Murphy Adds Plank to Platform: No Hedge Funds in Pension and Benefits System

Chase Brush | October 4, 2016 | Politics
Only declared Democratic candidate for governor takes progressive tack, but administration and consultant argue in favor of alternative investment strategies

Phil Murphy, former Goldman Sachs executive and U.S. Ambassador to Germany, is the first Democrat to declare his candidacy for governor.
Former U.S. ambassador Phil Murphy yesterday continued to flesh out what has become a fairly progressive economic policy platform for the Democratic gubernatorial candidate, calling on the state to dramatically scale down its investment in hedge funds as a way to mitigate losses for a broken pension and benefit fund.

Murphy, the first and so far only candidate to officially throw his hat in the ring for governor in 2017, said in a release that the state’s Division of Investment should “get out of the hedge fund business” when it comes to the pension system, currently some $44 billion in debt. The pension system saw a nearly 1 percent drop in market value over the course of the past fiscal year and shelled out close to $300 million in fees to outside hedge fund managers, according to state treasury officials.

Murphy’s opposition to using hedge fund investments in the pension system might seem ironic given his background as a multimillionaire and former financial executive, two titles that closely endear him to the interests of Wall Street.

“The days of padding the pockets of a few lucky and connected Wall Street insiders with our money needs to end, and as governor I will see they do,” Murphy said. “We are not going to close the gaping pension deficit with costly and risky hedge fund investment schemes. We need to get back to stable investments that can produce predictable and solid returns at a fraction of the cost.”

The announcement is sure to renew questions over the state’s investment strategy for its beleaguered pensions and benefits system, which has come under scrutiny in recent months for how heavily it relies on alternative investments, such as hedge funds, as a source of potential growth. State treasury officials, who have sought to use those investments to diversify the fund’s portfolio, argue that such a strategy can help protect it against the kind of widespread losses incurred during chillier economic climates, such as the downturn in 2008, during which the pension system hemorrhaged over $20 billion in lost assets.

But critics of the strategy, mainly public-worker union officials, question whether the grossly underfunded pension system can afford to continue investing in those funds. They argue that hedge fund investments have not always turned the kind of profit expected of them, not to mention that they require shelling out of millions of dollars in outside hedge-fund manager fees. Those concerns served as the basis of an intense debate over the summer that temporarily prevented that State Investment Council (SIC) from adopting an investment plan for the new fiscal year, as union and administration representatives on the board found themselves gridlocked over how much of a role hedge funds should play in the state’s strategy.

Council members ultimately elected to scale back hedge fund allocations for the system to 6 percent, a decrease that is projected to save an estimated $127 million in outside management fees, but concerns still remain.

The issue was revisited at the SIC’s most recent meeting last week, when members of the board heard testimony from officials at the Division of Investment on how the pension system fared in fiscal year 2016. Christopher McDonough, director of the Division of Investment, called it a “disappointing” year for the fund and reported that the pension system declined 0.87 percent, or around $6 billion, in market value. Investment losses were less than $700 million and included hedge funds, he noted, which in 2016 made up about 12 percent of the fund’s assets.

The value of the state’s pension fund dropped from $79 billion in June of last year to $72 billion at the end of this fiscal year, the DOI reported, primarily because more was paid out to the state’s 770,000 current and retired employees than was taken in over the time period.

Those losses were pounced on by Murphy’s campaign yesterday, which said they should “prompt the state to get out of the hedge fund business and lead to a complete overhaul in the mindset used to invest state funds.” In a press release, the Democrat argued that the practice of paying hedge fund managers exorbitant fees, sometimes regardless of investment performance, is “unsustainable.” He noted that the state paid $270 million in fees to hedge fund managers last year, $142 million of which he said was “paid without regard to return.”

Returns on New Jersey’s public pension and benefit fund, one of the largest in the nation, were among the worst of $10 billion-plus asset pension funds in 2016, according to DOI data. California’s pension system, which is the nation’s largest, decided to end its hedge-fund investments in 2014, with fees cited as a concern.

“On top of all of this, hedge fund managers receive favorable tax treatment, which needs to end,” Murphy said. “These fund managers get large investments from the state, and charge handsome fees without regard to performance. And then when they do receive performance fees, they are given a significant tax break on top of it.”

The opinion might come as a surprise to some observers, as Murphy, a former Goldman Sachs executive, has deep roots in the financial industry and might be otherwise assumed to take a favorable position on such diversification efforts. The Democrat announced his candidacy for the party’s nomination in May, and has since pushed a platform of progressive economic reform that includes tax breaks for the working poor and a revamped student loan program. Though Murphy, after securing the endorsement of Jersey City Mayor Steve Fulop last week, is now considered one of two odds-on frontrunners for the nomination, he’s had a hard time avoiding the obvious comparison to former Gov. Jon Corzine, another wealthy Goldman Sachs executive who ended his term with low approval ratings.

Murphy has tried to counteract that characterization over the past several months, and over the summer unveiled a policy platform full of sweeping revision to the state’s economy, the centerpiece of which involves the creation of a state-owned public bank. He added yesterday that the pension system’s losses should “further prove the potential of a public bank, owned by the state, to bring in stable and reliable returns to be reinvested in the pension system,” and that money “currently wasted” on hedge fund managers’ fees could be used for below-market loans to reduce college debt and help small businesses create jobs.

Still, treasury department officials maintain that hedge funds and other alternative investments present a good opportunity for the state to shore up the debt-loaded pension system during fiscal crises. They say that the strategy tends to produce positive results more often than not and that a modest allocation to hedge funds remains in the best interest of the system. At last week’s meeting, Gov. Chris Christie-appointed council chairman Tom Byrne called 2016 an “anomaly,” and encouraged the board to engage in more “out-of-the-box” thinking on investment strategies going forward.

Indeed, a consultant’s report released by the state recently determined that the hedge funds and other alternative investments generated more than 9 percent returns net of all fees over the past three years, beating the pension system’s 7.9 percent assumed rate of return and the 6.6 percent gains generated over the same three years by all of the system’s more traditional investments. Investment returns in 2015 and 2014 were 4.16 percent and 16.9 percent, respectively.

Joe Perone, communications director at the Department of Treasury, said yesterday that the state remains “highly sensitive to concerns regarding hedge fund fees and expenses.” The Division of Investment developed the Fund Alignment and Incentive Reform (FAIR) initiative in August in an effort to reduce hedge fund management fees, enhance returns, and offer greater transparency and lower operating costs, he said.

“The Division’s FY17 Updated (Annual Investment Plan) Proposal seeks to address the concerns of SIC members in that it reduces the overall allocation to hedge funds while maintaining a reasonable level of diversification and downside protection,” he said.

Perone also took issue with the Murphy campaign’s reporting of the pension system’s losses yesterday, saying that it was the equity-oriented hedge fund portfolio, which includes only about 4 percent of the system’s assets, that lost 13 percent on investments. The campaign’s press release had said all hedge fund investments, which make up 12.5 percent of the system’s assets, lost that much over the year.

The investment discussion takes place amid New Jersey’s wider pension and benefit debacle, over which Christie and Democratic lawmakers have remained at loggerheads. The two-term Republican has opted to cut actuarially required payments to the fund in repeated efforts to balance the state’s budget, while Democrats, led by Senate President Steve Sweeney (D-Gloucester), have fought to pass legislation requiring the state to make those payments. Under new pension accounting standards, the details of which were also discussed at last week’s SIC meeting, many of the state’s retirement funds will see depletion dates within the next decade, with the earliest, the Judicial Retirement System, coming as early as 2022.

It’s unclear, following last week’s breakthrough on another major impasse between lawmakers — a plan to replenish the state’s Transportation Trust Fund — how quickly Sweeney and other Democrats will move now to solve the pension issue. The other likely frontrunner in next year’s Democratic gubernatorial primary, Sweeney tabled a measure in August that would have put a question on this year’s ballot asking voters to require annual payments be made to the fund, saying that a TTF deal would have to come first.

Murphy, for his part, said the most important thing lawmakers can do is commit to funding the that system.

“Our investment strategy doesn’t need to be complex, it simply needs to be commonsense,” he said. “But the single most-important thing we can do to bring the funds back to health is for the state to finally pay its true share, and allow those investments to grow over the long term.”