ERS flunks state audit
By John Duchemin
Advertiser Staff Writer
A legislative audit of the state Employees' Retirement System has given it a failing grade, citing management problems, questionable investment decisions and inefficiencies that the audit says endanger the fund's mission of providing retirement pensions.
The Office of the Auditor discussed dozens of issues in its review of the Employees’ Retirement System. Here are highlights of some of the major issues. Download the full report and ERS’ 30-page response. (Acrobat Reader required.) • Investment oversight The ERS response: The audit failed to recognize positive performance trends in 2002, during which ERS ranked among the top half of pension funds. Trustees are aware of performance problems and are actively trying to solve them. The length of tenure of investment managers shows trustees don’t want to waste money replacing well-performing firms. Callan Associates is one of the nation’s largest pension fund consultants and, as such, has financial relationships with many portfolio managers — as would all of Callan’s major competitors. Callan has always disclosed its financial relationships with ERS portfolio managers. • Benefits backlog The ERS response: The auditor didn’t give credence to factors that helped cause the delays, such as other government departments failing to get documents to ERS in a timely manner. ERS efficiency has recently improved, and the audit failed to reflect that. The system agrees that providing interest on unpaid benefits would be beneficial to retirees and promised to consider doing so. • Wasted money The ERS response: The auditor lacked the expertise necessary to assess ERS’ computer problems, and the retirement system acted quickly to minimize the problems once identified. The audit also reveals confidential information that could jeopardize ERS’ legal position in the lawsuits.
The report by State Auditor Marion Higa says the fund has failed to deal with problems including a massive backlog in retirees' benefit calculations; potential conflicts of interest involving the ERS Board of Trustees, its investment managers and its chief adviser; and an inefficient computer system that has wasted millions of dollars in taxpayer resources.
Major findings
The audit said: ERS trustees have failed to properly manage fund assets. The fund has underperformed 88 percent of its peers nationwide in the past five years, in part because of investment strategies that differ from many other funds. Trustees have retained most of their investment managers for too long — most of them for more than 15 years, providing scant chance for competitive bids. ERS’ chief investment advisor, Callan Associates, has financial relationships with most of the fund’s investment managers, a situation that could lead to serious conflicts of interest.
The audit said: The ERS has not followed through on promises to eliminate a chronic delay in calculating retirees’ benefits. The delay has gotten longer — from about six months in 1997 to 18 months this year — and continues to cost most recent retirees between $280 and $7,000 per year because of discrepancies between initial estimates and final benefits. Attempts to deal with the problem have been ineffective and wasteful. Furthermore, ERS doesn’t pay interest on the amount owed, and retirees are underpaid as they wait for finalized benefits.
The audit said: The ERS has failed to replace its 16-year-old Wang computer system after spending almost $14 million. Improper oversight of a contractor led to multimillion-dollar cost overruns, delays and reciprocal lawsuits between ERS and the contractor.
ERS officials, trustees and lawyers yesterday disputed the auditor's conclusions, saying Higa and her staff lacked the expertise to understand the complex retirement system.
"While we appreciate the effort put forward by the Auditor's Office, we strongly disagree with the majority of findings in the audit report, which contains numerous factual errors and lacks the objective, qualified research necessary to produce a credible audit," ERS administrator David Shimabukuro said.
ERS issued a 30-page response to the audit, taking issue with most of its findings. ERS trustee Rick Humphries also responded, saying "misstatements and inaccuracies" in the report could lead people to wrongly conclude the $8 billion asset portfolio of ERS is being improperly managed. A lawyer for the fund said the audit jeopardizes ERS' position in a lawsuit with a computer contractor who was supposed to fix the fund's obsolete Wang computer system.
But Higa said ERS' response was the defensive reaction of an agency stung by independent criticism.
"Their response reflects the problems we found with the system," Higa said.
Officials for the fund, which manages retirement benefits for 93,000 state and local employees, retirees and beneficiaries, said they agreed with the main recommendation of the audit: that ERS work to fix several serious problems that it continues to face.
"We've already identified, and are working to address, many of the issues raised in the report," Shimabukuro said.
The audit said ERS staff have failed to address a backlog in finalization of benefits that has caused an 18-month backlog in retirees knowing the amount they will receive on their monthly pension checks.
In the interim, retirees get estimated benefit checks. But often they are underpaid — typically between $280 and $7,000 a year, the auditor found.
One retiree was underpaid $10,000 in the first couple years of his retirement, the auditor found. Another retiree did not receive a final benefit calculation for 14 years after he retired in 1988 — and this year was forced to repay the state $6,200 in overpaid benefits, and pay an additional $1,500 to secure his current level of benefits.
ERS has not only failed to reduce the logjam since a previous audit released in early 2000, but the backlog has since lengthened, the new audit found.
But ERS officials said the audit failed to take into account many recent measures to improve efficiency, and that Higa and her staff lacked the experience necessary to understand the computer system's problems.
"The report reflects the auditor's failure to comprehend the operations of ERS," the retirement system said in its response.
ERS also faces problems with its oversight, the audit found. Investment adviser Callan & Associates has financial relationships with 14 of the fund's 16 investment portfolio managers, meaning it has a potential conflict of interest in recommending whether the fund retain, terminate or hire new managers, the audit said.
ERS should also examine its management structure, which differs significantly from that of other states, the audit said.
The audit comes after the Legislature ordered an investigation of ERS management practices following the ERS board's decision in February to retain a money-losing portfolio manager, 3Bridge Capital, among whose principals was a former ERS administrator.
3Bridge has since been terminated, but the fund took heavy criticism from legislators who saw the February vote as a potential conflict of interest.
Higa's audit found that the board's decision to delay the termination of 3Bridge was because of "the (ERS) board's close contact with individual investment managers." She said trustees kept 3Bridge on the "watch list" of poorly performing funds for 2 1/2 years, frequently letting 3Bridge argue its way out of termination — decisions that she says cost the fund tens of millions of dollars that would have been earned had the money been with a better-performing manager.
ERS officials said the auditor's conclusions were unwarranted and that trustees followed regular procedures in terminating 3Bridge, which in the past had performed reasonably well — and deserved a second chance to prove itself.
"The auditor's criticism of the board's handling of the 3Bridge situation shows a lack of knowledge of the history of the manager's tenure," ERS said in its response.
But Higa said the ERS board was not paying enough attention to its fiduciary duty to shareholders.
"Their duty is not to the investment manager, it's to their beneficiaries," she said. "If an investment manager costs them so much money, it does not matter what their established procedures are. The question becomes, should they have waited so long, even though all the signs were there that 3Bridge was costing their beneficiaries money."
Gov. Linda Lingle said yesterday she has not read the audit, but promised to take it seriously. The governor appoints four members of ERS' eight-member board of trustees, which includes Lingle's state budget director.
"I want to meet Mrs. Higa, with the retirement system trustees and with my own staff," she said. "It's a little premature for me to comment right now, but it is an important issue for the retirees and for the state of Hawai'i."
Advertiser Capitol Bureau Writer Gordon Pang contributed to this report. Reach John Duchemin at jduchemin@honoluluadvertiser.com or 525-8062.
