendations from the investment consultant ... The board rarely deviates from its investment consultant's recommendations when selecting investment managers."
When ERS needs a new money manager, the "consultant recommends between four and six managers from its database," the audit states. "There is no requirement or practice of opening up the search process to managers outside the consultant's database ... Without another perspective from which to balance the investment consultant's recommendations, the board could fail to benefit from other, possibly better-performing investment managers."
The audit found that more than 85% of recommended money manager candidates and 100% of the managers chosen "have disclosed financial relationships" with Callan.
"While not technically representing a conflict of interest, the motivation to recommend these particular investment managers warrants close scrutiny," the audit adds. "The existence of such relationships should compel the board to supplement the consultant's recommendation with other criteria." The audit suggests that the system use competitive bidding as part of its manager search process.
In its response, the board said, "The auditor seems to be only guessing about the ERS' manager search process." The response also noted: "The RFP process recommended in the report is obsolete by current standards ... (and) could result in higher fees and untimely manager selection. Only a handful of funds still use the report's recommended method."
The search process used by the board "remains the prevailing standard in the public pension fund field," the board's response said. "Our investment consultant performs identical services for over 80 other public pension funds..."
Response on consultant
In its response, the board and staff also said: "The ERS investment consultant has the research resources to cover the entire industry. All institutionally viable investment managers are included at the onset of each ERS search."
The response notes "it is also difficult to justify the cost, time and distractions of an RFP process with the RFP creating little more information than is already available from our consultant."
That the audit implies Callan's "judgment and performance of services may be deficient because of a conflict of interest" is an "alarming allegation." The "only supporting basis for the auditor's criticism is the observation that out of 16 investment managers recommended over an extended period, 14 were investment managers with some sort of disclosed financial relationship, from which three were ultimately selected. This analysis fails to consider the materiality or lack of materiality of any disclosed financial relationship between the investment managers and the investment consultant. Although interesting, such an analysis falls short of being sufficient evidence of any impropriety to support the level of alarm suggested by the auditor."
Neither the audit nor the response details the managers' financial relationship with the consultant in terms of services or amount of money.
On 3Bridge, the audit noted that state Senate and House committee reports questioned whether the board's "reluctance to terminate the investment manager could be attributed to the manager's employment of ERS's former administrator."
"3Bridge was allowed to remain on the watch list for 21/2 years before its termination in August 2002," the audit states.
In response, the board said the "auditor's criticism of the board's handling of the 3Bridge situation shows a lack of knowledge of the history of the manger's tenure. Furthermore, the auditor does not provide sufficient evidence and details in the report, and fails to support her statement that `the ERS loss could have been as much as $128 million.' "
The board agreed that long-term performance has been below benchmarks. But its response contends the Hawaii fund outperformed its benchmarks for the three years ended June 30 and was in the 47th percentile among public funds for the year ended June 30.
The board said the administrator, to whom the CIO reports, is akin to an executive director, is responsible for both operations and investments, and reports to the board. "Why that is `fundamentally unsound' is puzzling" and "a gross misstatement," the response states.
The response also notes: "We are puzzled by the auditor's concern that 13 of our managers have been with the ERS for over 15 years. We view this as a positive ... Good institutional practice supports consistency and continuity in promoting good long-term results."