An audit of the Hawaii Employees' Retirement System could have been a road map for investment management reform. Instead, the audit, conducted by the state auditor, succumbed to some shortcomings similar to those for which it criticized the $7 billion pension fund.
The audit reveals a lack of sophistication in the review, and a chance to answer important questions for Hawaii and other funds was lost.
However, it does raise some substantive questions about the way investment management and pension consulting are carried out, not only at Hawaii, but at other large pension funds. For example, it raised the issue of the potential conflicts of interest at pension consulting firms that also consult with money management organizations, an issue that has been raised before but bears revisiting.
All these issues are worth examining, but the way the Hawaii audit was conducted damaged its credibility.
Marion M. Higa, state auditor, made a mistake in contracting with New England Pension Consultants Inc., Cambridge, Mass., for assistance in auditing the system. That arrangement put NEPC in the position of assessing a competitor, Callan Associates Inc., San Francisco, the system's consultant.
As the system's trustees and staff pointed out in a rebuttal to the audit, NEPC "was an unsuccessful competing bidder" for assignment as consultant to the Hawaii system, while NEPC also "regularly competes" with Callan for consulting engagements with other public pension funds. For those reasons alone the firm should not have been hired to assist in the audit.
In fact, too often the audit fails to provide the details or evidence of the practices it criticizes. For example, it criticizes the system's "delay in terminating an underperforming investment manager that employs the former administrator of ERS," referring to 3Bridge Capital LLC, San Francisco. It later adds that delay "may have cost the pension fund as much as $128 million." But the audit doesn't detail how it arrived at the $128 million.
The audit was critical of the system's reliance on recommendations from its consultant, especially the lack of competitive bidding for investment management services. "There is no requirement or practice of opening up the search process to managers outside the consultant's database," the audit notes.
The audit found 85% of the recommended money managers "have disclosed financial relationships with" the system's consultant, suggesting a potential conflict of interest. But the audit doesn't explore such ramifications, or other search processes in detail. The rebuttal, by the trustees and staff, notes the system's search process remains the prevailing standard with public funds. But that isn't necessarily a defense in light of potential conflicts.
The audit raises these issues, and others involving investment, to conclude that trustees "failed to properly manage the beneficiaries' assets." It found the system's total investment return for the five years ended June 30 ranked in the bottom 15% compared with other public retirement systems. But it fails to examine whether this was because of poor manager selection, poor asset allocation, or poor investment policy choices.
It seems critical of some long-term relationships the system has, stating the system "retained 13 investment managers for more than 15 years." But it gives no perspective of the managers' performance to help determine whether this longevity is good or bad.
The trustees' rebuttal, however, gives little information on how the board is dealing with issues such as consulting conflicts of interest, which might compromise manager evaluations.
Clearly the system has had subpar performance. But the audit makes it hard to generate any immediate policy changes. You don't need an audit to reveal the system's poor investment performance numbers. You need it to identify the causes and suggest solutions.
If the Legislature and governor expect to improve the performance of the Hawaii system, they should work from within the system, looking especially at the trustees, including how they are appointed, how competent they are, how they can be replaced. Trustees must take the blame for the poor performance and the way the system has been run.