Needed: New Rules for Pension Boards
When it comes to governance, there's something amiss in California and other states as well.
May was a busy month in the ongoing saga of California's failed system of pension governance. The Securities and Exchange Commission's investigation of CalPERS placement agents was followed by a lawsuit filed by California's Attorney General. The AG's aim is to recover funds, freeze assets and seek damages from the former CalPERS CEO and a revolving-door placement agent whose financial dealings appear suspect. Then, to thrust the issues right back into the trustees' own boardroom, the state's Fair Political Practices Commission has fined a sitting board member a second time for failure to file required disclosure documents in a timely and legal fashion. The commission was reportedly so annoyed that it raised the fine above the original staff recommendation.
So much for any semblance of the duty of care on this board, for prudent behaviors by trustees and for setting an example of governance — while the same board instructs private corporate boards of directors how to conduct their business affairs. After all, they're CalPERS. It reminds me of those old Lily Tomlin skits wherein she says, "Never mind, we're the phone company."
Before I get too wound up, let me say in advance that I respect the good intentions of the current chair of the CalPERS board, the new CEO, the state treasurer in his role as a pension trustee, and at least two of the untainted board members whom I've met professionally. This is not an indictment of the entire board as individuals. Rather, it's my observation that the board culture in this organization is rotten and the process of selecting trustees is obviously broken. Incidents like this don't keep recurring when there is a strong board culture of proper and disciplined governance. (The Los Angeles Times reported a few days ago that the board may now consider censuring the negligent trustee, under a recently adopted policy. It is not yet clear whether such censure would disqualify a trustee from voting or include a board-level request for resignation, as occasionally occurs in the private sector.)
A law that imposes strict personal fiduciary liability on board members who continue to stray will help rein in negligent behavior. If their life savings are placed at risk without the protection of indemnification and directors' insurance, they will clean up their act. Vigilance will become the watchword. The laws should also strip negligent trustees of voting rights and ultimately require their removal for fiduciary violations.
Good governance requires all trustees to discipline their own and not look the other way. Last month, I testified before the state legislature's commission on government efficiency on the need for pension reform. Part of that testimony focused directly on governance. I adapted and expanded its provisions from a previous column on a similar topic that featured the Government Finance Officers Association's recommended practices, so this language provides my latest thinking on the topic. Here's a synopsis of what the fundamental laws must ultimately provide:
• Independent trustees. A majority of a plan's trustees shall be independent of that retirement system and all its participating employers. No independent trustee may be employed by a public agency or be a participant or retiree in the system. No independent trustee may presently be affiliated with a service provider or vendor to the system, or an employee or retiree organization affiliated with the system. At least two-thirds of a board's independent trustees shall be qualified for service as certified or licensed financial, actuarial, accounting, legal, benefits or investment professionals at the time they are selected. All trustees shall be held to the highest reasonable standards of fiduciary law.
• Fiduciary standards. All trustees shall be subject to the highest prevailing fiduciary standards of the Duty of Loyalty, the Duty of Care and the Duty of Prudence with respect to investments, plan governance, and selection of staff and service providers. For this purpose, the Duty of Care shall include thoughtful, comprehensive and impartial consideration of the sustainability of retirement benefits and the consequences of investment underperformance and actuarial mis-estimations. The Duty of Care shall include full consideration of intergenerational equity in reviewing or approving actuarial assumptions and techniques. The Duty of Loyalty shall include recusal or disqualification from voting on any matter in which the trustee has a conflict of interest or a beneficial interest. The Duty of Prudence shall include an obligation to establish and maintain an investment portfolio reserve for market underperformance which may not be used to fund benefits increases, taking into account the current portfolio composition and historical market and business cycles. Trustees who are not disinterested trustees or independent trustees may not be insured or indemnified for actions which are found to constitute a conflict of interest or a breach of fiduciary duty.
• Code of conduct. Subject to approval by the Governor, the Attorney General shall publish a code of conduct to govern public pension fund governance and commercial transactions and relationships. The legislature shall establish or authorize sanctions and penalties for violations of the public pension code of conduct which may include both civil and criminal penalties.
• "Pay to Play" prohibitions. No person or organization may be engaged and compensated as an investment advisor or service provider to a retirement plan board or fund if, within the past five years, that person or organization or any of its employees, officers, partners or agents have made gifts or campaign contributions benefiting or supporting any person presently serving in any capacity related to the system's governance. Campaign contributions by residents eligible to vote for the recipient are exempt from this provision if they do not exceed the candidate's average individual contribution or $500, whichever is less.
One would expect progressive public pension board members to jump at the opportunity to implement best practices, but they won't. Here's why: Pension boards retain attorneys who represent and advise the trustees. No right-minded attorney is going to tell his clients that they should adopt rules that raise their personal or collective liability. It would be like advising a corporate board of directors to waive the corporate veil in matters of litigation — that just isn't going to happen.
Therefore, there are only two ways that these principles will ever be adopted in a meaningful way: The legislatures must enact them into law, or the courts must find in favor of these expanded principles through decades of litigation. Needless to say, the courts won't settle these issues during my career life, so I'm making my case to the only policymakers who can put these rules into action now: the state legislatures. Of course, I'll talk with any governor or policy staffers who would like to get the ball rolling as part of a more comprehensive pension reform initiative. Or any citizen group that advances a realistic ballot initiative for pension reform.
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