Under the leadership of new Treasurer Erick Russell, Connecticut’s $55 billion pension funds have seen significant improvements, but we are far from being able to proclaim “mission accomplished” and there is more to do to reform the management of state investments.
This is far from an esoteric or niche issue for policy wonks as every taxpayer and state worker is affected. Every 1 percent swing in performance of the $55 billion pension funds amounts to $550 million — more than Gov. Ned Lamont’s proposed tax cut, and larger than funding demands from schools, universities, and human service providers combined. Improvements in the state’s historical investment underperformance can alleviate the crushing income tax burden of transferring $7.7 billion in surplus contributions from state tax revenues to pay down the pension burden, and relieve state public employees and teachers from being docked an additional 2% of their wages each year to cover the investments hole. With even average performance in the past, Connecticut’s income tax might have been sliced in half or more.
Given the scale of this challenge, it is remarkable that decades of underperformance of Connecticut’s pension funds escaped public notice and scrutiny for as long as it did, until last year, when we revealed in a 113-page research report how Connecticut’s pension funds have had one of the worst investment track records of all 50 peer states, across all timeframes, which garnered significant attention and calls to action from across the state. Given the asset management and endowment investing expertise in Connecticut, this was a tragic paradox.
We came to this challenge rather unintentionally, with no partisan, ideological, commercial, professional, career, or personal agendas. Rather, in alignment with my tenure as co-chair of Advance CT, helping lead the state’s economic development and business attraction efforts, we’ve engaged in ongoing research chronicling CT’s remarkable economic transformation.
The more we dug in to economic data, the more it stood out to us that, despite Connecticut’s terrific progress in economic growth, improved fiscal responsibility guardrails, strengthened education/workforce training, record employment levels, and development of a deeper venture capital and innovation ecosystem; the woeful investment returns from our public pension funds posed a hugely significant but underappreciated challenge.
With 5,000 volunteer hours of expert analysis, our team dove deep into long suppressed investment problems, and after release of our research report publicly 15 months ago, our recommendations for improvements in the management of Connecticut’s investments were heard loud and clear, despite some initial defensiveness and pushback from some corners. Since our report, we have been impressed with the responsiveness and leadership demonstrated by Russell, who is as accessible as he is transparent. With help from the chair of the Investment Advisory Committee, renowned endowment management expert and former Carnegie Corporation Chief Investment Officer Ellen Shuman, we have seen tangible changes.
Connecticut’s pension fund was once second worst in the nation. Its progress is ‘breathtaking’
In particular, Russell has implemented several key internal reforms, including restoring professionalism to the operation (i.e. publishing performance reports promptly, updating investment policy statement); and changing asset allocation towards a more normalized mix of assets, reversing mistaken decisions such as a dramatic overweight to emerging markets/largely Chinese stocks and a dramatic underweight to US equities — which resulted in Connecticut largely missing out on the bull run in US stocks over the last decade.
There is no question Connecticut is already benefiting from Russell’s reforms, with one-year investment returns of ~12.8% through calendar year 2023 and ~8.5% through fiscal year 2023, which places the state easily in the middle of the pack if not upper half of states on a one-year basis, though long-term performance remains weighed down by Connecticut’s historical underperformance through no fault of Russell. The state’s employees will not need to again be docked 2% of their wages this year.
Even though things are clearly trending in the right direction, there is a rush to declare ‘mission accomplished’ prematurely. For example, at last week’s lively 5-hour long public hearing held by the Finance, Revenue, and Bonding Committee of the General Assembly, where we testified alongside Russell and his staff at the invitation of Committee Co-Chairs Sen. John Fonfara, D-Hartford, Rep. Maria Horn, D-Salisbury, and Ranking Members Sen. Henri Martin, R-Bristol, and Rep. Holly Cheeseman, R-East Lyme; the state’s chief investment officer made repeated errors in his testimony, which we had to correct in real time.
For example, unfortunately, the treasurer confused legislators when he wrongly insisted in response to questions from Sen. Ryan Fazio that the state had benchmarked itself against all 50 states to claim we jumped from 2nd worst in the nation to the top 40th percentile in investment performance over the last decade, and to the top 27th percentile on a one-year basis, though we warned him in advance that these assertions were not correct. Given the overhang of prior years’ underperformance, rising to 40th percentile over the last decade represents a nearly impossible leap.
When the treasurer repeated the erroneous claims in legislative testimony, a quick fact-check debunked the assertions, revealing the treasurer’s office was inadvertently benchmarking against 85 funds that were largely local municipal funds with far fewer resources and sophistication, in lieu of 50 genuine peer state funds. In reality, on a 10-year basis, we’ve jumped from second worst to around eighth worst in the nation.
Likewise, we had to correct perhaps inadvertent jumbling and misrepresentation of a hodgepodge of questionable financial benchmarks across asset classes and funds — representing not apples to apples comparisons or even apples to oranges, but a fruit punch of misfits.
The actual performance was so improved, it was not necessary to damage credibility with confusing claims. As we testified to the legislature, while we commend Russell’s impressive initial reforms, there is much more to be done to bring investment management in line with best practices gleaned from 50 peer state comparisons, and we are heartened there is strong interest and momentum not only in the General Assembly but across the state for continued reforms, with support from diverse constituencies ranging from labor to teachers to investment experts. We’ve risen from bottom of the pack to middle of the pack, but we could rocket from middle of the pack to genuine top performance if additional reforms were implemented.
Here are 10 recommendations for how Connecticut can continue to improve management, governance, and investment performance of pension funds; interestingly, many of these recommendations were made by the State Legislature in 1989, but not adopted.
1. Regularly provide performance reports, benchmarked against performance of 50 peer states, using commonly accepted financial benchmarks used by a majority of other states for each asset class. This is to prevent arbitrary selection of obscure financial benchmarks without benchmarking to peer states and best practices. Shifting benchmarks within asset classes each year from the S&P 500 to the Russell 3000 to the MSCI ACWI, to varied consultant benchmarks, smacks of moving goalposts to find a favorable headline of “beating” a cherry-picked benchmark no matter the result.
2. Independent oversight and review by auditors reporting to the General Assembly. Having independent, outside, non-conflicted auditors reporting directly to the legislature and/or possibly the state comptroller provides needed objectivity to those hired to deliver the report card, such as the US Government Accounting Office. We commend the Finance, Revenue, and Bonding Committee for voting unanimously 51-0 to advance Senate Bill 453 proposing independent oversight a week after our presentation calling for such a move.
3. Overhaul turgid cumbersome performance reporting to report performance in a clear dashboard with visuals to provide better public understanding of investment performance. This would replace the dense, 600-page reports/IAC Info Packets and inaccessible data-heavy tables. Furthermore, a visual dashboard with gauges and graphs showing trends and magnitude across key indices can improve public accessibility and understanding. This is what most successful corporate boards, state agencies, and non-profits do to inform constituents of performance efficiently, allowing for quick visual glances of magnitude and direction of key metrics.
4. Establish clear and reasonable criteria/guidelines for replacing/exiting underperforming external investment managers. Such pruning would be broadly applicable to the set of external investment managers employed by Connecticut. We still have outside managers who have been delivering substandard performance, some for 25 years. Not “re-upping” with new commitments to those managers is a good first step; there is no reason to keep them on our books, while paying them millions in fees.
5. Establish more stringent criteria/guidelines for limiting exposure to any single external investment manager. For example, this would require that Connecticut is not the single largest client of any of our external investment managers, and that no single external manager represents the majority of Connecticut’s exposure in any single asset class, on a current valuation basis, and not just an original-cost basis.
6. Statutorily empower the IAC with fiduciary responsibility rather than purely advisory responsibility. Amazingly, it remains one of only two or three states in the nation with a sole fiduciary model for pension investments, vesting all authority in a single elected official with no checks and balances, and consequently few outside experts willing to serve on a relatively toothless IAC. An empowered board of directors for checks and balances and oversight is standard good governance across sectors.
7. Prioritize reducing unnecessary/redundant/excessive fees paid to external managers. Most years, Connecticut pays well over $100 million in fees to external asset managers, though our own consultants have noted we pay higher fees than usual in some instances.
8. Continue shifting towards low-fee, passive index funds. Ironically, a generic, non-professionally managed US 60/40 or 70/30 portfolio, akin to the asset mix held by most normal Americans in retirement accounts, would have outperformed Connecticut’s professionally managed portfolio by billions.
9. Establish statutory eligibility requirements for future treasurer candidates. This would be similar to how statutorily, candidates for attorney general must have legal backgrounds. Since we’ve gotten a haircut from some poor performing outside asset managers, based on technical credentials and certifications required, it is harder to qualify as a licensed hair stylist in Connecticut than to manage the state’s $55 billion pile of money.
10. Do not be distracted by demands for higher compensation for financial professionals in the treasurer’s office. Our chief investment officer is one of the highest paid among his peers, bringing home $463,691 last year and $423,372 the year before, though our pension funds were down -10% that year, and far above the 50 state median and average salaries. Compensation alone was surely not the reason why Connecticut went through 12 chief investment officers in a span of 10 years, with some chief investment officers quitting within 10 days of starting the job.
Some of these recommendations may seem obscure or technical, but we cannot overstate the urgent importance of the challenge of continuing to reform management of the state’s pension funds. After all, had the state merely generated the median investment performance across 50 state peers over the last decade, Connecticut could have cut income taxes by nearly half. And we can’t just hope that the system works without further reforms; as Fonfara, the co-chair of the finance committee, mused during the hearing, “I can’t help but wonder, where was the investment advisory council during that time [when investments were underperforming], these folks that are supposed to be the watchdogs?”
Implementing these reforms would save the state billions in lost investment revenue and put more money back in the pockets of Connecticut’s public employees, teachers, and taxpayers – who are the ones ultimately hurt the most by Connecticut’s chronic historic underperformance.
Jeffrey Sonnenfeld is senior associate dean and Lester Crown Professor of Management Practice at the Yale School of Management. Steven Tian is research director of the Yale Chief Executive Leadership Institute.
