Auditor of the State Completes Special Audit of Ohio STRS

Ohio STRS’ receives a clean audit of its operational efficacy in transparency, investment management, cost of living adjustments and usage of regional offices.

Ohio Auditor of the State Keith Faber’s office released on December 29, 2022, a report of its special audit upon the State Teachers Retirement System of Ohio. The report found no evidence of fraud, illegal acts or data manipulation related to funds held in trust by the Ohio STRS system in the 80.9% funded fund, as of the June 30, 2022.

The audit resulted from complaints in a June 2021 Benchmark Financial Services, Inc. report, titled “The High Cost of Secrecy: Preliminary Findings of Forensic Investigation of State Teachers Retirement System of Ohio, Commissioned by Ohio Retired Teachers Association (ORTA).” After obtaining background information about the allegations in interviews and preliminary examinations of records, the state auditor declared a special audit.

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As a defined-benefit pension plan, Ohio’s STRS draws primarily on three sources to fund retiree benefits: employer and employee contributions, both set at 14% of current salary, and investment earnings. STRS can influence only investment earnings, because only the state legislature can change the contribution rates. The STRS Board adopted a 7% assumed rate of return on investments as of its June 30, 2022, actuarial valuation. STRS, like other state pension funds, uses the assumed return rate as its discount rate for valuing liabilities.

Among 29 allegations, BFS raised questioned the calculation and payment of pensioners’ cost-of-living adjustments that the auditor’s report found had been made, a required.

Reviewing allocations made to private equity, allegations were made that the pension had violated the Ohio Revised Code § 149.49 that allots “for an opportunity to inspect or obtain copies of public records related to the pension’s investment managers, investment consultants, performance compliance auditor, investment cost monitor, financial auditor and custodians, as well as board and staff.”

Faber’s report wrote, “Determining Public Records Law violations is beyond the scope of this report,” noting that the Ohio Revised Code § 1333.61 codifies the Uniform Trade Secrets Act. Under this statute, trade secrets are definable by two elements: (1) that the information “derives independent economic value, actual or potential, from not being generally known to, and not being readily ascertainable by proper means by, other persons who can obtain economic value from its disclosure or use;” and (2) that the information “is the subject of efforts that are reasonable under the circumstances to maintain its secrecy.”

According to the auditor’s report, “some PE firms have indicated that they would cease working with pension funds if they are required to disclose the fees they charge.”

“STRS cannot achieve 7% overall portfolio returns using relatively riskless investments such as certificates of deposit (which for example, may currently yield only 0.1% – 4%) or money market funds,” according to the report. “Pension systems must rely on investments posing more risk, such as stocks, real estate, hedge funds, and private equity (PE) funds. STRS attempts to reduce the risk associated with these investments by hiring internal investment staff and outside investment consultants to advise regarding investment goals and strategies, and by using significant diversification, STRS’ classification of PE performance fees as trade secrets” is valid, although Ohio STRS could potentially “negotiate with [its] investment firms to allow more transparency.”

Another allegation against the pension system was that it did not complete its 10-year actuarial review in a timely manner and failed to conduct its mandated 10-year fiduciary audit.

Other accusations against the pension plan included the fact that, “due to conflicts of interest pervasive in the investment consulting industry, it appears that STRS has never received disclosure regarding the specific amounts paid to [investment consultants Callan and Cliffwater] by those investment managers employed by STRS, detailing the specific services provided to those managers.”

Analysis of this accusation by Auditor of the State Faber, disproved the claim, with Faber writing “Callan notifies STRS of potential conflicts quarterly, and external managers notify STRS of conflicts when they arise.” Furthermore, STRS receives annually ADV forms filed to the SEC from consultants, Cliffwater and Callan, in accordance with the Investment Advisers Act of 1940. During the audit, the auditor of the state reviewed ADV Forms filed by Callan and Cliffwater from 2011-2021, and confirmed via inquiry with STRS that there were few material changes noted by either firm and the ones noted didn’t relate to their business with STRS.

STRS’s response to the BFS report, re-iterated by the Auditor of the State report, wrote “Callan discloses a list of money manager clients to STRS Ohio quarterly. These disclosures make clear the types of services Callan could provide to money manager clients and the costs of those services… anyone reading Callan’s Form ADV can determine both the median amount and maximum amount of compensation Callan could receive from its money manager clients.”

The Auditor of the State concluded STRS has a lower overall cost of investments than its peer pensions, as reported by CEM Benchmarking Inc., the industry-standard source for comparing pension plan costs, including fees. This is due to a combination of STRS managing a larger portion of its portfolio internally at a lower cost, as well as paying less than peers overall for fees on external management. The fees STRS paid in 2020 on its AI compares favorably to peer pension averages.

The BFS report stated, “We note with great emphasis that since STRS investment managers may withdraw their fees from pension accounts in the absence of any diligent monitoring by STRS, the risk of looting, i.e., illegitimate withdrawals, is dangerously high, in our opinion.”

The auditor found, “Per review of STRS’ control procedures, STRS has segregated investment purchasing duties among internal staff (investment operations, finance / accounting, and the Executive Director) and two external organizations (GCM Grosvenor and the Ohio Treasurer of State). Duties are sufficiently segregated to mitigate the risk of ‘looting.’”

The BFS report alleged, incorrectly, according to the audit, that are no are no benchmarks established for bonuses, while also alleging that compensation was excessive, citing bonuses being paid out in years where the fund overall investment returns were negative as an example. According to the auditor, when considering average salary and bonus rates at peer pensions where data is available, STRS does not appear to be an outlier. However, Faber advocates that the board, ORSC and legislature should consider whether investment performance bonuses are appropriate for pension systems and, if appropriate, whether legislation should include restrictions surrounding such payments.

The most troubling of the 29 allegations was that the pension failed to make its mandated cost-of-living adjustment increases. The BFS report purported that the pension failed to adjust for any COLA increases in 2013, with no resumption of COLA in the following years. “In 2013, STRS did not pay the annual COLA; in 2014, 2015, and 2016, the COLA was reduced from the promised 3 percent to 2 percent. In 2017, the COLA benefits were reduced to zero,” wrote the BFS complaint.

The report found this, too, an invalid argument, citing Ohio Revised Code § 3307.67(A), which “reduced STRS’ COLA from 3% to 2% beginning after August 1, 2013.”

Furthermore, the STRS board uses their statutory authority to determine when and if to pay COLAs, the auditor found.

“From 2018-2020, suspended their COLA in accordance with their statutory authority, while from 2020-2021 OSHPRS suspended their COLA,” the audit said. “The other Ohio pensions do not have this authority in their statutes.”

At the March 2022 meeting, the STRS Board voted in favor of a one-time, 3% COLA increase to eligible plan retirees, the increase took effect July 1, 2022.