It started in the waning days of Connecticut State Treasurer Paul Silvester's tenure. That was when he decided to take the state's pension fund in a bold new direction: boost the $19 billion retirement fund's position in private equities. From July 1998 to the end of the year, he placed more than $500 million in retirement money with five private equity funds.

It was Silvester's prerogative. As the sole trustee of the fund, the treasurer had plenty of power to make the move. And it was a smart one. It yielded healthy returns for Connecticut.

For Silvester, however, there was more in the reallocation than just the satisfaction of a job well done. The treasurer had been asking for and taking kickbacks in return for placing state pension money with the five funds.

The FBI investigation that unearthed Silvester's illegal practices spilled onto the front pages of national newspapers. It was quite a shock for the normally staid world of public pension investments.

Around the same time, California State Treasurer Matt Fong was under scrutiny. He had accepted thousands of dollars in campaign contributions for his U.S. Senate bid from some of the equities dealers with whom he dealt as an ex-officio board member of the California Public Employee Retirement System. In one case, Fong received $12,000 from principals in an overseas investment firm with which Fong had advocated investing $325 million in CalPERS money. Fong responded to criticism of his actions by noting that he was only one of 13 voting members on the CalPERS board, and that in accepting the campaign contributions, he had broken no laws.

He hadn't, but the incident ended with public criticism and a diminution in Fong's reputation.

The issue raised by both the Silvester and Fong cases, of course, is whether public pension funds in general are vulnerable to self- dealing, and what might be done to ensure that they are insulated from the impact of fund officials cashing in on the power to invest pension money.

That is exactly the question that officials at the Securities and Exchange Commission decided to mull over in the wake of the Silvester and Fong incidents. What the mulling led to was a draft of new regulations released by the SEC last fall. The rules were aimed at keeping elected officials who might directly or indirectly have some influence over pension investment decisions at arm's length from the financial services companies with which the funds might do business. In the SEC's view, the public employee pension world was vulnerable to the same taint that had earlier sooted the bond-dealing world: a so- called "pay to play" relationship where there was too often the appearance of a quid pro quo when it came to campaign contributions and what firm wound up with a government's business. "An adviser that participates in pay-to-play practices undermines the merit-based selection process established by the public pension plan," the SEC stated in its draft rules.

The SEC recommended that investment advisers be prohibited from doing business with any government for two years after making a campaign contribution to any elected official in that government, and that investment advisers also be prevented from raising money on such a candidate's behalf.

Rules the SEC might view as critically necessary are seen as overkill by most in the state and local pension business. "If I did up a list of the top 100 things for this industry to be concerned about, those things wouldn't even make it," says Gary Findlay, executive director of Missouri's public employee retirement fund, discussing the Silvester and Fong cases. "By and large, state laws address these issues through campaign finance laws, as well as through fiduciary rules within state law or public pension law that make it illegal to reap personal gain from any action taken as a fund trustee."

In arguing against federal regulation, pension fund managers assert that the industry in general is performing well, and that cases of corruption are few and far between. "If you're looking for white- collar crime on which to shine a spotlight," Findlay says, "this isn't the place to shine it."

Among the organizations that wrote the SEC to argue against the new regulations was the Government Finance Officers Association. Gary W. Anderson, executive director of the Texas Municipal Retirement System, and chairman of GFOA's Committee on Retirement and Benefits Administration, contends that in the vast majority of cases, employee retirement systems aren't run by a single individual, elected or appointed, with the kind of sole discretionary investment power wielded by someone such as Connecticut's treasurer. Much more commonly, says Anderson, public employee retirement systems are run by boards comprised of anywhere from a handful to more than a dozen people, few if any of whom hold elective office, and none of whom has any direct control over investment policy.

Second, argues Anderson, there are few areas of internal government business that get more intense scrutiny than public employee pension funds. After all, they are watched very closely by the hundreds of thousands of employees who are counting on the money being there when they retire, not to mention by legislatures, some of which have coveted burgeoning pension fund assets.

In protesting against the SEC regulations, pension fund managers make one fundamental argument above all: If you really want to judge whether the industry needs another layer of rules and regulations, then take a dispassionate look at how the industry has operated overall. According to a report released last April, sponsored by a consortium of government interest groups, including GFOA and the National Conference on Public Employee Retirement Systems, public employee pension funds have never been in better shape. Based on 1999 numbers, public employee pension funds are in aggregate more than 95 percent funded in view of future liability.

One reason for that--besides the stock market's 1990s surge--pension fund managers say is that over the last 15 to 20 years, the funds have become more professionally managed, and those managers have been given greater flexibility in where to invest. To prove their point, fund managers point to a report released in April 1999 by the Center for Retirement Research at Boston College. The report suggests that when the statutory constraints placed on public employee pension investments are taken into account (many jurisdictions, for example, cap what percentage of funds can be invested in high-risk equities, overseas markets, real estate and so forth), public-sector fund managers actually outperformed their private-sector investment managers over the past 10 years.

Still, public-sector money managers do worry about the potential impact of scandals such as the Silvester case, and the question of appearances raised by the Fong campaign-contribution incident. And what they fear is a return to the old days when the behavior and investment practices of public employee funds were tightly circumscribed by overarching laws and regulations. "You can't have a list of rules long enough to stop someone who is bound and determined to line their pockets," says Texas' Anderson. In fact, Connecticut is one of the few states that already has--and had when Silvester was in office--tough anti-pay-to-play rules around for its employee retirement system. Those rules did not, however, inoculate the fund from scandal.

None of this is to say that all public employee pension funds are crisply managed and robustly healthy, says David G. Bronner, the long- time director of the Alabama public employee retirement system. He notes that a small percentage are still woefully underfunded at a time when, given the stock market's 10-year run, they ought to be overflowing with assets. West Virginia's employee pension fund, for example, lags the pack, but a huge part of the reason for that is structural: The fund wasn't allowed to invest in equities until just two years ago. In fact, analyses of underperforming funds traditionally find a typical culprit: ultra-conservative investment standards that hogtie pension fund managers.

Still, Bronner doesn't blithely discount the danger of political influence over pension investment. "In places where politicians are up to their eyeballs in handling investment operations, there's always the potential for a conflict of interest."

Which is why the SEC rules aren't really adequate to the job of preventing conflict of interest, argues John D. Abraham, who follows public pension policy for the American Federation of Teachers. What really needs to happen, he thinks, is for pensions and politics to be severed altogether. That would mean fundamental structural changes in the makeup of many of the boards that oversee retirement funds. "There's no evidence of widespread corruption," acknowledges Abraham, "but in systems where you have elected treasurers and comptrollers overseeing these things, you're just asking for trouble down the road."

Trouble or no, SEC officials at this point seem to be listening to the arguments against new regulations. A year after it issued its proposed pay-to-play rules, the SEC appears to have backed off, and it is now considering a system of voluntary standards developed by the financial services industry.

However, should those politicians that Bronner refers to as "up to their eyeballs" in pension investment decisions fail to keep their eyes on the prize--the long-term health of the funds they oversee--the SEC is no doubt ready to dust off its regulations and apply them.