A recent report shows that Hawaii’s public pension fund ranked at the bottom among comparable funds for its investment returns over the past decade.

The report, issued by Northern Trust, compared 12 funds with investments of more than $1 billion for the 10-year period ending Sept. 30, 2011. Northern Trust is the so-called bank custodian for the Hawaii Employees’ Retirement System‘s securities, safekeeping its assets and tracking the plan’s performance. It compared Hawaii’s performance with that of 11 other client funds it handled over the same 10 years.

The report shows that the average annual percentage return for Hawaii’s fund over the past 10 years was 5.44 percent. That’s critical to the health of the fund because until last year, the plan was based on earning investment returns of 8 percent annually. The target was lowered last session by lawmakers to 7.75 percent for the financial year ending June 30, 2011.

Meeting that target would mean the system would be adequately funded over 30 years. Any gap between earnings and contributions would have to be made up by employees and taxpayers.

Missing the 7.75 return rate translated into the system being more than $3 billion below target over the 10 years, according to Rod June, chief investment officer for the ERS. Today, that would break down to about $161 million for each percentage point the pension system misses its target in a single year, he said.

The retirement system’s board chairman, Colbert Matsumoto, acknowledged that the fund’s performance has not been satisfactory, but stressed that the trustees look at several indicators to gauge the fund’s health.

“Our performance over the 10-year period is disappointing,” he told Civil Beat in an interview. “The trustees periodically have to figure out the right mix to allocate to different assets to best get us to that absolute target — taking into account risk, return and liquidity.”

The board of trustees is charged with safeguarding investment assets and investing funds to finance promised benefits for state and county employees.

The Northern Trust report shows that by any measure from three months through 10 years, the Hawaii fund has ranked poorly among comparable funds under Northern Trust.

• Its three-month performance of minus 11.21 percent — meaning it generated a negative 11.2 percent return — placed it in the 77th percentile. (The first percentile is the best.)
• Its one-year performance of minus 0.57 percent placed it in the 88th percentile.
• Its two-year performance of 4.12 percent placed it in the 96th percentile.
• Its three-year performance of 2.81 percent placed it in the 84th percentile.
• Its five-year performance of 1.65 percent placed it in the 79th percentile.
• Its seven-year performance of 4.75 percent placed it in the 71st percentile.
• Its 10-year performance of 5.44 percent placed it in the 92nd percentile.

Matsumoto said the fund’s lagging performance “is not necessarily because our portfolio is bad,” and pointed to the overall volatility of the investment markets over the past decade.

If you compared the ERS fund to the S&P 500 over the past 10 years, its managers have beaten that key measure, which averaged below 3 percent over the time frame.

“That helps tell us how difficult of an environment this has been over the last 10 years,” Matsumoto said. “The integrity of the fund depends on a combination of investment returns, the right contribution rates, and a liability that is contained.”

Not all of the fund’s investments performed poorly over the past decade. Its small-cap growth assets generated an 8.56 percent return over the period; its international emerging markets assets generated a 14 percent return; and its timber, or forest assets, generated an 8.14 percent return.

Matsumoto said apart from the legislative 7.75 percent return goal, the system maintains a customized goal that’s a composite of multiple indexes. That customized benchmark was 5.7 percent for the 10-year period ended Sept. 30, 2011.

“That benchmark helps us determine from a relative standpoint if our performance is up to par,” Matsumoto said. “So even though our return is low on an absolute basis, on a relative basis, it’s still respectable.”

Wes Machida, administrator for the ERS, said the system maintains a long-term view of its performance. He said the ERS has achieved an average annual return of more than 8 percent over the past 40 years, including the most recent 10 reflected in the Northern Trust rankings.

Still, the system has made changes to its investment strategies to better reach its goals.

For example, the ERS has terminated 35 of its fund managers since 2000, and 37 managers have been brought on during that same time period. It had a total of 33 investment managers at the end of the 2011 fiscal year.

“From time to time, we have managers that will stumble and don’t perform,” he said. “Sometimes there’s a change in management, which from our perspective represents a risk factor and we lose confidence in their ability. Typically, we won’t terminate a manager based on performance for a quarter or two quarters or even a year. We have long-term — in terms of our investments — expectations.”

Here’s the current list of fund managers, showing the ERS paid out $39.8 million in fees to investment fund managers in fiscal 2011.

The same legislation that lowered the return assumption also gave the ERS trustees the power to annually review that target and make adjustments. Previously, it could only be set by the Legislature.

“All pension funds — public and private — are being forced to reexamine their return assumptions,” Matsumoto said. “We may be pressed to lower it further, which will have significant ramifications with regard to the unfunded liability.”

The health of Hawaii’s public pension fund is a major concern of the Abercrombie administration and some lawmakers. As it stands, the fund faces a nearly $9 billion unfunded liability — meaning the amount it owes future retirees.

The investment performance is just one area of concern. Another is that employees are able to spike their pay — typically through excessive overtime — to dramatically boost their pension benefits, which adds to the unfunded liability.

The ERS is proposing a cap on how much overtime can count toward pensions and wants the state and counties to pay for spiked benefits.

Steps have already been taken to lessen future burdens by lowering benefits for employees hired after July 2012. But that doesn’t do anything to lower the burden of the state in meeting what it has promised retirees.

“For taxpayers and our members, we’re trying to do everything we can to sustain the fund,” Machida said.