The Pension Bonus Conundrum

You get what you pay for -- or don't.
May 7, 2009 AT 3:00 AM
Girard Miller
By Girard Miller  |  Finance Columnist
The finance columnist for Governing.

Last month's news reports carried two stories about large state pension fund executives taking political heat for awarding bonuses to investment professionals despite huge market losses in 2008. It's becoming a familiar chorus: How could you pay them a bonus when the plan lost money?

With all the media hubbub about corporate CEOs, bankers and auto execs pulling down huge bonuses as they ruined their companies and their economies, it's understandable that state politicians would seize the opportunity to grandstand this issue. After all, public pension funds are losing billions of dollars. In Missouri, the highly respected executive director of the state pension fund, Gary Findlay, took heat over their plan's incentive awards and in California, the twin goliath plans -- CalPERS and CalSTRS -- both made news over bonus awards to investment professionals and outgoing executives.

I wrote about this issue in my January column, long before these two latest news stories. It didn't take a genius to see this train a-coming. And my viewpoint remains the same: Public pension funds need to attract the brightest talent they can in the context of public service and living in the goldfish bowl, and that means a portion of their investment professionals' compensation should be performance-based. The trick is how to structure it so that the rewards match or respect the public's perceptions of fairness. Paying out large cash bonuses in a year when the fund has lost 25 percent of its value is not the right match, obviously.

There is an old saying in the investment management business: You can't eat relative returns. It applies to money managers, and it should apply to investment professionals as well. Just because an investment team avoids losses of the magnitude of the market indexes is not sufficient grounds for paying big cash bonuses, even though the long-term returns of the pension fund will ultimately benefit from this favorable relative performance in a down market.

What can be engineered, however, is a deferred compensation structure or a "long-term incentive bonus plan" that awards employees a right to receive an earned bonus (from beating their benchmarks, even in a down year) but payable to them after the market has rallied enough for the public to see some positive returns again. This would be the governmental equivalent of underwater stock options awarded to investment company executives and portfolio managers when their firm's market value has fallen along with the rest of the market. They get their reward by staying with the company through thick and thin, and their stock options are later more valuable when normal conditions resume. The same deferred-rewards arrangement would make sense for public pension professionals. They could be awarded a grant for their performance during market downturns, assuming they actually deserve one by outperforming tough, objective benchmarks and mitigating market losses. But, they can't cash out until the market returns to positive numbers. If that takes two or three years, so be it. Those who are looking for a quick buck are probably not well suited to public-sector portfolio management anyway.

To remain competitive in the financial world where investment talent is well rewarded, it would not surprise me to see some of the state pension funds spin off their investment divisions into separate subsidiary companies that operate on a private-sector model similar to the Vanguard mutual funds' investment advisor. As I understand it, third-hand, the Vanguard portfolio management company is owned entirely by the funds and operates at breakeven (tax-wise) every year, while still paying attractive market-based compensation to their professionals. No taxes are paid at the subsidiary level because they charge only enough in management fees to cover expenses including the bonus compensation. This type of "captive" arrangement might shelter public pension investment professionals from some of the public outcry, by technically removing these people from the public payroll.

A captive investment company for public pension funds might also have other advantages, including the ability to invest other public funds and retirement assets. Interested public officials are welcome to e-mail me for further insights and thoughts along these lines.

Girard Miller
Girard Miller | Finance Columnist |