SPRINGFIELD, Ill. - The $14 billion Teachers' Retirement System of Illinois overvalued its real estate portfolio by at least $115 million, needs to establish real estate auditing procedures and needs to improve its internal accounting, a report contends.
The $115 million overstatement is a result of not following generally accepted accounting principles, the report said. The report was written following an audit conducted for Illinois Auditor General William B. Holland by KPMG Peat Marwick L.L.P., New York.
The audit report also recommends system officials "review their current practice of allowing individuals and entities under contract with the (s)ystem to give, and pension officials to accept, goodwill expenditures or any other items of value."
Fund executives agreed with the audit findings regarding valuations and auditing procedures and are making changes. But they are not following the recommendations regarding goodwill expenditures - such as costs of out-of-town trips - and items of value.
Scott Mulford, public information officer for the fund, said the valuation discrepancy is an accounting interpretation issue. As stated in the audit, the system will "adjust internal procedures to ensure major investment transactions are properly recorded."
Mr. Holland said in an interview: "I would say it was more than an accounting technicality." With a $2 billion real estate portfolio, the fund will be better off improving accounting and controls, he said.
Regarding goodwill expenditures, the report noted system officials said fund trusteesformulated their own standards because state law is silent on the issue. Trustees have reviewed their practices twice in the past three years, the report said.
Fund trustees accept goodwill expenditures only from existing vendors, whom the system says must "live or die" according to their performance, the audit report says. Until a manager has a track record with the fund, goodwill expenditures will not be accepted.
Mr. Mulford said the system's stance on goodwill expenditures is accurately reflected in the audit.
As noted in the audit, eight trustees and some of their spouses, along with four staff members, traveled to Florida in 1995 to visit hotel properties, shopping centers, apartments and farms. The audit said fund officials reported the trip allowed trustees to see some properties and evaluate the possibility of future real estate transactions in the region.
While some of the costs were borne by the fund, fund officials estimate investment managers spent $14,000 for accommodations and meals at sites not owned by the system.
The system's response in the audit report is that trustees will continue to accept goodwill expenditures from existing managers who are not on their watch list.
Illinois Teachers "has established practices which they feel are appropriate and effective in preventing actual improprieties and abuses," the audit report says.
Meanwhile, the audit could lead to additional scrutiny of the system's investment procedures.
"I would like to take a look at some of the things" that came out of the Illinois Teachers audit, said state Sen. Tom Walsh, R-LaGrange Park, who sits on the Senate's audit commission.
He said while it appears nothing the fund did was illegal, and officials "addressed the issue fairly well" before the audit commission, he would like to know more about issues such as goodwill expenditures.
The audit's findings already prompted criticism from state lawmakers, who disagreed with hiring Thomas Zimmerman - the fund's former chief investment officer - to manage overlay portfolios following his resignation from the fund (Pensions & Investments, April 29).
In real estate, the system's large portfolio carried a net unrealized loss as of the fiscal year 1995, although the portfolio reports positive performance for the last three years.
According to the audit results, Illinois Teachers carries a net unrealized loss of about $166 million - about 7.5% of book value - on what is among the largest percentage allocation to real estate of big pension funds. The fund's target allocation to real estate is about 15% of total assets.
According to data provided by the fund, the real estate portfolio returned, on a time-weighted annualized basis, 12.65%, 11.09% and 7.85%, respectively, for the one-, two- and three-year periods ended Dec. 31.
The $115 million in real estate adjustments stemmed from the following situations, according to the audit report:
The fund acquired deeds in lieu of foreclosures on three properties it held mortgages on, and in the process did not value the transfer at fair market value as required by GAAP. The result: a $27 million restatement.
Similarly, the fund did not carry a mortgage loan in probable foreclosure at fair value, resulting in a $16 million restatement.
The fund valued six properties and three commingled funds at book value, although the audit determined that because they were available for sale or development, they should have been valued at "the net realizable value" (the price at which they could be sold). The difference was $38 million.
The fund capitalized about $13 million in costs attempting to obtain necessary entitlements to land it is buying, meaning it added the purchase costs to the value of the property. Because of uncertainty regarding the deal's feasibility - an appraisal indicates it won't be possible to get all the necessary entitlements - those costs should not have been capitalized, and a loss of $12 million should be recognized, the audit says.
A shopping mall investment made by the fund appears to be "permanently impaired" because of vacancy problems and environmental contamination. The auditor recommended a loss of $22 million be taken.
An official at Illinois Teachers' general consultant, Callan Associates Inc., San Francisco, declined to comment on the system audit as a matter of policy. The system does not use a specialty real estate consultant.
Terry Williams contributed to this story.