The 2019 Election That Should Have Hedge Funds And Wall Street Worried

There’s a good chance you don’t know the name of your state auditor, or whether your state is one of the 24 that elects someone to that position. There’s an even better chance that you can’t name Kentucky’s auditor.

But the Kentucky state auditor’s election this year will be among the most interesting and important races in the country, even though it will take place in the shadow of the state’s heated gubernatorial contest and the run-up to the 2020 presidential election.

That’s because Christopher Tobe, an independent financial adviser who is one of four Democrats running for the position, has promised to wield the office’s powers in a way they haven’t been used before — not in Kentucky and maybe not anywhere else — in an effort to clean up the state’s worst-in-the-nation public pension system.

Tobe, a former member of the board that oversees the majority of Kentucky’s pension system, has pledged to use the auditor’s subpoena power to force the board to open its books. That would be a move toward what he calls “radical transparency.” It could, in theory, expose the state’s overreliance on risky hedge fund and private equity investments that Tobe argues have led to corruption and Wall Street excesses and contributed to the pension system’s state of ruin.

The Kentucky pension system, Tobe said, “has become kind of a gravy train” that benefits everyone except the thousands of state workers whose retirements are at risk. “I just want to shine the light on all this stuff,” he said. “Nobody’s bothered to look.”

Opening the books of the worst-funded state public pension system in America may mean as much to residents of other states as it does to Kentuckians. It could set an example across a country where many state pension systems have made similarly risky bets and where public pensions overall are stuck in a constant state of crisis.

“An honest and accelerated investigation” into some of the biggest problems facing public pension systems “could be an informative tool not just for Kentucky but for the rest of the nation,” said Bill Bergman, director of research at the nonprofit Truth In Accounting.

The Worst Pension System In The Country

Few issues have dominated Kentucky politics over the last half-decade like the pension system, as the public has become increasingly nervous — and even angry — over the health of those retirement funds. The state pension system is the current or future source of retirement benefits for nearly 500,000 Kentuckians, or about one of every nine residents. Reform efforts dominated the last round of statewide elections in 2015 and have become a recurring topic in the state legislature. Last year, Kentucky teachers shut down schools and flocked to the state capitol to protest changes to their pension plans proposed by Gov. Matt Bevin (R). The protests inspired a record number of Kentucky teachers to run for office in the 2018 elections. This year, Kelsey Hayes Coots, a teacher who helped organize the statewide walkouts, is also running for auditor.

But so far this year, Tobe is the only candidate to home in on this specific aspect of the pension system: its riskiest investments and the potential for corruption surrounding them.

Tobe has been involved with Kentucky’s ailing pension system for more than two decades, in nearly every role except the one he’s now pursuing.

He worked in the state auditor’s office in the early 1990s. In 2008, he was appointed to the board of trustees that oversees Kentucky Retirement Systems, the largest of the state’s pension plans. Two years later, he became a whistleblower when he went to the Securities and Exchange Commission to allege that placement agents ― who are hired by investment funds to find investors ― had improperly directed pension investments to their clients. (The complaint was ultimately dismissed.) Since then, he has written a book about the state’s pension crisis and drafted and publicly advocated for legislation aimed at cleaning up the system.

The Kentucky legislature has passed reforms. State workers have filed lawsuits against the pension board. A former trustee went to prison on bribery charges. A former auditor even investigated the pension system’s reliance on placement agents and made detailed recommendations for how to improve oversight of that.

But none of that has sparked the oversight or transparency that Tobe wants. So in December, after current state auditor Mike Harmon, a Republican, released an audit that Tobe viewed as a “rubber stamp” of the pension system’s worst practices even as it criticized the system’s oversight and accounting functions, Tobe decided to run for office himself. He said his goal is to end corruption in Kentucky, which Harvard University’s Edmond J. Safra Center for Ethics ranked as among the most corrupt states in the nation in a 2014 study. But his main focus will stay on what he knows best: the state’s pension system.

“I’d be one of the most qualified auditors in history taking on one of the most corrupt governments in history,” Tobe told HuffPost. “It’s not just the pensions ― the pensions are just where the biggest problems are.”

Nationwide, state and local pension systems held more than $3.8 trillion in retirement assets in 2016 for more than 19 million workers, according a recent Pew Charitable Trust analysis. At the end of the 2017 fiscal year, the 50 state pension systems had $1.6 trillion in unfunded liabilities.

No state pension system is in more dire shape than Kentucky’s, which has $33 billion in unfunded liabilities across eight pension plans. Kentucky Retirement Systems, which oversees five of those plans and manages retirement assets for most state workers (other than teachers and judges), is in even worse shape: At the end of 2018, it held just 12.9% of the assets it will need to pay out, making it the worst-funded public pension plan in the country.

To counteract problems created by chronic underfunding and losses during the Great Recession, states like Kentucky began to pour pension money into riskier, so-called alternative investments like hedge funds in the hope that their big bets would pay off. These kinds of investments, however, are costly, thanks to the high fees that hedge fund managers charge. And they haven’t paid off ― at least, not for public pension plans. Kentucky went even further than other states: By the end of 2014, its pension plans had 25% more alternative investments, 27% higher costs and 15% lower returns than other states’, according to its own reports.

Kentucky went so far as to outsource the creation of a hedge fund of hedge funds ― an even riskier and higher-fee proposition ― to a Wall Street investment firm. All that fund did was regularly underperform the post-recession market.

Bevin won the governorship in November 2015 promising to clean up the pension system. Since he took office the following month, he has poured money into it and pushed various reforms.

Bevin didn’t oppose alternative investments during his campaign, but since his victory, Kentucky Retirement Systems has made a show of its efforts to get out of the riskiest hedge fund investments it holds, albeit at a much slower pace than other states that have made similar commitments. It continued to divest its hedge fund holdings in 2018, but by the end of the year, nearly 30% of Kentucky Retirement Systems’ overall portfolio was still tied up in various alternative investments.

That’s actually not far off the national average, which has ballooned to 26% over the last decade, according to the Pew analysis of state pension systems. Pew’s analysts argue that percentage should be much lower. Legendary investor Warren Buffett believes states should abandon alternative investments and high-fee management contracts ― which he has called “a fool’s game” ― altogether.

Tobe contends that the Kentucky pension system’s move away from hedge funds is little more than a bait-and-switch meant to assuage the public while it shifts to private equity partnerships, which carry just as much risk and require similarly high fees.

“‘Hedge fund’ isn’t a good word anymore, and there’s no real definition,” he said. “So they call themselves all sorts of other names.” 

Fighting Corruption

Along with many other longtime pension experts, Tobe thinks there’s a clear reason why states like Kentucky are so reluctant to walk away from their riskiest investments, even as they jeopardize the retirements of millions of public workers nationwide: The fees required to manage such investments are making a lot of people a lot of money.

Alternative investments like hedge funds and private equity partnerships typically require pension systems to pay higher-than-normal fees while promising them an outsized percentage of whatever profits those investments generate. In Kentucky, fee costs rose from just $13.6 million in 2009 to more than $125 million in 2014, The Intercept reported last year. Those costs have continued to rise, putting free money into the pockets of Wall Street firms, bankers and investors even as the funds themselves continue to underperform the market. (Pension systems nationwide pay roughly $2 billion in such fees annually.)

“There are some good investments in those, but we don’t really know how good they are,” Tobe said. “But there are a lot of bad investments too. We just don’t know. What we do know is that we’re paying a lot of excessive fees.”

That lack of public knowledge is a deliberate policy, not just in Kentucky but everywhere else, too. Over the last decade, Wall Street firms and their partners in state and local pension plans have obtained exemptions from public record laws under the guise that their contracts contain “trade secrets” ― and therefore must be shielded from public scrutiny ― according to Edward Siedle, a former attorney at the SEC who now forensically investigates public pension systems (and who served as Tobe’s attorney for his whistleblower complaint). That means that in many cases, a state like Kentucky can hand out contracts without publicly disclosing the fees the pension plans are paying or the people who are getting paid.

Kentucky lawmakers tried to change that in 2016, when they passed a pension reform law meant to bring transparency to Kentucky Retirement Systems’ practices. The law passed unanimously, but at the last minute, two of its most important provisions disappeared. One would have required full fee disclosure; another would have mandated an open bidding process for pension investment contracts. At the time, some Kentucky lawmakers wondered if Gov. Bevin or others who supported the hedge fund investments had conspired to eliminate the provisions ― although the state legislator who authored the law disputed that idea in a 2017 interview with HuffPost.

Tobe criticized the removal of those provisions, saying that shift had saved “10s of millions of dollars” for Wall Street. Since then, Tobe said, Kentucky Retirement Systems has proceeded largely as if the rest of the law didn’t pass, either.

In 2016, Bevin reignited questions about potential corruption in Kentucky’s pension system when he appointed a hedge fund manager named Neil Ramsey to the Kentucky Retirement Systems board of trustees. Ramsey, as HuffPost reported at the time, failed to initially disclose his ownership of multiple investment firms. He was also a major donor to Bevin’s 2015 gubernatorial campaign and inaugural committee, and he owned a house that was sold to Bevin in 2016 ― a transaction that drew scrutiny because of the seemingly discounted price on the property. (Ramsey was recently removed from the Kentucky Retirement Systems board.)

Kentucky’s Executive Branch Ethics Commission found that Bevin didn’t do anything wrong. But to Tobe and experts like Siedle, the whiff of potential scandal was indicative of the sort of corruption that can take place when, as Siedle explained at the time, fund managers can contribute to candidates or causes and soon afterward get hired by the public pension system.

Tobe is running for auditor so that he can actually root out the corruption instead of merely speculating about it. Although there may be no easy-to-recall precedent for such aggressive action on pensions by a state auditor, elected officials have transformed the oversight roles of other positions with the same brand of aggressive advocacy. 

Over nearly two decades as Connecticut’s attorney general in the 1990s and 2000s, now-Sen. Richard Blumenthal (D) pioneered an aggressive approach to law enforcement, “moving away from the traditional role of state attorney to one of citizens’ advocate” (to quote the Connecticut Post). Blumenthal targeted Wall Street banks, oil giants, Microsoft and Big Tobacco, and others followed in his footsteps. When he ran for the U.S. Senate in 2010, Blumenthal celebrated that in his wake, “attorneys general across the country have become more activist.”

“One AG committed to exposing wrongdoing can have a huge impact, and the same is true if you have a single state auditor with subpoena powers and a willingness to take on Wall Street,” Siedle said. “He could raise the bar and cause other state auditors to look at things they’re not looking at now and expose the wrongdoing.”

“Just opening the books,” Siedle said, “would expose so much.”

So far, the Kentucky pension board’s refusal to use competitive bidding and to disclose its investment contracts ― and state lawmakers’ refusal to force those issues ― has produced a lack of transparency that makes it hard to root out corruption. The Supreme Court’s 2010 Citizens United decision, which shields many corporate electoral donations from disclosure, makes it virtually impossible.

“I think there’s pay-to-play behind it,” Tobe said. “But since we have Citizens United, there’s no way to prove it.”

Unless, perhaps, an auditor was able to fully open the books.