William R. Atwood, executive director of the Illinois State Board of Investment, Chicago, is at the center of a game of chicken between a statutory obligation to pay pension benefits and a fiduciary obligation to invest assets to earn at least an 8.5% assumed rate of return. It's a dilemma triggered by the failure of the Illinois General Assembly and Gov. Pat Quinn to fund any state pension contributions this fiscal year and by the $10 billion board's three constituent retirement systems, which each separately set their return assumptions: Illinois State Employees' Retirement System, Judges' Retirement System and General Assembly Retirement System.
With his skills, Mr. Atwood, working with ISBI's trustees, is up to the challenge to lobby the Legislature and restructure the board's investment allocation. Mr. Atwood learned about management working on public policy issues in his early 20s, first for then-Sen. Charles Percy and later for Govs. James R. Thompson and Jim Edgar. “The good thing about government, as a young man at least at that time, is you had the opportunity to get a lot more responsibility early on (than in the private sector),” he said. “I learned a lot about how organizations operate, budgeting, legislature management; and you learn how to function in organizations.” In his late 20s, he entered money management — first joining Investment Counselors Inc., St. Louis, serving as vice president for business development, “a kind of chief operating officer,” responsible for operations, business development, marketing, client services, personnel — “everything except portfolio management” — and then working in various capacities with various firms until he was encouraged to apply for the opening for ISBI executive director. He was hired there in 2003.
What's the biggest risk or challenge ISBI faces? Funding and associated liquidity problems. Our plan sponsor (the state) is just not in a position to reliably fund its obligations. So the consequences for us are pretty extreme. It has increasing consequence for our ability to meet our actuarial assumption.
Is liquidity risk the new LDI, liquidity-driven investing? It is. For us, two years ago liquidity was not a big issue. And now it is the issue, getting sufficient investment funds and hitting what is a very aggressive bogey of 8.5% is a tough number. But then try to get 8.5% while remaining sufficiently liquid to transfer out $1 billion a year out of a $10 billion fund.
Are the trustees and investment staff fiduciarily required to invest the assets to achieve that assumed 8.5% return when there is a lack of contributions and a liquidity need to pay benefits? The answer to that question is ambiguous. You enter into a generational arbitrage at some point. Your duty to get 8.5% is about future generations. Your duty to preserve the corpus of the fund is about making sure you have funds for the current generation of retirees. What's the duty of the board when the interest of current retirees conflicts with the interest of future retirees? And there is not a clear-cut answer to that except the board has to balance those interests.
If the current market and economic environment continues, can pension funds in general be sustained? We aren't going to have 11%, 12% equity return, but we also aren't going to have inflation rates of 3% or 5%. The real material question is, what is the premium investors can expect over inflation? What's the investment return premium they can expect over the growth of assets over the growth of liabilities? So my point is even as there is downward pressure on investment returns, there is similar downward pressure on liabilities with the possible exceptions of mortality, people living longer.
Has ISBI made the investment arbitrage in the proceeds it received from state pension bonds, generating a return higher than the cost of the debt? In 2003, ISBI got $1.55 billion and in 2010 January, $812 million. No, not thus far. I'm still reasonably confident over time we will outperform the cost of capital.
In general, ISBI has underperformed its investment benchmarks. Why? The challenge we have is the 8.5% return assumption, which led to an aggressive investment portfolio, which in an up market would be expected to outperform but in a down market we are challenged. So over the last five years, the board sought to increase total return and we increased the allocation to real estate. We invested in commercial mortgages, residential mortgages and some construction loans. We had leverage in the real estate portfolio, which the index doesn't have. So in the financial tsunami we got crushed. The other parts of the portfolio — domestic equities, international equities, private equity and real estate, except for mortgages — performed well.
What incentives do you use to attract and retain staff? We pay people what we can. I think our staff tends to be paid more than most public employees but far less than what the industry pays.
How do you feel about incentives in general? I think in most private-sector platforms it is good and valid. (For a public fund,) I wouldn't want to have an aggressive bonus program in an economy going into the (tank) and state revenues flat and state employees worried about losing their jobs. I don't want to stand in front of the (public) explaining why I'm paying some guy a $50,000 bonus. Maybe he did save the portfolio millions of dollars. In an absolute world, he is entitled to that bonus. In a public fund, the optics of that are awful.
Is there a failure of communication about the purpose of a bonus? I don't think it's realistic. We are talking to legislators, not business school professors down at the University of Chicago. We are not afforded the luxury of that much explanation or, for that matter, the honorability of intentions. We may not get a fair hearing.
What practice in money management do you find troubling? Soft dollars. I want my managers to seek out the lowest-priced best execution, end of discussion. They can pay for their own research. We are paying them fees to be a money manager. I don't want them to pay for research with my commission dollars.
Do you forbid that? No, it's just impractical. The SEC tightened it up a few years ago.
Are money management fees justified? On the long-only managers, we just aggressively negotiated those fees. It's increasingly a commoditized business. Managers have to justify that fee.
Infrastructure is a really good example. They price themselves like private equity. Private equity earns those fees. And on a risk-return basis, they justify those fees. The idea of 150 basis points and 20% carried interest on an infrastructure fund is really difficult to justify. Unfortunately, the carried interest is immaterial because none of these guys are making 8% (the benchmark). But 150 basis points on a fixed-income proxy is a tough nut to crack.
What keeps you awake at night? Not inflation. The world economy, I think, is at greater risk for a deflationary environment than a hyperinflationary environment. And the problem is I think policymakers know how to respond to an inflationary environment; they don't have any idea how to respond to a deflationary cycle. I don't, either.
What would you like to see to help ensure against market collapses? Restoration of Glass-Steagall. When you have merchant banks operating under the same platform as savings banks, the savers are at great risk.