Special Report Legislative Joint Auditing Committee September 14, 2012

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1 INTRODUCTION This report is presented to the Legislative Joint Auditing Committee in response to investment policy and practices identified during the Arkansas State Treasury financial audit for the fiscal year ended June 30, The Treasurer is charged with serving as the custodian of monies as required by Arkansas Code. Historically, the Treasurer has also been responsible for making specific investment decisions associated with state funds held in excess of immediate needs. The State Board of Finance is primarily responsible for the Arkansas State Treasury Investment Policy and the types of investments allowed, as established by Arkansas Code. Changes in the overall investment environment have made it increasingly difficult to maintain adequate safety, liquidity, and return on investment. The rate of return on the Arkansas State Treasury investment portfolio has decreased steadily over the last five years from 5.3% for the year ended June 30, 2007, to 0.78% for the year ended June 30, OBJECTIVES The objective of the report was to review the current Arkansas State Treasury Investment Policy and Treasury investment practices to identify possible opportunities for enhancement. SCOPE AND METHODOLOGY Special Report Legislative Joint Auditing Committee September 14, 2012 Review of State Board of Finance Investment Policy and Arkansas State Treasury Investment Practices Division of Legislative Audit (DLA) staff reviewed the Treasury Investment Policy, Arkansas Code related to Treasury investments, and Treasury cash and investment holdings during the year ended June 30, Additionally, DLA staff analyzed each of the stated Treasury Investment Policy objectives of safety, liquidity, and return on investment to identify possible opportunities for enhancement. Treasury investment practices were compared to investment practices of the State s largest retirement systems for the year ended June 30, The methodology used in conducting this review was developed uniquely to address the stated objectives and, therefore, was more limited in scope than an audit or attestation engagement performed in accordance with Government Auditing Standards issued by the Comptroller General of the United States. ARKANSAS DIVISION OF LEGISLATIVE AUDIT 172 State Capitol, Little Rock, AR Phone: Fax: Report ID: PSSR08412B Report Date: August 23, 2012

2 Review of State Board of Finance Investment Policy and Arkansas State Treasury Investment Practices BACKGROUND The Arkansas State Treasurer is an executive officer of the State, established by the Constitution of the State of Arkansas, and is to perform all duties required by Arkansas Code. The Treasurer is charged with serving as the custodian of monies that Arkansas Code requires to be held in the Treasury, which totaled $3.27 billion in state and federal funds at June 30, As investor of state and federal funds, the Treasurer, pursuant to Ark. Code Ann , is authorized to invest Treasury funds in the manner prescribed by the Arkansas State Treasury Investment Policy, which is approved by the State Board of Finance. The State Board of Finance is composed of the Governor, Treasurer of State, Auditor of State, Bank Commissioner, and Director of the Department of Finance and Administration. The Governor chairs the Board, and the Treasurer of State serves as the secretary. The Board generally meets twice a year to discuss any changes to the Treasury Investment Policy and to approve the rate required for the Treasury certificates of deposit. The current Treasury Investment Policy was adopted June 25, 1997, and has been amended twice. COMPARISON OF INVESTMENT PRACTICES The current Treasury Investment Policy approved by the State Board of Finance states that the objectives of the Treasury s investment practices, in priority order, are safety, liquidity, and return on investment. To meet these objectives, the State Treasurer and designated investment officers will: Seek to ensure the preservation of capital by adhering to all restrictions on the investment of funds by law and the Treasury Investment Policy. Maintain liquidity by seeking to match the maturity structure of the portfolio to reasonably anticipated cash requirements, as well as maintain an adequate portion of the portfolio in readily marketable securities. Optimize the return on investment by structuring the portfolio in such a way that a market rate of return is earned through budgetary and economic cycles within the existing constraints of safety and liquidity. DLA staff compared the Treasury s investment practices associated with each of these objectives with the investment practices of the Arkansas Pubic Employees Retirement System (APERS) and the Arkansas Teacher Retirement System (ATRS). Treasury investment practices were only compared to the fixed income portions of APERS and ATRS because of similarities to Treasury holdings. Other portions of the APERS and ATRS portfolios, such as equity securities and real estate holdings, were not included in the analysis. The results of DLA analysis are presented in the sections below. Safety As noted below, APERS and ATRS receive higher rates of return on investment than does the Treasury, primarily because the current Treasury Investment Policy prohibits the Treasury portfolio from having an average maturity longer than five years; conversely, the bond portfolios of the retirement systems are allowed to exceed 10 years. Further, the Treasury s investments are primarily government obligations, while the retirement systems bond portfolios contain a higher proportion of corporate obligations. Nearly all of the Treasury's government obligation bonds are backed by mortgage-based instruments. Investing exclusively in government obligation bonds could create a concentration risk in the Treasury investment portfolio. Fixed income investments at the retirement systems are historically very safe. The Treasury investment practice of only investing in bonds backed by the U.S. government is an even safer approach. In certain economic situations, depending on the individual investment management decisions made, losses are 2

3 Arkansas Division of Legislative Audit Source: Arkansas State Treasury Exhibit I Arkansas State Treasury Short- and Long-Term Investment Holdings Fiscal Years 2009 through 2011 FY 2011 Holdings FY 2010 Holdings FY 2009 Holdings Description Amount % Amount % Amount % Cash on hand and collection items $ 3,943, % $ 17,869, % $ 6,421, % Demand deposits 207,052, % 214,961, % 195,834, % Money market funds 1,088,400, % 818,141, % 1,417,287, % Total Short-term Holdings 1,299,395, % 1,050,972, % 1,619,543, % Certificates of deposit 418,434, % 705,271, % 789,600, % U.S.-backed bond obligations Note 1 1,491,067, % 1,493,468, % 963,468, % Municipal bonds 15,000, % 15,000, % 0.00% Notes receivable 41,885, % 66,105, % 65,357, % Total Long-term Holdings Note 2 1,966,387, % 2,279,845, % 1,818,426, % Totals $ 3,265,782, % $ 3,330,818, % $ 3,437,969, % Note 1: These obligations consist entirely of bonds issued by the Federal National Mortgage Association (FNMA), the Federal Home Loan Mortgage Corporation (FHLMC), the Federal Home Loan Bank (FHLB), and the Federal Farm Credit Bank (FFCB). Note 2: The current Arkansas State Treasury Investment Policy states that the average portfolio maturity will not exceed five years. possible and have recently occurred in fixed income portfolios at the retirement systems and the Treasury. To authorize the Treasury to invest in longerterm bonds and certain corporate bonds, selected sections of Arkansas Code and the Treasury Investment Policy will need to be changed. Liquidity As seen in Exhibit I, at June 30, 2011, the Treasury held $1.3 billion in short-term cash and cash equivalents (representing 40% of Treasury holdings) that could be accessed at any time for immediate expenses. The percentages of cash and cash equivalents for APERS and ATRS were 2.5% and 1.9%, respectively. DLA analysis indicated that Treasury receipts generally supply most of the liquidity needs of the Treasury. When additional liquidity is needed, it is only for a short period, usually less than one month, and the amount is a very small fraction of the usual balance of cash and cash equivalents on hand. The average balance of cash and cash equivalents on hand was $1.211 billion for the two-year period ending June 30, 2011, and the average total Treasury holdings for this same time period never decreased more than 7.4% ($252 million) or increased more than 6% ($203 million) in any one month. Maintaining excessive amounts of cash and cash equivalents reduces the overall return on Treasury holdings because the rates of return on these accounts are currently less than 0.02%. Assuming Treasury liquidity needs remain constant and funded by current receipts, the balance of cash and cash equivalents on hand could be significantly decreased. For example, based on DLA analysis, subtracting the largest liquidity need based on month-end balances ($252 million) from the average amount of liquidity maintained ($1.211 billion) reveals that excess liquidity of approximately $1 billion was maintained for the two-year period analyzed. If 3

4 Review of State Board of Finance Investment Policy and Arkansas State Treasury Investment Practices $1.0 billion were moved from cash and cash equivalents into U.S.-backed bond obligations earning 2.0% that were held by the Treasury at June 30, 2011, an additional $20.0 million in annual earnings would have resulted. Total Treasury investment earnings were $24.9 million for the 2011 fiscal year. Return on Investment As seen in Schedule 1 on page 6, the five-year average rate of return on fixed income investments at APERS and ATRS was 7.52% and 7.44%, respectively, while the Treasury s rate of return on holdings was 2.74%. Each 1% increase in rate of return on all Treasury holdings at June 30, 2011, would have produced an additional $32.66 million in earnings per year for the State. A modified Treasury Investment Policy could improve the overall rate of return. The September 2012 report titled Arkansas State Treasury Review of Selected Bond Investment Transactions provides information related to certain transactions that reduced the rate of return on Treasury investments. The report also demonstrates the need for more oversight and input from the State Board of Finance and greater segregation of duties in the Treasury investment process. Furthermore, an increase in the Treasury rate of return would benefit the Budget Stabilization Trust and General Improvement Funds that, on average, received 87.40% of the earnings from Treasury investments over the last 10 years. A more detailed description of the distribution of investment earnings is provided in Appendix A on page A-1. OTHER INVESTMENT PRACTICES Some significant investment practices at APERS and ATRS could provide better internal controls over Treasury investments. Specifically, both APERS and ATRS: Contract with investment consultants who advise their boards on ranges and types of investments in their portfolios and assist the boards in assessing risk, evaluating money managers, and developing an overall investment strategy. Contract with money managers to carry out specific investment objectives. Use their boards to periodically review performance targets and approve investment strategy and the hiring of consultants and money managers. The current Treasury Investment Policy allows the use of consultants and outside money managers, but the Treasury does not use these services. Furthermore, the State Board of Finance does not exercise oversight authority over most Treasury investment decisions. DLA analysis of the internal controls related to the investment of Treasury funds indicated a lack of segregation of duties associated with the investment responsibilities of the Treasury. Use of other investment practices by the Treasury, as discussed above, would provide additional information and documentation related to investment decisions. CONCLUSIONS Small increases in the rate of return on Treasury holdings will produce significant increases in earnings for the State. To achieve these increases, the State Board of Finance, the Treasury, and the General Assembly should determine if a slight increase in risk in the investment portfolio is acceptable. Also, the Treasury should evaluate its liquidity needs to optimize overall return on investment. Cooperation from many government offices and multiple branches of government will be essential for changing the State s method of investing Treasury funds. Specific changes to Arkansas law will be required, funding issues will need to be resolved, traditional duties may need to be reassigned or shared, and new policies may need to be developed. However, such efforts could result in a significant, continuous source of revenue for the State. 4

5 Arkansas Division of Legislative Audit The recommendations below are intended to provide general suggestions for improving investment of Treasury funds. The State Board of Finance and the Treasury should consider contracting with an independent investment consultant for a comprehensive analysis of Treasury investments and recommendations for new investment policies and practices. The State Board of Finance and the Treasury should consider placing funds with outside money managers and allowing them to make specific investment decisions within given criteria. The State Board of Finance should consider developing a new Treasury Investment Policy, based on recommendations from an independent investment consultant, with the intent of enhancing Treasury investment options and ensuring the Treasury is obtaining the maximum rate of return on its investments without significantly increasing risk. The State Board of Finance and the Treasury should develop procedures that facilitate the Board serving a more active role in oversight of Treasury investment activities. The General Assembly should consider expanding the composition of the State Board of Finance to include private citizens who are experts in financial investment to allow the Board a greater opportunity to provide experienced financial oversight to the Treasury. Management response is provided in Appendix B on page B-1 of this report and in Appendix A of the September 2012 report titled Arkansas State Treasury Review of Selected Bond Investment Transactions. 5

6 Schedule 1 Arkansas State Treasury Comparison of Rate of Return on Fixed Income Investments With Retirement Systems and National Rate of Inflation Fiscal Years 2007 through 2011 APERS Arkansas Public Employees Retirement System ATRS Arkansas Teacher Retirement System Fiscal Year Five-Year Average 7.11% 4.43% 2.70% 15.19% 8.15% 7.52% 6.30% 6.50% -0.30% 17.40% 7.30% 7.44% Arkansas State Treasury 5.30% 4.10% 2.29% 1.21% 0.78% 2.74% Inflation 2.67% 5.55% -1.98% 1.36% 4.06% 2.33% 20.00% 15.00% 10.00% 5.00% APERS ATRS Treasury Inflation 0.00% -5.00% Source: Arkansas State Treasury, APERS, and ATRS (unaudited by the Division of Legislative Audit) 6

7 Appendix A Treasury Investment Earnings Receipt and Distribution The Treasury s receipt and disposition of interest income are governed by numerous sections of Arkansas Code. Generally, as provided in the Code, interest receipts are credited to the Securities Reserve Fund. The only exceptions are interest receipts on trust fund certificates of deposit (CDs) and interest receipts on the State Treasury Money Management Trust Fund, an investment fund managed for state and local government entities. For trust fund CDs, the interest receipts are credited to the trust fund that provided the investment, and for the State Treasury Money Management Trust Fund, interest receipts are credited to the Fund and subsequently allocated. This process is summarized below. Investment Proceeds (interest, dividends, gains from securities purchased at a discount, etc.) Treasury Trust Fund Account (Trust Fund CD interest) Securities Reserve Fund (returns earned on investments of Treasury general liquidity) Money Management Trust Fund (returns earned on investments made by MMTF participants) The disposition of Securities Reserve Fund interest receipts is governed by Ark. Code Ann (a), (d). This disposition includes transfers into numerous funds. The amounts distributed to most of these funds is determined by the average daily balance of the funds determined each month and other factors, with the monthly residual transferred to the Budget Stabilization Trust Fund and the General Improvement Fund. The 10-year (2001 through 2010) average percentages distributed to each fund are as follows: General Improvement Fund 43.72% Budget Stabilization Trust Fund 43.68% Highway Department Fund 6.34% Treasury Funds (formerly cash funds) 1.68% County Aid Fund 1.36% Municipal Aid Fund 1.36% Game and Fish Fund 1.03% Certain Federal Funds 0.55% State Central Services Fund 0.19% Constitutional Officers Fund 0.09% The General Improvement Fund and the Budget Stabilization Trust Fund receive most of their funding from the Securities Reserve Fund and have both been significantly affected by the recent decline in investment earnings. This decline affects numerous state agencies, institutions, and local governments. The General Improvement Fund provides financing for a variety of projects in both state and local government. State agencies and institutions may lack available funds because of the agency s business cycle. The Budget Stabilization Trust Fund provides relief in many of these circumstances. Agencies borrow and pay back money at different times. Source: Arkansas Code, Arkansas Administrative Statewide Information System A-1

8 Appendix B TREASURER OF STATE RESPONSE TO LEGISLATIVE AUDIT The Treasurer of State s Office would like to acknowledge the Division of Legislative Audit (DLA) for its work in assembling their reports presented to this office on August 22, 2012: Special Report: Arkansas State Treasury Review of Selected Bond Investment Transactions and Special Report: Review of State Board of Finance Investment Policy and Arkansas State Treasury Investment Practices. In today s volatile investment climate, the challenge Arkansas faces requires cooperative efforts to explore possible opportunities for enhancement while providing uncompromising safety, operating liquidity and wealth building yield. Concerning the selected transactions, the State Treasury s goal has always been to provide the best yield for taxpayer dollars using the guidelines in the State Board of Finance Investment Policy. In 2009, because of declining economic conditions, Treasury felt it obligatory to try a different approach to generate more money. One area of consideration for potential yields on the bonds Treasury sold were step up bonds. Based on historical data, none of these bonds ever increased to the higher yield; therefore, selling the bonds at a profit was a logical choice. However, as reported, the yield was not as anticipated due to the low interest rate of the money markets. Treasury has not sold any bonds since February and will not sell again until there are better yields in money markets for the time between purchasing bonds and the actual settlement date. The State Treasury s 40% liquidity is also a concern. As of June 30, 2012, the short-term liquidity percentage was 29.39%. Daily analysis is given to Treasury receipts and expenditures to determine short-term and long-term needs. With additional revenue and expense data from the Department of Finance and Administration, Treasury should be able to decrease the percentage of liquidity even further. The State Treasury will contact DF&A to obtain this information either on a daily, weekly or monthly basis. As currently allowed in the Treasury Investment Policy, DLA s recommendation to hire one or several outside money managers will be considered. In today s changing economic environment, the Treasury s intent is to insure our state receives the highest return on investments while maximizing safety and minimizing risks. The State Treasury will also consider DLA s recommendation that the State Board of Finance play a larger role in Treasury investment oversight. The Arkansas State Treasury will continue to follow the guidelines of the Investment Policy and looks forward to continued discussions with DF&A and the State Board of Finance regarding investment strategies. B-1