AUDIT AND FINANCE

Released June 26, 2000

 

Santa Barbara County Employees’ Retirement System

 

INTRODUCTION

 

The Santa Barbara Civil Grand Jury is mandated under California Penal Code Section 925 to ". . . investigate and report on the operations, accounts, and records of the officers, departments, or functions of the County . . . ."   It was decided some 35 years ago to retain an independent outside auditing firm to audit the County's financial statements.  To avoid duplication of effort, the Grand Jury joined with the Auditor Controller (AC) and the County Administrator (CA) to retain the same independent auditor.

 

The Grand Jury Audit and Finance Report will consist of two sections:

Section I.  The independent audit of the County's general purpose financial statements, including comments and recommendations of the current auditors, KPMG Peat Marwick LLC.

Section II.  Santa Barbara County Employees’ Retirement System

 

INTRODUCTION  Section I

 

To fulfill the statutory requirements of California Penal Code 925, the Grand Jury reviewed all pertinent activities of the Auditor-Controller, staff, consultants and primary interfaces such as the County Administrator and staff.  It also reviewed KPMG’s management letter dated July 31, 1999.

 

CONCLUSION  Section I

 

The Grand Jury wishes to commend the Auditor-Controller, his staff and their able consultant, KPMG Peat Marwick, LLC, for their use and oversight of the standard budgeting process and controls that have performed well for the last three years.

 

INTRODUCTION  Section II

 

SANTA BARBARA COUNTY EMPLOYEES’ RETIREMENT SYSTEM

 

The Grand Jury conducted a comprehensive review of the policies and procedures that govern the management, administration, investment advisory, consulting advisory, fiduciary compliance, and due diligence oversight of the Santa Barbara County Employees’ Retirement System (SBCERS) investment portfolio.  The purpose of this study is to ensure that the Santa Barbara County Board of Retirement is performing its fiduciary obligation to provide prudent investment oversight of the SBCERS investment portfolio on behalf of the current and future plan participants.

 

Grand Jury Finding 1:  The portfolio analytics and investment advisory report are currently provided by separate entities.

 

SBC Board of Retirement Response to Finding 1:  Agree.  Government Code Section 31596(b) relating to the CERL authorizes firms properly licensed to conduct business of a trust company, to serve as a custodian of assets owned by the system.  In addition, Government Code Section 31595 requires the Board of Retirement to discharge their responsibility in a prescribed manner (See recommendation 1).  To insure this fiduciary mandate is met, the Board retains an independent consultant for the purpose of performance measurement and other specialized needs.  This is separate from custodial and investment advisory/management services. 

 

Grand Jury Recommendation 1:  Consolidate the portfolio analytics and investment advisory review so one consultant can produce a single, comprehensive investment review.

 

SBC Board of Retirement Response to Recommendation 1:  Not Be Implemented.  The services provided by a custodian and a pension consultant are separate and distinct.

 

Custodian.  Safekeeping/custody services have been established to protect against potential fraud and embezzlement of assets/securities.  Investment trade executions (purchases and sales) are required to settle through the custodian as an independent third party that holds the  investment instruments in the name of the retirement system. The important characteristics of a quality Global Custodian will eliminate the opportunity of settlement failure, complete the transaction within all the necessary market efficiencies, and compile aggregate data for independent analysis.

 

Consultant.  The constitutional requirement outlined in Government Code Section 31595, contains several provisions.  Specifically, subsection “b” and “c” mandate the prudent person rule and diversification of assets with a minimum risk.  To facilitate this requirement, a pension consultant has been retained for the specific purpose of (1) assisting in the development of investment goals and procedures, (2) asset allocation modeling and characteristics, (3) investment manager allocation guidelines and objectives, (4) performance measurement and benchmark objectives, and (5) ongoing quantifiable scientific review to effectively succeed in reaching stated portfolio expectations.

 

The distinguishing differences between a custodian and consultant are significant and each is a critical component of a complex investment strategy.  To consolidate these functions violates their respective roles.

 

Grand Jury Finding 2a:  The Retirement Fund has exceeded $800 million and the BOS has not created a separate Board of Investment.

 

SBC Board of Retirement Response to Finding 2a:  Agree.  Government Code Section 31520.2 relating to the County Employees Retirement Law of 1937 (CERL), does allow, but does not require a Board of Supervisors to establish, by resolution, a Board of Investments when the assets exceed $800 Million.

 

BOS Response to Finding 2a:  Agree. The Retirement Fund balance is approximately $1.25 billion as of June 30, 2000.

 

Grand Jury Finding 2b:  The BOR not only oversees retirement investments, but must also determine who shall receive disability benefits, giving the appearance of a conflict of interest.

 

SBC Board of Retirement Response to Finding 2b:  Disagrees Wholly.  There is no conflict.  The notion that investing funds and granting benefits, particularly disability, “gives an appearance of conflict,” is certainly unsubstantiated and speculative.  The actuarial impact is not information considered in a disability matter.  This theory challenges the fiduciary responsibility and questions the integrity of the BOR.

 

BOS Response to Finding 2b:  Disagree partially.  We agree that the Board of Retirement oversees retirement investments and determines who shall receive disability benefits.  However, both of these responsibilities have been defined in the County Employees Retirement Law.  The fiduciary responsibility of the Boards of Trustees of 1937 Act retirement systems is outlined in CA G.C. Section 31595(a)(b) and (c).  Government Code sections 31720-31755 define law pertaining to disability retirement matters.  It is apparent that the law perceives no conflict of interest.  The respective Board of Retirement grants disability retirements in each of the twenty 1937 Act counties statewide.

 

Grand Jury Finding 2c:  The current structure of the BOR does not guarantee that Board members possess the financial expertise necessary to adequately supervise the investment portfolio.

 

SBC Board of Retirement Response to Finding 2c:  Disagrees Wholly.  The current structure of the BOR is constituted pursuant to Sections 31520.1 and 31520.3, consisting of nine members and two alternates.  One is the County Treasurer, four are elected by either the general, safety/alternate or retired/alternate employees, and four appointed by the BOS, of which one could be (is) a member of the Board of Supervisors.  In the past BOS appointments have had experience in actuarial matters, investment trust, and bank portfolio management.  Future BOS appointments could continue to have such experience (See recommendation 2).  In addition, there are educational opportunities that the BOR has and will continue to be utilized (See finding/recommendation 3).

 

BOS Response to Finding 2c:  Disagree partially.  The Retirement Board consists of nine regular members and two alternate members. Six are employees (2 general, 1 safety and 1 alternate, 1 retired and 1 alternate, all elected by their peers for 3-year terms); four are appointed to 3-year terms by the Board of Supervisors; and one is the County Treasurer.  We agree that this structure does not guarantee that Board members possess the financial expertise necessary to adequately supervise the investment portfolio.  However, this is the structure established by Government Code 31520.1 and 31520.3 under which all 1937 Act counties are constituted.  To ensure that its fiduciary mandate is met, the Santa Barbara County Retirement Board engages the services of an independent professional consultant to measure the performance of investment managers against established market benchmarks.

 

Grand Jury Recommendation 2c:  The 1999/2000 GRAND JURY recommends that the BOS invoke Government Code Section 31520.2 to establish a Board of Investment for Santa Barbara County Employees Retirement System.

 

SBC Board of Retirement Response to Recommendation 2a,b,c:  The recommendation need not be implemented.  The formation of a Board of Investment (BOI) is not necessary.  The structure is not overtly changed, the suggestion in Finding 2b is unfounded and quantifiable justification has not been established, and would not guarantee adequate supervision under the statutory scheme.

 

With the retirement system being established in 1944, the BOR has had the full fiduciary accountability, and the retirement system has enjoyed strong demographic and financial strength over this period of time.  There are twenty CERL Counties, and their estimated asset total exceeds $60 billion, each having multiple benefit plans, and global investment strategies employing some 375-investment professionals.

 

Los Angeles County represents one half of the assets and one-third of the investment professionals.  Section 31520.2 was introduced into the CERL at their request for business reasons given their membership and asset size, and not to avoid any appearance of conflict.  To date no other CERL County has made the provision applicable.  The remaining 19 average $1.65 billion in assets and 10 professional investment advisors, and are able to discharge fiduciary responsibilities without conflict.

 

As noted in F2c, the structure of the BOI under Section 31520.2 is not radically changed. The nine member Board and one alternate, will consist of the County Treasurer, four elected by the general, safety (alternate) and retired employees, (current elected members will served until future elections are held), and four BOS appointments of individuals having institutional investment experience.  There is no evidence to support that by establishing a BOI adds investment value.

 

BOS Response to Recommendation 2:  The recommendation will not be implemented because it is not warranted.

 

There are 20 county retirement systems under the 1937 Act, sixteen of which have retirement fund balances which exceed $800 million. Los Angeles County is the largest retirement system with over 88,000 active participants and approximately $30 billion in its fund.   Except for the Los Angeles County Board of Investment, the management of each county retirement system is vested in a Board of Retirement.  Most boards of retirement, in carrying out their fiduciary responsibilities in light of the prudent person rule, have hired outside firms to manage their investments.   This is true with Santa Barbara County.

 

In order to better evaluate the Grand Jury’s recommendation, the County Administrator researched total fund performance over the past one, three and five years of all retirement systems that met the $800 million threshold and are authorized to establish a Board of Investments (BOI) under Government Code 31520.2.

 

Our purpose was to compare the performance of counties without a BOI with the performance of Los Angeles County  which has a BOI.   Our research indicates that over a 5-year period, several counties without a BOI equaled or outperformed LA County. The table below shows the portfolio performance over one, three and five years for the 16 retirement systems, which meet the criterion under Government Code 31520.2:

 

Counties With Assets In Excess 0f $800 Million

Annualized Returns for Period ending 6/30/00

COUNTY

ACTIVE PARTICIPANTS

FUND BALANCE (market value)

1 YR RATE OF RETURN

3 YR RATE OF RETURN

5 YR RATE OF RETURN

Los Angeles

88,420

$30.3 billion

15.2%

14.6%

15.7%

Orange

20,357

$4.8 billion

11.85%

12.70%

14.46%

San Diego

16,910

$3.7 billion

15.75%

14.59%

16.02%

San Bernardino

15,529

$3.6 billion

9.74%

12.70%

14.12%

Sacramento

10,547

$3.3 billion

9.54%

13.19%

15.41%

Alameda

9,859

$3.8 billion

10.88%

13.10%

15.36%

Contra Costa

8,475

$2.5 billion

6.6%

13.0%

15.7%

Kern

6,853

$1.4 billion

9.43%

11.4%

13.62%

Ventura

6,840

$2.1 billion

7.2%

12.9%

14.8%

Fresno

5,899

$1.3 billion

8.4%

11.8%

14.0%

San Joaquin

4,835

$1.3 billion

7.93%

10.17%

13.71%

Santa Barbara

4,500

$1.2 billion

6.7%

12.1%

14.5%

San Mateo

4,400

$1.2 billion

6.8%

10.5%

15.3%

Stanislaus

4,281

$900 million

6.58%

10.86%

13.49%

Sonoma

4,236

$928 million

8.78%

12.92%

15.81%

Marin

2,885

$955 million

10.7%

12.7%

15.2%

Notes:

1. Fund balance information provided by Wagerman Associates

2. Rate of return Information on provided by retirement investment administrators of individual counties

3. Rates of return are gross and do not include management fees

 

We concluded that the establishment of a Board of Investments was not a critical factor in managing retirement portfolios as evidenced by the total fund performance of these sixteen systems.   Rather, other factors, such as risk tolerance as evidenced in asset allocation, have a more direct bearing on fund performance.

 


We also noted that Santa Barbara County’s performance is comparable to the performance of counties of similar size as shown in the following chart:

 


We estimate that if a new Board of Investments were established (assuming the new Board would be comprised of four new members, four members holding joint membership with the Board of Retirement and the County Treasurer) it would cost the Retirement system approximately $37,000 per year.

 

Summary

 

The establishment of a Board of Investments is optional and is subject to the Board of Supervisors’ discretion.  We believe that the Board of Retirement is meeting its fiduciary responsibility without any conflict of interest as to granting of disability retirements.  Based on the findings of our survey, we believe that a Board of Investments is not warranted.

 

Grand Jury Finding 3:  Currently the BOR receives one week of investment training.

                       

SBC Board of Retirement Response to Finding 3:  Disagrees Wholly.  The BOR conducts an annual investment and actuarial workshop, in addition to other training items.  BOR members are encouraged to attend ongoing training provided through the System’s membership in the State Association of County Retirement Systems (SACRS) and the California Association of Public Retirement Systems (CALPERS).  BOR members have also received investment training through the Institute for Fiduciary Education (IFE).  SACRS provides two three-day training/conferences each year.  CALPERS provides numerous annual round table training sessions, three of which are directed towards trustee’s development.  Recently the BOR held a governance workshop and identified specific goals and objectives, with future internal training sessions to be expanded.

 

Grand Jury Recommendation 3:  If the Board of Retirement continues to manage the retirement investments, more extensive orientation and ongoing investment training is essential.

 

SBC Board of Retirement Response to Recommendation 3:      Agree.  The level of understanding and education of each BOR member should not only address investments, but also insure a strong and solid fiduciary commitment in all areas of their responsibilities (See Grand Jury Finding 3).

 

2000-2001 Grand Jury Comments

 

The 2000-2001 Grand Jury finds that the responses provided by the SBC Board of Retirement and the Board of Supervisors are defensive rather than constructive.

 

Regarding Finding 2b, the Grand Jury Report indicated “the appearance of a conflict of interest,” not that there was a conflict of interest.  Not withstanding the Board of Retirement’s response, because the BOR is zealous in the matter of investments, there is the appearance of a conflict of interest in their also participating in governing disability benefits.

 

Regarding  Recommendation 2c, the 2000-2001 Grand Jury has noted that a separate Board of Investments is not being considered for the Santa Barbara County Employees’ Retirement System. If the County is to proceed with only one board, those board members should be held to the mandated Board of Investments (professional) qualifications, so that the investment portfolio can receive the attention that it deserves.