Katherine and Richard are Governing columnists with expertise in government management.E-mail: firstname.lastname@example.org
No one knows much about how public pension funds are governed or who's governing them. It's about time we did.
Texas pensions have a problem. Four-fifths of the nearly 100 public retirement plans are underfunded -- not by a thousand dollars here and a million there. All totaled, they're in the hole by $22 billion.
That was enough to catch the attention of Texas Attorney General Greg Abbott. As part of his investigation into the situation, he's found that some of the problem can be traced to mismanagement by the boards of directors. Some boards have been manipulating actuarial assumptions to make their funds appear to be in better financial shape than they are. One board even shifted the interest rate assumption from 7 percent to 10.25 percent, allowing it to reach its goal of increasing benefits and decreasing contributions. But that action also increased the pension fund's long-term liability substantially. In other instances, there were conflicts of interest -- some board members had been hired by investment managers after these firms had contracted with the retirement board. In addition, 10 percent of the plans had failed to file or were late in filing legally required financial reports with the Pension Review Board.
"Inadequate governance," Abbott says, "will cause a pension fund to nose-dive and crash."
The risks are great in states and localities that have fallen into arrears. Connecticut, Indiana, Rhode Island and West Virginia just start the list of states with dramatic pension fund problems. In Illinois, the state pension systems face a $41 billion shortfall, and that's after bonding out some $10 billion in liabilities just four years ago.
Even governments that don't have dramatically underfunded pension plans are facing unprecedented problems in paying for their liabilities, largely as a result of prior years' decisions to put off actuarially required contributions and a more recent phenomenon: the growth in the number of retirees.
Here's one way to understand the current funding pressure: A decade ago, the amount paid out annually by state and local pension plans was $60 billion. Today, it's closer to $150 billion. Here's another calculus: In 1988, Kentucky paid an amount equivalent to 8.2 percent of employee salaries into its retirement fund. For the current fiscal year, it's 16 percent; in five years, it will be 30.7 percent.
The growing anxiety over pension plans and their funding has been exacerbated lately by a new accounting rule that makes clear the huge liabilities states and localities have built for post-retirement health care. There isn't a direct link between pensions and other post-employment benefits but the funding comes from the same place, leading to tension between funding pension plans and funding other post-employment benefits.
Clearly, pension boards are functioning in a more challenging environment than ever, with more sophisticated and varied responsibilities and roles. For instance, statutory or constitutional restrictions on investments other than those with minimal risk -- such as bonds -- have been lifted. That means that public-sector pension plans can place their assets in a broader range of investments. So today, 70 percent of funds are invested in equities, compared with only 39 percent in 1990. Along with the dramatic shift to equities, a growing number of states are trying to juice up returns by putting some of their money in other alternative investments such as hedge funds, which can be a high-risk, high-return investment. "It's not that investing in something with an expectation of higher return is necessarily bad," says Susan Mangiero, president of Pension Governance, a consulting firm. "But you need to do even more in terms of assessing the risk."
Public funds are responsible for managing more than $3 trillion in assets -- money that will or already does pay retirement benefits to as many as 14 million public servants and 7 million retirees and their family members. How that money is managed stands to affect not only those retirees but also the coffers of states and localities themselves, since investment shortfalls put pressure on general budgets to make up the difference. And yet, very little is known, either in or out of government, about the boards -- how they're governed and who's in charge of overseeing the many calculations, estimations and factors that go into managing a public pension fund. When he looks at what's happening in his state, Abbott sees a need to make improvements before things get worse. "Caution flags," he says, "are being raised."
Boards with five, 10 or even 20 members run the pension show in the states and most large cities and counties. There are exceptions: New York State's plans are managed almost exclusively by the state's comptroller -- a situation that Governor Eliot Spitzer and Attorney General Andrew Cuomo are questioning.
While specific board functions vary from state to state, in general boards are in charge of overseeing pension operations, guiding investment policy, hiring investment consultants, making determinations on individual pension issues and approving changes in actuarial assumptions. Aside from periodic cases of outright fraud, most board members are men and women who genuinely wish to do a good job. Often, however, they don't have the necessary skills. As one observer put it, boards tend to be "incompetent groups of competent individuals."
As the funds have grown larger, the choice of individual board members should reflect that need for expertise. But the selection of individuals is often under the control of a pantheon of politically motivated individuals and groups -- seats are reserved for employees, retirees, union members, elected officials and other subsets of groups -- and does not lend itself to careful recruitment of an appropriate mix of different skills. It's much harder for a public board than it is for a private one to look at its current composition, see the potential holes in expertise and go after the skills that are missing.
The various groups from which members can be appointed each have positives and negatives. Union-selected trustees will certainly watch out for the retirees, but they may be less financially savvy. And trustees who hold political office may have a greater incentive to reduce state contributions to pension plans, freeing up money for other endeavors.
On many boards there's an air of foxes guarding the henhouse since many board members are pension recipients themselves. In Illinois, for example, employees and retirees make up more than half the members of most pension boards. In Texas, Abbott found that state and local pensions were dominated by employees. And that's a problem, Abbott says. There is a danger that they will "intentionally or inadvertently game the system."
Bottom line: A balance of representation is desirable, and it's critical to include citizen representatives -- someone outside of government. "When you're not benefiting from the money, you have a different take on it," says Lynn Reed, a board member of Minnesota's Center for Public Finance Research, which came out with a critical report on Minnesota's pension performance last year. "The people who are involved are people of good will, but they don't ask the taxpayer kinds of questions."
Many pension board members simply don't have the appropriate training to understand the plethora of numbers that only an actuary could love. It's not so much a case of cooking the books, as being unable to read the books with any degree of skill. When the Mississippi Public Employee Retirement System conducted a survey of other state systems on behalf of the National Association of State Retirement Administrators, it found that, among the 25 or so systems that responded, only nine plans had any formal education policy for board members, only six had mandatory educational requirements and only one had a mandatory certification program.
Things get particularly tricky when it comes to the nitty-gritty investing decisions. How much money can appropriately be placed in hedge funds? Stocks of local companies? What are the trade-offs in the short term and the longer stretch? Boards are frequently presented with a variety of options by the investment managers they've hired, and millions of people will be affected by these decisions. But one of the integral roles of the board is to apply appropriate oversight to these recommendations.
"Without a level of sophistication, these boards can get swayed by misinformation," says Lance Weiss, senior manager with Deloitte Consulting. Board members may have the right intentions but lack the knowledge or background to make good decisions. "These are people," he says, "who were teachers or state employees and have been retired for 20 years. You start talking about alternative investments, and they're lost."
Investment decisions aren't the only thing that's complicated here. Boards are presented with a wide array of assumptions including projections of investment returns, retiree life span and inflation rates. Each of these is based on enormously complex calculations and can have dramatic impact on the way plans are managed.
Consider the figure used for inflation. The higher that number, the higher the rate of return investments have to achieve to adequately fund a plan. According to the National Association of State Retirement Administrators, of 117 entities surveyed, the range of inflation rates used recently varied from 2.5 percent to 5 percent. Thirty-five based their calculations on an inflation rate of 3 percent or less and 43 believed it would be 4 percent or more. That single percentage point may not seem like a lot, but it can represent hundreds of millions of dollars to a large plan.
Of all the problems that surround pension plan governance, the ones most likely to get attention are conflicts of interest: either on the part of the pension board members themselves or the investment managers they hire.
Pension boards in such localities as Chicago, Philadelphia and Milwaukee County, and such states as Ohio, Illinois and California have encountered conflict-of-interest problems over the past six years as members were accused of accepting perks from investment firms and using influence to procure contracts for campaign donors. Illinois' two-year-old problems involved a former trustee for the Illinois State Teachers' Retirement System who was indicted on charges he sought kickbacks from investment firms. The TRS board subsequently adopted new restrictions and disclosure requirements.
In California, the problem centered on allegations that two high-ranking state officials had steered pension business for the state's teachers' fund to companies from which they received sizable contributions. The retirement fund trustees took relatively dramatic action. They voted to halt business dealings with financial investment firms that contributed large sums to the governor or other elected officials. The new rule limits to $5,000 the amount that firms can give to board members (including the controller, state treasurer and governor) in campaign cash annually, if they want to qualify for investment business.
A Massachusetts commission report looked at this issue in the Bay State and found many red flags. Massachusetts board members were allowed to receive honoraria for participation in conferences financed by investment vendors and sometimes received compensation from individuals or firms that do business with the boards or allowed family members to provide services to the board. Moreover, many members of the more than 100 pension boards overseen by the Public Employees Retirement Administration, according to the Massachusetts commission, "do not possess a full understanding of the importance of competitive bidding and the need to negotiate contracts aggressively." For example, boards were retaining vendors for long periods "without entering the marketplace to ascertain if the vendor remains competitive with others."
While few states can boast solid pension-fund governance, a growing number are taking positive steps toward reform. Ohio, for example, increased education and training of board members. It also changed the composition of the board to remove a couple of elected officials while adding an additional retiree representative and three appointed investment experts.
Some states are looking into ways to cut back on the diverse responsibilities that boards undertake. In a handful of states, the investment function has been separated so that the oversight for all long-term state investments is placed under another entity. The benefit here is that such an arrangement provides focused attention on a very complex topic by men and women with sufficient training.
Arizona took particular care to outline and document the different functions performed by the board and the staff, concluding that it was the top-level functions in which the board needed to be most engaged. "The board's responsibility is to oversee the decision making of management," explains Paul Matson, executive director of the Arizona State Retirement System. But, for that dichotomy to be effective, the board couldn't just get its information from staff. It needed independent sources of information. So the board gets direct feedback from an external auditor, an independent investment consultant and an independent actuary.
In Missouri, continual improvement of pension governance has been an ongoing initiative for the better part of a decade now. It has gotten board members out of the business of day-to-day operations and transferred tasks such as hiring and firing money managers to the staff. This lets the board focus on policy and monitoring performance.
Gary Findlay, executive director of the Missouri State Employees' Retirement System argues that states will be well served by providing a statutory framework that will give boards the capacity to govern in a less political environment. That includes retaining legal counsel separately from the rest of government, hiring independent auditors and setting reasonable compensation levels for the men and women who actually work for the pension system (in an effort to compete adequately with the private sector). As a trade-off for this authority and the delegation of day-to-day tasks to the staff, Findlay says, there needs to be rigorous and transparent reporting of all pension-fund activities so that both the board and the legislature can provide adequate oversight.
The results of such changes in Missouri have been tangible. According to Findlay, the system has reduced turnover in the staff and volatility in its investment returns. It has matched or exceeded the returns experienced by other funds in good markets and has fared considerably better in bad markets.
Maryland is another state that has been making positive changes. In the early days of this decade, its portfolio's performance ranked in the bottom quartile compared with other public-pension plans, according to the Department of Legislative Services of the Maryland General Assembly. One of its investment managers was being investigated by the Securities and Exchange Commission and another was twice indicted for alleged improprieties. The board also had lost $27 million due to a failed computer procurement. After the state hired a consulting firm to make suggestions for reform, the legislature took action to balance the composition of the board -- replacing some employee representatives with members of the public -- and improve expertise. For instance, it added requirements for minimum experience for investment expert trustees and required all board members to receive at least eight hours of investment and fiduciary training each year.
Others have taken similar steps. San Diego, a city that has been brought to the brink of bankruptcy by pension problems, has removed some of the positions that were designated for active and retired employees in favor of individuals with financial expertise.
Education and training of board members has been a focus of reforms in Ohio, Louisiana and Massachusetts. A Reform Initiatives Advisory Committee Report in Massachusetts, for example, encouraged the Public Employee Retirement Administration Commission to require that every board member meet a basic level of education and be subject to an ongoing, continuing certification process concerning their responsibilities as fiduciaries and trustees.
Of course, it's difficult to attract a board member with sufficient expertise if the compensation isn't sufficient. Even at a big fund like CalPers, for example, members are paid $100 a day for meetings that can go on for 10 to 12 hours. And that kind of compensation is par for the course.
Pensions can no longer be regarded as a footnote to government policy. The stakes are huge, both in dollar terms and in the capacity of the public sector to compete for talented men and women to govern those plans.
Although those running pension plans are appointed, it's the elected officials who are accountable -- not for micromanaging pension systems and making decisions but for providing the oversight necessary to ensure that decisions are made honestly and effectively.