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Federal E-NewsSeptember 2007
First Executive Director of New National Institute on Retirement Security (NIRS) Named The NIRS Board of Directors announced on September 25 their selection
of Beth Almeida, a PhD in Economics with a union background, to head
up the new not-for-profit organization whose purpose is to conduct research
and education programs regarding the traditional pension system in the
United States. In addition to her experience with the IAM, Ms. Almeida has headed up research initiatives with the Center for European Integration Studies at the University of Bonn, Germany; the European Institute for Business Administration; and the Center for Industrial Competitiveness at the University of Massachusetts. NIRS was formed by NCTR, NASRA and the Council of Institutional Investors (CII) earlier this year to help offset the "research" and other reports prepared by opponents of DB pensions in support of their efforts to convert public systems to a defined contribution model. A board consisting of two representatives from each of the three sponsoring organizations, with a seventh member chosen by these six, governs it. NIRS’ current chair is Laurie Fiori Hacking, the executive director of the Minnesota Teachers Retirement Association. “The establishment of NIRS and selection of Almeida comes at time when Americans and policymakers are concerned about retirement security,” said Ms. Hacking. “Under Almeida’s leadership, NIRS will conduct research and disseminate findings regarding the U.S. pension system. Traditional defined benefit pensions have provided a reliable and cost-effective retirement income for generations of American workers. Yet, many aspects of these retirement systems and their impacts are not widely researched and understood,” Hacking commented. According to Ms. Almeida, "Clearly, there is a need to examine
pensions and their retirement security role, as well as the impacts
on financial markets, the economy, and the recruitment and retention
of workers such as teachers, police officers, and firefighters.”
Almeida will assume the NIRS post on November 1, 2007. The House Financial Services Committee held a hearing on the new proxy access proposals of the Securities and Exchange Commission (SEC) at which institutional investors and shareholder rights activists blasted the competing rules. With no consensus on the now evenly-divided Commission, Committee Chairman Barney Frank (D-MA) thinks that "more work needs to be done" by the SE before anything is finalized. The House Financial Services Committee heard testimony on September 27 regarding the SEC’s competing proposals addressing shareholder access to the proxy. One proposal, supported by two Republican Commissioners and often referred to as the “short proposal/rule,” would permit the exclusion from a company's proxy materials of all shareholder-proposed bylaws concerning director nominations. The other proposal, supported by the two Commission Democrats and referred to as the “long proposal/rule,” would permit an exception, or override, to this general bar, allowing shareholders with a 5% equity stake in a company, held for at least one year, to propose such election-related bylaw amendments. SEC Chairman Chris Cox voted for both. (See July/August 2007 NCTR Federal e-News) Furthermore, the SEC’s proposals raise a number of other related questions regarding the proxy, including the potential exclusion of non-binding shareholder proposals from management proxies, such as giving a company the right to “opt-out” of the shareholder resolutions process, either by obtaining approval from shareholders through a proxy vote, or, if sanctioned under state law, by having a Board vote authorizing the company to opt-out. Witnesses included Don Kirshbaum, Principal Investment Officer –
Policy, Office of the Treasurer, State of Connecticut; Ann Yerger, Executive
Director, Council of Institutional Investors; John Castellani, President
of the Business Roundtable; Timothy Smith, Chair of the Social Investment
Forum; and Paul Schott Stevens, President and Chief Executive Officer,
Investment Company Institute (ICI). Ann Yerger told the Committee that CII “strongly opposes both proposals as currently drafted.” She said the short proposal “would obliterate the current rights of shareowners to submit binding or non-binding access resolutions,” and that the long proposal “imposes such onerous requirements on shareowners simply interested in sponsoring access resolutions that the proposal is empty and unworkable.” For example, she noted that under a 5% threshold, “Even the ten (10) largest public pension funds combined would be unlikely to meet this threshold at a public company of any size—whether it be a large-, mid-, or small-cap company.” Finally, she pointed out that the disclosure requirements of the long rule that would be imposed on investors “for some inexplicable reason are far more extensive than currently required even for shareowners planning a hostile takeover of a public company.” Mr. Stevens with the ICI characterized his members as “hav[ing] one foot in each camp” on the issue as both significant shareholders of public companies as well as public companies with their own shareholders and boards of directors. He said the ICI “generally supports the SEC’s proposal to afford certain shareholders direct access to a company’s proxy materials for director-related bylaw amendments,” but believed that the “5%/1 year” thresholds should be greater. However, he based this view on his members’ holdings, noting that portfolio holdings of 2,409 domestic equity mutual funds for 276 complexes as of the fourth quarter of 2006 showed that an estimated 87 mutual fund complexes had a total of 1,887 holdings of 5 percent or more of the U.S. companies in which they invest. The Social Investment Forum’s leader understandably focused his comments on the questions raised by the SEC involving either eliminating entirely or severely limiting the ability of any investor to sponsor any shareholder proposal, and not just proxy access for the purpose of nominating directors. He called an opt-out provision allowing a board of directors or a company’s current shareholders to vote to disenfranchise future shareholders as running contrary to the SEC’s commitment to universal shareholder suffrage, and he described the idea of allowing companies to follow an electronic petition model for non-binding shareholder proposals (“electronic chat rooms”) in lieu of the current rules as appropriate only if used as a supplement to, not a substitute for, the existing shareholder resolution process. Finally, presenting the opposing viewpoint was the Business Roundtable (BRT). In a nutshell, Mr. Castellani argued that the current process for reform was working. “[W]e have seen more governance changes in the past 5 years than during the previous 50,” he insisted. As proof, he offered 2007 survey results of BRT members on governance practices, showing 91% of boards are made up of at least 80 % independent directors; 72 % of boards meet in executive session at every meeting; 75 % of CEO’s serve on no more than 1 other board; 84 % of boards have adopted majority voting for directors in just two years; and the average tenure of a CEO is down to 4 years. Given this strong record of reforms, Castellani told the Committee that the SEC is correct in reaffirming its exclusion of director election proposals from the proxy in the short proposal. Proxy access, presumably in any form, will discourage qualified, independent directors from serving and, in the BRT’s opinion, shift the cost of special interest nominees to companies and, ultimately, to shareholders.” “Simply put,” the BRT leader said, “proxy access is a bad idea whose time has passed.” The comment period for the rules expires October 2, 2007, and the SEC has promised to have the new rules in place for the next proxy season. However, with Democratic Commissioner Campos having left the Commission, there would appear to be no consensus now as to the correct approach. Furthermore, in a meeting with a number of public pension CEO’s in late August, Chairman Cox said it was important to him that proxy access issues be addressed by a five-member Commission. Following the hearing, Congressman Frank was quoted as telling reporters that "I think we're going to be suggesting that they need to start over again." Will SEC Chairman Cox decide to follow Financial Services Committee Chairman Frank’s recommendation? For many, this would not be such a bad outcome for now. As CII’s Yerger put it, the status quo – under which the last proxy season operated pursuant to the AFSCME v. AIG court ruling – is better than either SEC proposal. Many institutional investors would agree. SCHIP Clears Congress, But Promised Presidential Veto Likely to Stick In what some believe could be a harbinger of the healthcare debate to come, both the House and Senate have cleared legislation to reauthorize and expand the popular State Children’s Health Insurance Program (SCHIP), but the partisan politics involved with the ideological future of healthcare as a whole threaten to stall any real expansion for the foreseeable future. As the Presidential campaigns increasingly focus on healthcare reform, the stalemate is only likely to get worse before it gets better. Earlier in the year, renewal and expansion of the State Children’s Health Insurance Program (SCHIP) seemed an easy bipartisan issue that would allow both parties and both Houses of Congress to walk away feeling good about policy and politics. Over the course of the last few months, however, the issue has degenerated from a discussion over expansion of a specific program to one dealing with the ideological future of healthcare as a whole and the roles of government and private insurance in providing coverage. SCHIP provides healthcare to the children of the working poor whose families make too much to be eligible for Medicaid but still cannot afford insurance. Over the course of the program’s 10-year history, waivers from the Department of Health and Human Services (HHS) have allowed program modifications to the baselines established in the statute. As a consequence, eligibility now varies by State, with some States allowing coverage for families with incomes up to 200% of the Federal poverty level while others set the bar at 300% of poverty; however, the Administration has recently drawn a line in the sand and denied New York State’s waiver request to cover those with incomes of up to 400% of the poverty level. Following weeks of tense negotiations, a deal was finally reached on the differing versions of the legislation passed by the House and the Senate. (See July/August 2007 NCTR Federal e-News) The compromise legislation would provide an additional $35 billion in funding over the next five years, bringing total spending on the program to $60 billion. According to supporters of the legislation, this would be enough to increase enrollment to 10 million, up from 6.6 million, and greatly reduce the number of uninsured children in the country, currently estimated at around 9 million. The additional funding would be paid for by a 61-cent-per-pack increase in the tobacco tax; the House provisions dealing with Medicare Advantage plans, strongly opposed by Senate GOP supporters of the bill, was dropped. However, the Administration strongly opposes the bill, with White House Press Secretary Dana Perino saying "The president will veto this bill because it directs scarce funding to higher incomes at the expense of poor families." However, according to press reports, White House spokesman Tony Fratto explained "The money isn't the issue. It's the view of what the role of government has to be in health care." The Congressional Republican leadership, working closely with the White House, tried hard to keep their troops in line on the vote. The office of House Minority Leader John Boehner (R-OH) reportedly told the press “The Democrats’ bill does more to ensure that government-run healthcare gets a fighting chance in Washington than it does to insure the kids who need affordable health care in this country.” And Senate GOP leader Mitch McConnell (R-KY) said "If Democrats want to expand government-run health care, they should do it in the light of day, without seeking cover under a bill that was meant for poor children, and without the politics." But in a marked change from the two only other situations in which the President has vetoed a bill, some Republicans were having none of it. For example, Senator Pat Roberts (R-KS) is reported in the Los Angeles Times to have said "The Administration is threatening to veto this bill because of 'excessive spending' and their belief that this bill is a step toward federalization of health care," adding, "I am not for excessive spending and strongly oppose the federalization of health care. And if the Administration's concerns with this bill were accurate, I would support a veto. But, bluntly put, they are not." Can a Bush veto be overridden in the House? Old pros say it is just not close enough for Democrats to pull it off, but this is not stopping the House and Senate majority leadership. If for no other reason, the veto override vote keeps the issue in the press and keeps the pressure on vulnerable Republicans. According to the Washington Post, House Speaker Nancy Pelosi (D-CA) promises "If the President refuses to sign the bill, if he says, with a veto, 'I forbid 10 million children in America to have health care,' this legislation will haunt him again and again and again." So, assuming no success with this first veto override attempt -- which could come within a week -- the plan appears to be to pass a short–term extension of the SCHIP program at current funding levels and then reintroduce the conference agreement every 6 to 12 weeks in order to force yet another veto and an override attempt. Sadly, the melt-down over SCHIP illustrates that the consensus for healthcare reform in general has not yet been able to produce agreement over the manner in which it should be achieved in particular. Even with strong support for the legislation from a diverse group that includes the health insurance industry and children's and disease-control advocates, most of the nation's governors, AARP and the American Medical Association, the current political mood is such that compromise seems unlikely. With public approval ratings for both the Congress and the Bush White House at dismal levels, both sides would appear to have little to lose by continuing to attack each other instead of trying to find common ground, with Democrats bashing Bush for putting children’s health at risk, and the White House playing to its conservative base by charging the Democratic Congress with fiscal recklessness. As was once thought before the popularity of the SCHIP program seemed to suggest otherwise, healthcare reform -- even incremental reform – looks like it will remain deadlocked until after the 2008 elections. New IRS Normal Retirement Age Regulations Increasing Source of Concern
On May 22nd, the IRS provided final regulations dealing with portions of its 2004 proposed regulations on the subject of in-service distributions after normal retirement age. (See June 2007 NCTR Federal e-News) The new regulations (which, for a governmental plan, will apply for plan years beginning on or after January 1, 2009) will now permit a pension plan (a defined benefit plan or money purchase pension plan) to pay benefits upon an employee’s attainment of normal retirement age, even if the employee has not yet had a severance from employment with the employer maintaining the plan. The problems begin with the new regulations’ handling of what qualifies as “normal retirement age.” Under the final regulations, normal retirement age under a plan must be an age that is “not earlier than the earliest age that is reasonably representative of the typical retirement age for the industry in which the covered workforce is employed.” However, what about plans with different normal retirement dates for different classes of employees or different normal retirement dates for different participants in the same class of employees? Also, the regulations provide that benefits may not be distributed prior to normal retirement age solely due to a reduction in the number of hours that an employee works. There is a safe harbor providing that a normal retirement age of at least age 62 is deemed to meet this new “typical retirement age” standard. This would also include a normal retirement age defined as the later of age 62 or another specified date, such as the later of age 62 or the fifth anniversary of plan participation. (There is also a safe harbor for plans where substantially all of the participants in the plan are qualified public safety employees; in such cases, a normal retirement age of age 50 or later is deemed to meet the new standard.) However, IRS Notice 2007-69 states that the new regulations do not provide a safe harbor or other guidance with respect to a retirement age that is conditioned (directly or indirectly) on the completion of a stated number of years of service. For plans subject to Section 411 of the Internal Revenue Code, if a participant’s normal retirement age changes to an earlier date upon completion of a stated number of years of service, typically this will not satisfy the vesting or accrual rules of that section, according to the Notice. Sponsors of governmental plans and other plans not subject to the requirements of § 411 are asked to submit comments on whether normal retirement age under such a plan may be based on years of service. Comments are also requested on whether and how a pension plan with a normal retirement age conditioned on the completion of a stated number of years of service satisfies the requirement that a pension plan be maintained primarily to provide for the payment of definitely determinable benefits after retirement or attainment of normal retirement age and how such a plan satisfies the pre-ERISA vesting rules. Comments are due by November 25, 2007. Alan Winkle, Executive Director of the Public Employee Retirement System of Idaho, has taken the lead in having developed a list of the specific issues that the regulations and the Notice present for the public sector. These are being circulated under separate cover to all NCTR and NASRA members for review to assist in future discussions with IRS/Treasury and possibly formal comments as well. Congress, SEC Looking at Role of National Credit Rating Agencies in the Current Credit Crisis Triggered by the Subprime Mortgage Collapse
Both the House Financial Services Committee and the Senate Banking Committee have begun hearings into the recent “credit crunch” in the capital markets and, more specifically, the role of credit rating agencies in the problems that have developed with debt instruments such as mortgage-backed securities and collateralized debt obligations (CDOs). With home foreclosures rising precipitously and the collapse of the housing market threatening an economic recession in the opinion of some economic experts, the role of credit rating agencies in the mortgage market is coming under intense scrutiny. This role is generally as follows: mortgage bankers, who make loans to homeowners, often resell the loans to investment firms, which in turn bundle and repackage them as a piece of a structured security; this security is then reviewed and evaluated by the credit rating agencies, which grade the bonds based on their risk of default, and it is this rating which determines the interest rate investors earn, and thus governs the attractiveness of these instruments. Investors have criticized Standard and Poors (S&P), Moody's Investors Service and Fitch Ratings because their ratings on bonds backed by subprime mortgages (to people with poor or limited credit) were not adjusted to accurately reflect the default rate on these mortgages until mid-July, when downgrades in credit ratings on bonds backed by subprime mortgages caused many investors to dump these securities. In short, investors and Congress are asking why the credit rating agencies gave out such high ratings to these securities in the first place; why these agencies then failed to adjust those high ratings as soon as the performance of the underlying assets began to decline; and finally, why the necessary and appropriate independence from the issuers and underwriters of these securities was not maintained. The show began on the Senate side of the Hill on September 26 with the Banking Committee where the focus, in the words of Chairman Christopher Dodd (D-CT), was on “abusive and predatory subprime lending” that was “facilitated by Wall Street with the support of credit rating agencies.” Dodd said he wanted to examine “the circumstances of these downgrades [of credit ratings on structured financial products, particularly subprime residential mortgage-backed securities], the integrity of the ratings process, the oversight by the SEC, and whether statutory, regulatory or industry changes are warranted.” The Ranking Republican on the Committee, Senator Richard Shelby (R-AL), summed it up by noting the numerous reasons that have been offered for “why the rating agencies got it wrong.” “Some have suggested the rating agencies awarded high ratings to curry favor with the large investment banks,” he noted. “Others have criticized the rating agencies for playing an active role in structuring these complex deals,” Shelby continued, “which presents a number of conflict of interest concerns.” The next day, it was the turn of the House Financial Services Committee, where Congressman Paul Kanjorski (D-PA), Chairman of the Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises held a similar hearing on the role of the credit rating agencies in the structured finance market. Kanjorski was particularly critical of the role of the major rating agencies in evaluating CDOs in terms of their likelihood for defaults. “Their investment-grade stamp of approval helped to provide credibility for the CDOs that had the toxic waste of liar’s loans and problematic subprime products buried deep within a deal,” Kanjorski declared. “In return,” Kanjorski noted, “the rating agencies also made great sums of money from issuers.” It was this financial relationship between the rating agencies and
those they rated that troubled members on both sides of the aisle, on
both sides of the Hill. For example, Senator Jim Bunning (R-KY) pointed
out that it was “like a film production company paying a critic
to review a movie, and then using that review in its advertising."
Senator Shelby complained that, with the credit agencies being paid
by the underwriters instead of investors, “It seems to me that
money’s trumping ethics.” SEC Chairman Chris Cox appeared before the Senators to announce that his agency had opened an investigation into whether the credit rating agencies were unduly influenced by issuers and underwriters of residential mortgage-backed securities “to diverge from their stated methodologies and procedures for determining credit ratings in order to publish a higher rating.” The SEC’s examination is also focusing on whether the credit rating agencies “followed their stated procedures for managing conflicts of interest inherent in the business of determining credit ratings,” specifically seeking to determine whether their role in the process of bringing such securities to market impaired their ability to be impartial. For their part, the credit rating agencies claimed that there was no intention to mislead investors. Moody’s even suggested that investors bore some of the blame, noting that even though they had “discouraged market participants from using our ratings as indicators of price, as measures of liquidity, or as recommendations to buy or sell securities,” some market participants may have used our ratings for such purposes. “They are not designed to address any risk other than credit risk and should not be used for any other purpose,” Moody’s stressed to the Senate banking Committee. Moody’s also blamed the problem in part on “a constant erosion of underwriting standards between 2003 and 2006 – including misrepresentations by mortgage brokers, appraisers and borrowers.” Many lenders and brokers who were charged with upholding lending standards stopped playing that role effectively, according to Moody’s testimony. In the end, “Along with most other market participants,” Moody’s simply “did not anticipate the magnitude and speed of the deterioration in mortgage quality (particularly for certain originators) or the rapid transition to restrictive lending.” S&P told the Senators that they had learned some hard lessons, and that “we are fully aware that, for all our reliance on our analysis of historically rooted data that sometimes went as far back as the Great Depression, some of that data has proved no longer to be as useful or reliable as it has historically been.” Furthermore, “the collapse of the housing market itself has been both more severe and more precipitous than we had anticipated,” the S&P witness admitted. S&P also stressed, as did Moody’s, that their ratings “speak to one topic and one topic only — credit risk.” However, S&P also acknowledged that “ratings matter,” and that even though they made repeated statements about the nature and role of ratings, “To the extent those efforts have failed to communicate sufficiently clearly about that topic, we view this hearing, and this process overall, as an opportunity to begin to rectify that. We recognize that we bear primary responsibility for getting the message out.” S&P’s testimony also focused on the “issuer pays”
approach to fees, and stressed that “there is no evidence —
none at all — to support” the contention that S&P has
issued higher, or less rigorously analyzed, ratings so as to garner
more business under this model. “The real question,” S&P
insisted, “is not whether there are potential conflicts of interest
in the ‘issuer pays’ model, but whether they can be effectively
managed by S&P and other credit rating The effectiveness of such self-regulation will certainly continue to be a primary question as Congress continues its examination of the credit rating industry. Changes in this area, including replacing the “issuer pays” model with an alternative, such as subscriber fees, could have a significant impact on investors, so stay tuned. FDA Prescription Drug User Fee Act Reauthorized; Biogenerics Provisions Fails to be Included in Final Version
President Bush signed into law on September 25 legislation (HR 3580) to expand FDA oversight of prescription drug safety and reauthorize the Prescription Drug User Fee Act. The new law increases the user fees paid by both pharmaceutical companies and medical device companies to the FDA to reduce approval times for new products. The fee increase for prescription drugs will increase by about 25% to $400 million annually. In addition, the new law gives the FDA the authority to require pharmaceutical companies to conduct postmarket clinical trials on drugs that have been approved and to impose fines on companies if they fail to do so. The FDA is also given the power to require new label warnings if problems appear in such trials. Furthermore, companies are required to publicly release the results of all clinical trials that show how well their approved drugs performed. A new computerized surveillance system, designed to try to identify safety problems with drugs that recently have come on the market by scanning insurance and pharmacy claims data to try to identify problems, was also approved. It would replace the current system of reliance on anecdotal reports from physicians and drug companies. The new law would grant six months of market exclusivity to drug makers who conduct studies on new pediatric uses of their drugs, a more generous grant than contained in the original Senate version of the bill, which called for only three months of such exclusivity. But perhaps the biggest disappointment for many was the decision not to include a biogenerics provision in the final compromise bill. Unlike with traditional drugs, which had a generic process authorized by the Congress in 1984, there are no similar statutory provisions establishing a similar scheme for biologic medicines. Thus, there is no generic competition for these drugs. If such biogenerics were available, they could save purchasers billions of dollars. (See April 2007 NCTR Federal e-News) Even though the Senate Health, Education, Labor and Pensions (HELP) Committee had reported a bipartisan compromise bill (S. 1695) in June authored by Senators Edward Kennedy (D-MA), Hillary Rodham Clinton (D-NY), Orrin Hatch (R-UT) and Mike Enzi (R-WY), the House balked at including a provision. Major disagreements between key lawmakers in the House over when and how generic companies should be allowed to launch competing drugs has continued to be a major stumbling block for advocates of an FDA approval process for generic alternatives to expensive biotech drugs. With the loss of the FDA reauthorization as a potential vehicle to
carry such legislation, it is essentially dead for the rest of the year.
Congressman Henry Waxman (D-CA), author of the House version of the
legislation (H.R. 1038), confirmed this prognosis in mid-September in
a speech to the Generic Pharmaceutical Association. Furthermore, it
will be difficult in to move a biogenerics bill as a free-standing measure
in 2008, given the continuing concerns by those in the House who believe
the safety issues raised by the Biotech industry, and the stated opposition
of the Bush Administration. Annual AFT Survey Finds Public Employee
Salaries Rise, But Still Trail Private Sector The median increase in average salaries across the 45 jobs surveyed
was 5.7 percent from 2006 to 2007, which is the highest increase recorded
in the last five years. According to AFT, this faster salary growth
likely reflects the fact that state revenues and spending rebounded
significantly in the last two fiscal years, allowing states to make
up for the deep program cuts enacted during the last national economic
downturn. Despite this year’s higher-than-average salary growth, the AFT study documents that the salaries of most state-employed professionals still trail those of their private sector counterparts. For example, private sector salaries exceed state-employee salaries in 17 of the 20 cases in which job comparisons were made, and in six cases (biologist, buyer, chemist, economist, geologist and lawyer), the gap is 50 percent or more. Across all 20 occupations, private sector salaries are, on average, about 30 percent higher than those of state employees. Of note is the fact that for the eighth consecutive year, the AFT report finds that collective bargaining is a key factor in reducing the private-public sector salary gap. For example, buyers in collective-bargaining states earn 20 percent more than their noncollective-bargaining counterparts, chemists earn 19 percent more and accountants earn 17 percent more. Across all 45 occupations, the collective- bargaining advantage averages about 14 percent. “We still have a long way to go to ensure that all states can recruit and retain skilled professionals for critical public service jobs, but this year’s salary uptick is encouraging,” according to Edward J. McElroy, AFT’s president. “States that are investing in public services and public employees deserve credit for their wise stewardship of public dollars. These investments are the bedrock of safe, healthy and prosperous communities,” McElroy stresses in AFT’s press release announcing the new publication. Congress Examines Impact of Hedge Fund, Private Equity Taxation on Public Pensions; NCTR, NASRA, NCPERS Clarify Positions on Legislation Tax hikes for private equity -- and the potential impact of increased fees on investors, particularly public pension plans, that could result -- continue to be a major focus for the Congress. For example, the Senate Finance Committee held a hearing in early September specifically to examine this issue. While NCTR and NASRA have now made their “no position” position explicitly clear, the unprecedented retraction of an August 24 letter from NCPERS on this hot topic continues to be something of a hot topic itself. On a more upbeat note, public pensions have been given a leadership role in a new Treasury effort to address private equity market issues through “best practices” as an alternative to new laws and regulations. On September 6, 2007, the Senate Finance Committee held a third hearing on the taxation of carried interest and private equity, this time focusing on pension fund involvement with the issue. As Committee Chairman Max Baucus (D-MT) explained, Senators want to know to what extent would any increase in tax liability for fund managers be passed through to investors, and to what extent would this pass-through affect retirees and pension plans. To help answer his questions, the Committee heard from Dr. Alan J. Auerbach, Director, Burch Center for Tax Policy and Public Finance at the University of California, Berkeley; Mr. Donald B. Trone, President of the Foundation for Fiduciary Studies; and Mr. Russell Read, Chief Investment Officer, California Public Employees’ Retirement System (CalPERS). Professor Auerbach explained that it is difficult “to formulate precise predictions regarding the economic effects of increased taxation of carried interest,” but he had concluded that taxing all income from carried interest as ordinary income “would be equivalent to an increase in costs on the order of 10 to 20 basis points annually.” Furthermore, while he conceded that at least some of the burden of a tax increase on carried interest would be passed along to investors, he believed that the split was “unclear.” For example, Auerbach testified, “If half of the tax increase were shifted to investors, this tax burden would imply a reduction of at most around 2 basis points in the annual return on these pension funds’ assets, and quite possibly much less.” The Foundation for Fiduciary Studies is a not-for-profit organization established in September of 2000 to develop and advance practice standards of care for investment fiduciaries. Its president, Donald Trone, told the Committee that even though a tax hike on carried interest would have the impact of reducing the investment’s return, as well as reducing the attractiveness of its expected risk/return profile, he believed that, “[i]n reality, the current, unbridled exuberance for these investment strategies means that a tax increase will have little-to-no-effect on their use.” As Trone explained, “even knowledgeable and responsible investment fiduciaries often are not capable of accurately modeling a hedge fund’s risk/return profile because of the lack of portfolio transparency and the absence of audited track records.” In his view, “Unfortunately, in many cases where fiduciaries have invested in hedge funds and private equity, speculative hubris has supplanted procedural prudence.” Finally, CalPERS’ CIO, Russell Read, explained the CalPERS alternative investment management program and its role in maximizing risk-adjusted returns, providing a hedge against long-term liabilities, and diversifying the overall CalPERS portfolio. As of July 31, 2007, Read told the Senators that the alternative investments portfolio, which accounted for 7.1 percent of total CalPERS assets, had outperformed its public equity benchmark and the CalPERS actuarial rate in all periods, with a one-year return of 28 percent compared with its benchmark of 15 percent; a three-year return of 22 percent against a benchmark of 17 percent; and a 10-year return 8 percent higher than the benchmark. With regard to charges, Read said that these private equity fee structures are currently variable across funds, heavily negotiated, based on a number of factors, and difficult to reduce for the very best General Partners. Therefore, due to the interrelated nature of the economics for a private equity fund, “it is complicated to say generically how a change in one component will impact the total economics,” he explained. “As each fund is individually negotiated, an adjustment to one component will lead to offsetting negotiations on other components,” Read testified. Therefore, as far as fees are concerned, the CalPERS CIO stated that their level was “only one consideration” in the analysis of a private equity investment opportunity. “CalPERS’ historical performance indicates that on a net basis, attractive returns can be generated compared to both its benchmark and the actuarial rate providing incremental benefit to its beneficiaries from investing in the best private equity funds, not the cheapest,” Read stressed. When pressed as to a CalPERS position on pending legislation, he explained that his board is not taking a position on the legislation at this time. Ever since the possibility of increased taxation of private equity managers and public partnerships raised its head, opponents have argued that pension plans in general, and public sector retirees in particular, would pay the price. (See July/August 2007 NCTR Federal e-News) Chairman Baucus had previously stated his belief that such arguments were “overstated,” and the September 6 hearing seemed to confirm this viewpoint, at least in his mind. Baucus observed at the hearing that “hedge funds and private equity funds may need pension funds more than pension funds need private equity or hedge funds.” This means that “hedge funds and private equity funds may not have the economic power simply to pass along increased costs to pension funds,” Baucus suggested. However, an August 24, 2007, letter from the National Council on Public Employee Retirement Systems (NCPERS) to Chairman Baucus and his GOP counterpart on the Finance Committee, Ranking Member Charles Grassley (R-IA), strongly stated otherwise. Writing as “the principal trade association working to protect the pensions of America’s public employees,” NCPERS told the Senators that the legislation the two Committee leaders had previously introduced (S. 1624, to tax publicly traded investment partnerships like corporations), as well as H.R. 2834, a House bill addressing the taxation of carried interest, would have “enormous negative impacts on the economy, public pension funds, and the many public employees who depend on defined benefit pension for their retirement security.” The NCPERS letter said it would be “unreasonable” to think that raising taxes on private equity funds would not “be borne, in some measure” by pension funds. The result would be that “pension plan sponsors will be forced to make up the difference by increasing pension contributions or allowing the unfunded liabilities of public pension plans to increase.” On behalf of NCPERS’ “more than 500 public pension funds,” the letter reminded the two powerful Senators of the “pension beneficiaries who will bear the burden of these tax increases: your states’ first responders, firefighters police officers, teachers, State, county and municipal employees, and members of the judicial system – in short, all of the public employees who serve the citizens of your state.” This letter has now been formally retracted. The Finance Committee was advised in a subsequent September 4 letter from NCPERS President Robert Podgorny that the position NCPERS took in the earlier letter “is not the view of NCPERS’ full membership.” While some NCPERS members feel otherwise, the retraction explained that the majority of NCPERS members do not believe that the two bills in question could adversely affect the public plan community. NCPERS will therefore not be taking a position on the legislation, the letter explains. NCPERS also declined an invitation to testify at the September 6 hearing. NCPERS' original letter came as a surprise to many, as it apparently had not been discussed or shared with other organizations representing public employees, employers, or pension plans. In fact, both NCTR and NSRA have been carefully attempting to remain neutral in the debate over taxation issues related to private equity, and have now issued a joint letter to the Finance Committee on this subject in light of “recent media reports regarding the position of public pensions on this issue.” The NCTR/NASRA letter notes “whenever the Congress considers
policy changes – from tax code adjustments to modifying business
standards or requirements – there is the potential that such changes
could raise costs for an industry, thereby potentially lowering returns
for investors.” However, the letter goes on to state that, “as
State and local officials, we also understand that there is a wide range
of issues beyond that of investor returns Congress must consider as
it contemplates these policy changes.” The letter therefore makes
it clear that the two organizations don't want to interfere with Congressional
efforts to develop tax policy in this area, and that NCTR and NASRA
"neither oppose nor support specific legislation on this issue."
The hedge fund/private equity “wars” could soon be coming to a head, as the House Ways and Means Committee continues to press ahead with plans for a major tax reform bill. As that Committee’s Chairman, Charles Rangel (D-NY), recently told reporters, “If it’s in the [tax] Code, it’s in the bill.” Tax increases on the private equity industry are likely candidates to pay for reforms in other areas, such as the alternative minimum tax (AMT). In addition, the focus on hedge funds and other alternative investment vehicles continues to raise the question in many minds on Capitol Hill as to the appropriateness of their use by public pension plans. For example, at the September 6th hearing on carried interest, Senator Grassley pointed out “there are some pension plans that have an alarming amount of the plans’ assets invested in these risky investments, and in funds that are not registered with the SEC.” He said, “This gives me pause,” noting that “I fear the day that a pension plan goes under because a hedge fund or sectors of the private equity industry go under.” While Grassley also said “I do not believe that pension plans should be prohibited from investing in private equity and hedge funds,” he warned that “plan fiduciaries must tread lightly when assessing the risk and return and the cost associated with these investments.” Senator Grassley earlier this year introduced legislation (S. 1402) to restore the SEC’s authority to require hedge fund registration. In short, regulation of pension fund investments in alternatives such as private equity still very much remains an open question. However, on a more positive note, on September 25, the Treasury Department announced the formation of two advisory groups to address market issues involving private equity, and public pension interests have been given a prominent leadership role. Specifically, CalPERS’ CIO Russell Read has been tapped to head up the investor group, which includes representatives from labor organizations, endowments, foundations, corporate and public pension funds, investment consultants, and non-U.S. investors. Formed under the direction of the President's Working Group on Financial
Markets, an interagency panel whose purpose is to improve the operations
of financial markets, the two advisory groups (the other composed of
asset managers), are charged with developing recommendations for a set
of "best practices" for investors in private pools of capital.
The Investors’ Committee, which Read will chair, is to develop
detailed guidelines covering information, due diligence, risk management,
and reporting in order to enhance market
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