Our Take: Under-the-Radar Bonus Battle

While Congress debates overhauling bankers' compensation, public retirement systems - a far less glamorous corner of the investment world - are being pressed to reform pay practices too. Surprisingly, these little-noticed battles within state and local organizations might actually end up helping Wall Street and the fund management business.

Public-sector retirement funds are one of precious few niches where demand for investment professionals hasn't wilted amid the financial crisis. Although these portfolio managers and executives earn far less than private-sector counterparts, they enjoy better job security and shorter work hours. Unlike mutual funds or hedge funds, the retirement systems receive steady cash inflows from payroll deductions without having to compete for investors' allegiance, regardless of market conditions.

Now that the American public has come to view all bonuses for financial professionals as thinly disguised theft, public fund managers' compensation is drawing fire. The complaints are loudest at public agencies that manage most assets in-house, rather than through outside investment firms.

Frozen in Texas and Ohio

Last month, after being criticized by Texas state senators, the chief investment officer of that state's Teacher Retirement System "agreed to forego" an estimated $167,835 performance incentive he had earned for 2008. Retirement system trustees also decided to withhold all remaining performance pay for investment staff until the fund experiences a year of positive returns. (That board's reaction to the political onslaught contrasts with the principled stance taken by the former board chairman of Texas' separate university endowment, as detailed here three weeks ago.)

In Ohio, the State Teachers Retirement Board suspended performance incentives for investment staff as of Feb. 1, freezing any bonus accruals for the remaining five months of the current fiscal year. It also froze headcount and salaries and lengthened the standard workweek from 37.5 to 40 hours.

At the same time, the board changed the incentive plan to make future bonuses more sensitive to absolute returns of the investment fund - both upside and downside. (The present plan looks mostly at returns compared with benchmarks. Absolute returns play a smaller role.)

Why Not Peg Bonus To Absolute Return?

The general public seems to view tying investment professionals' pay to absolute returns as a long overdue step toward accountability. For a professional, though, the shift raises fiduciary questions. Retirement funds aren't hedge funds. Rather than chart a course independent of market behavior, nearly all retirement funds manage returns primarily through asset allocation. Pegging a portfolio manager's compensation to absolute returns could encourage individual managers to deviate from stated investment objectives. In fact, that's why mutual funds don't award managers a fixed share of their fund's total returns.

Ohio's new pay plan also promises to sweeten bonuses when the overall retirement fund achieves large positive returns. Should the markets regain lost ground over the next few years, the new plan could end up enriching eligible employees more than their current bonus plan.

If Wishes Were Horses, Richard DeColibus Could Manage Money

Beyond these micro details, the hue and cry against public fund managers' pay levels might ultimately benefit the investment profession in another way. Harassed by politicians pandering to a financially illiterate mass media and public, boards of public retirement systems might conclude managing in-house is more trouble than it's worth. To escape recrimination over pay levels, more boards may opt to farm the work out to private-sector investment firms.

They'd end up paying far more in management and performance fees than they're paying now in staff compensation to do it in-house. Still, I know if I were a trustee or the chief executive of a public retirement fund with a record of outperforming benchmarks, I'd be sorely tempted to switch to outside managers - perhaps needlessly sacrificing beneficiaries' dollars - just to get geniuses like Richard DeColibus off my back.

"Beating the benchmark return by about one-third of one percent is not exactly a masterful performance," DeColibus, a retired schoolteacher and former president of the Cleveland Teachers Union, informed the Ohio State Teachers Retirement Board last December. "....If we had seen the coming market slide and moved into bonds, even T-notes would have been a smarter investment and we would not have lost $25 Billion. In fact, we would have made money. But, we failed to anticipate it, a $25 Billion error."