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Where Pension Incentive Pay Makes Sense — and Doesn’t

Long-term financial incentives for investment success are commonplace in the private sector, but tricky to design in public retirement plans. The implementation challenges are structural, operational, methodological and, yes, political.

Two hands with palms upright holing a stack of cash wrapped in a bow.
To continue a theme I introduced in my last column, the compensation structures for public pension professionals will need a tune-up if we expect them to deliver superior investment returns. The first steps toward performance improvement don’t require a lot of money — just a willingness to bump up the salaries of those with proven investment IQs as demonstrated through relevant credentialing programs. Beyond that, however, it gets much trickier for the plans seeking to deliver optimal performance in unforgiving and highly competitive capital markets.

In public pension systems, incentive bonus compensation is not unheard of, but relatively rare and virtually nonexistent among smaller and mid-size plans. Senior staff rarely have their jobs or a bonus put on the line for competitive underperformance, so variable and “at-risk” compensation is a foreign idea to many. There’s also a common public-management wariness of the distorting behavioral impact of ill-designed employee incentives that must be addressed. Beyond that, forget about stock options, phantom stock and other “top hat” long-term incentives commonplace in the private-sector investment industry, although there are a few experiments underway in the largest public systems where compensation consultants are trying to help boards navigate these choppy waters.

Most pension systems assign their boards of trustees with ultimate responsibility for the portfolio blueprints and frequently the selection of money-manager firms, or at least for the approval of their contracts. Some have an investment committee consisting of a subset of the full board. Often the sharpest trustees know something about investments, but most never had a comparable role previously. In either model, systems often have non-compensated, non-professional board members making themselves the center of implementation decisions, rather than overseers and independent directors monitoring and assessing those decisions.

Before launching into the prerequisites for a successful incentive compensation strategy, it’s helpful to first exclude the majority of pension systems that are unlikely to beat the averages consistently no matter how hard their staffs may try. Smaller and mid-size plans with limited staffs — whose boards are primarily reliant on the recommendations of investment consulting firms and insist on trustees making portfolio manager selections — are generally going to be unrealistic candidates for achieving portfolio outperformance. They miss the point that trustees can’t objectively and effectively oversee themselves when it comes to measuring and delivering investment performance. Such boards unwittingly trap themselves in circular mediocrity, and many will resist change.

Many of these pensions would likely be wiser to take the approach used by Nevada’s Public Employees’ Retirement System, which emphasizes index funds and accepts attainable market returns at low cost with a lean staff. Playing such a checkers, not chess strategy may be optimal for most public plans, especially the smaller ones. There is nothing wrong with this strategy; all it requires is a sensible assessment of what’s achievable and what’s really not, given the plan’s size, its board and staff expertise, and its decision-making apparatus and culture. Whether the board’s operational strategy is “maximin” or “minimax” when it comes to risk/return decisions, that self-assessment should set the stage for realistic staffing decisions and compensation policies.

Systems that adopt the no-frills staffing strategy can still deploy meaningful six-figure long-term retention incentives (as distinguished from numbers-driven payments for top-tier outperformance) when their boards determine that the chief investment officer has repeatedly maximized the opportunities available to their portfolio. Retention incentives can be designed to include a clawback if something blows up later, such as a personnel scandal or a subsequent huge investment loss.

There is a third option in theory, but it hasn’t widely proven to be cost-effective: to outsource the investment function to private firms that typically charge fees much higher than the cost of internal staff and which score their own successes. For most public pension boards, this outsourced chief investment officer strategy is a bridge too far. I’ll save that topic for another time, knowing that OCIO marketers will instinctively dispute my assessment.

The Major Hurdle

Almost all public systems do employ an independent investment consulting firm to advise the board, and often the staff, in the design of the overall portfolio and typically the identification, screening and monitoring of money management firms that actually run the portfolios. In such a system, it’s hard for anybody to assert that they and they alone are responsible for superior performance.

Public pension systems thus have a major hurdle to clear before they can seriously undertake and defend a plan to award higher, non-traditional compensation to better-performing senior staff members. That’s the perennial problem of performance attribution in a decision-making kitchen that has multiple cooks.

The bottom line of portfolio performance attribution must ultimately come down to who did what, at what level, why, with what impact over relevant time periods, and whether those were good decisions. Public pension plans seldom get all this right, although some do make the effort.

Then there is the optics problem of paying for relatively strong portfolio performance in down markets. One reason to require performance measurement periods longer than a five-year window is that with market cycles of less than seven years, averages are likely to be distorted by recent random market meltdowns. When the performance benchmarks are negative numbers during one of these downturns, you can count on taxpayer groups and pension hawks to go ballistic over the idea of rewarding staff for “losing less.” As the saying goes in the investment industry, “You can’t eat relative performance.” Thus, a properly designed plan needs to anticipate such measurement outcomes, with the solution being that the payouts for losing less should be postponed by design until markets return to positive territory and those smaller losses yield bigger profits.

Thinking Long-Term

There’s also an emerging technology factor in our era of rapidly developing artificial intelligence and machine learning systems. One can envision a future in which a pension compensation consultant using this new technology can custom-design a performance attribution system for each client. That should encompass a pension system’s unique actuarial parameters, investment portfolio premises and strategy, risk and fee tolerances, and staffing and operational structures.

Everybody involved in the process needs to know whose presence and inputs can make a material difference over a multiyear period, why, and ultimately which actually did. Benchmark hurdles must be achievable, rigorous and fair, and there should also be a small handful of independent industry-standard indexes for objective comparisons that cannot be manipulated by self-interested participants who would benefit financially from a “low bar” bogey.

For the major public plans where a pay-for-performance model has a realistic chance of success, the next missing piece of this puzzle is to develop a long-term incentive-and-retention pay plan for top investment staff by measuring, recognizing and rewarding stellar contributions over longer time periods — something in the range of seven or eight years for most systems. Any extraordinary compensation for winning results should be calibrated to disburse a mere fraction of each portfolio’s tangible outperformance over stringent benchmarks that pension watchdogs can embrace.

Few public pension professionals will get rich from these designs. In fact, the average performers should fall short of the prizes, just like average investors in the retail marketplace. However, the stars who clearly contribute megamillions (or more) of hard-won “alpha” investment value — genuine, consistent market-beating returns — should rightfully enjoy a more comfortable retirement income stream than their professional peer-group average. Nobody complains about the huge payouts to successful public university football coaches; is this really that different when the pension system’s stakeholders are the investment world’s playoffs-winning fans?

New Roles for Consultants

For trustees and chief administrators, the first step is to put the topic of performance attribution and long-term incentives on the pension board’s strategic planning agenda. In a professionally facilitated education and discussion session, trustees should focus foremost on policy, strategy and oversight — and take themselves off the player roster. Boards should realign professional responsibilities where the lines are blurry and send purposeful signals to staff leaders as to what will be expected, and materially rewarded, when they outperform Mr. Market.

The successful investment consulting firms should also be celebrated and rewarded for their achievements, as measured in hard numbers: They will have to be objectively successful in fostering both performance and risk mitigation. Performance fees could become an industry norm for larger plans that seek superior, risk-bounded investment outcomes from their consultants. A “collaboration bonus” could also extend to staffers who actively engage with successful consultants, as long as they are not just free-riders.

At the risk of tasking the foxes to build the henhouse, this may be a case where the pension consulting industry’s leaders should convene a technical task force to work with the low-profile state pension investment officers’ network under the auspices of the major national public pension associations. The team could outline a sensible, principles-based analytical framework to calibrate what most professionals would agree to be baseline and superior risk-adjusted multiyear investment performance metrics at the plan level. This could include three or four standard benchmark index formulas that reflect sensible baseline portfolio allocations at the most commonly accepted levels of risk tolerance. Trustees could then pick the one that best matches their portfolio policies, running in parallel to a custom benchmark.

Such an experts’ report should identify what new types of data are needed to perform the analytics, given who is on point in asset allocation; the sourcing, researching, recommending and selection of outside managers; monitoring and mitigating risk; and negotiating fees. They could outline the features of a few alternate compensation plan structures. Then a technical draft can be reviewed and smell-tested by others for feasibility in gaining trustee acceptance and eventually establishing best practices.

Where Less Is More

By now it should be obvious that the public pension performance pay puzzle is far more complicated than just paying higher salaries for effective processes, team building and savvy PR. Success may require a board-level governance consultant to initiate and coordinate the process, before the technical and compensation experts can arrive on stage. My guess is that there are at most 100 public plans nationwide capable of this transition. But they hold the bulk of public fund assets, so this is worthwhile.

For the rest, less is more: Many should instead emulate the no-frills Nevada strategy, to avoid wasting resources by going through unnecessary motions and avoidable costs to no avail. Otherwise, they will continue to resemble roulette gamblers who persistently play and lose despite knowing the house odds, or Lake Wobegon parents who collectively believe that their children are all above average.

Given the megabillions of public funds deployed by these systems, where capital is highly concentrated, a tectonic shift like this would clearly be beneficial but requires leadership. Strong efforts by the prominent national public pension associations and influential governance consultants could help nudge the industry in the right direction(s). But ultimately it’s the trustees, stakeholders and plan sponsors who must look in a mirror and plot their course realistically, one system at a time.

This is the second in a two-column series on financial incentives for public pension investment staff. Read the first installment here.

Governing's opinion columns reflect the views of their authors and not necessarily those of Governing's editors or management. Nothing herein should be construed as investment advice.
Girard Miller is the finance columnist for Governing. He can be reached at
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