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U.S. Public Pension Fund Governance: How to Balance Expertise and Representation

Caroline Nowacki
Monday, July 6, 2015

Pension funds manage large amounts of money, often for large shares of the population in one locality, and beneficiaries rely on pension payments at an age when other cash flow options are very limited. Therefore, the performance of pension funds has a profound political impact, which can explain why governments want to be involved in their management and oversight. In fact, for historical reasons as well, many of these institutions are part of, or closely watched by governments. On the other hand, pension funds, even when part of government, increasingly and largely fulfill their missions by investing on stock markets. The strategies to reduce risks and achieve higher returns using stock markets have become more and more sophisticated, and pension funds have often took advantage of financial markets’ products by hiring asset managers and consultants. The result though is that our pension funds have the governance, decision-making and accounting mechanisms of governmental institutions, but have an investment strategy that requires the organization of a private investment fund, and should actually have the strategy and governance of a company of its own type: a long-term investor.

The very idea behind defined benefit pensions is that sophisticated institutional investors are better able to bear long-term risks than individual workers. This implies “expertise” from funds’ leaders and employees to skillfully find investments that match these long-term liabilities, provide for short-term payments, and assess and mitigate short and long-term risks while achieving the necessary returns. These funds have a complex investment mission, but in addition, their relationship with government brings them into a world where “representation” is key and where they have to navigate a complex network of stakeholders. From talking with a few US public pension funds board members and staff of various sizes and locations, and drawing upon papers from Ambachtsheer (2007), Clark & Urwin (2007, 2008), and Ambachtsheer & Mac Laughlin (2015), below are a few insights on the challenges of “representation” and “expertise” for boards in US public pension funds.

One of the trickiest mechanisms in pension governance is the fact that the government as employer, and current employees through unions, nominate board members. Both the government and the employees share the interest of having a working pension in the long run, but also have short-term goals that may be as strong.  However, the only mission of the nominated board members is to protect the interests of the silent majority of pension holders. A well-known conflict of interest might arise for board members between pleasing who nominated them and going against them when it serves the long-term interests of pension beneficiaries. The rules and procedures for the board are designed to prevent the short-term interest of stakeholders to prevail, and clearly emphasize the fiduciary duty of the board. People with whom I talked in the USA were very aware of this mission and procedures, took them very seriously and associated emotions and values such as ‘caring’, ‘respect’, and ‘seriousness’ to the role of being a board member. The connection of these board members to employees or government actually reinforced the feeling of duty and the will to follow procedures to do a good job and get peer recognition. The legitimacy of board members nominated by government or the union comes from their representation power more than from their business or financial expertise. Aligned with this vision, board members saw diversity of background as an asset. They could ask questions that experts might not think about and remind staff and consultants of the needs and characteristics of the pension beneficiaries to orientate the strategy, notably its risk profile. As noted by Clark (2007) in a historical study about Trust funds, choosing board members with emotional ties to the fund beneficiaries, pre-existing or built through the rules and culture of the fund, increases the likelihood that they will act with the best interest of the beneficiaries in mind compared to members of private boards primarily incentivized by financial rewards. However, the literature also emphasizes that the will to act right does not guarantee that the board members will have the knowledge and expertise needed to take good business and financial decisions, even when they educate themselves. A board chosen based on qualifications would have better odds at collecting and making sense of information as well as being able to challenge executive management and consultants.

The board has a crucial role of “checks and balances” toward the executive directors of the fund, asset managers and consultants. Currently, according to interviews, a basic financial knowledge as well as the ability to read, process and reflect on large amount of information in a small amount of time were judged sufficient for the job. Through this process, the board ensures that staff and consultants are made accountable for their decisions and actions. However, to ‘whom’ the board is accountable is an issue. The board should only owe their loyalty to pension holders, but pension holders do not really monitor nor have any power over board members. Only the institutions who nominated them can choose to renew their mandate or not. This problem of accountability is widely recognized, and a best practice is now to have an internal assessment and feedback process on the board’s performance. However to judge this performance in the long run without giving too much weight to short-term results is also a challenge. Another way to promote accountability is to build a culture and peer pressure that incentivizes board members to not only follow the procedure but also actively seek and promote strategies to achieve long-term results. This peer pressure and culture can be built among pension funds, but should also be shared with direct stakeholders: the government, employees, retirees, the press etc. The issue is that expertise is needed to formulate the strategy, but representation might be best to convince the government and other stakeholders.

Currently, in the USA, board members tend to separate their role from staff by identifying themselves as a representative authority, and the staff as experts to which investment decisions are delegated. Part of the problem of using a consultant and many external asset managers is that it gives the opportunity for the board and sometimes the executive directors of the fund to transfer a large part of the decision-making authority and therefore of the accountability to the managers. In that case, when short-term results are bad, they can fire the manager, sometimes at the detriment of the long-term vision. Clark identified this tension as “delegation versus deference”. The government as employer and the employees find people close to them as representatives to whom the staff will be accountable. But, since board members are only secondarily chosen for their skills and expertise, board members delegate to consultants and employees the decisions that need to be based on expertise. US Pension Funds’ Board members said that the board has the ‘sole control’ on the strategy, but recognized that the staff, working everyday on the investments’ implementation, is in fact often more influential than the board, who meets only occasionally. In addition, the chairman of the board possesses almost all the decision power, and being influential as a ‘regular’ board member was identified as a challenge. The problem is that expertise and experience is highly needed to support a specific vision and the leadership necessary to design and implement a long-term strategy. It is also necessary to counter short-term pressure coming from government, employees or the media, by explaining and gaining acceptance of the strategy despite results visible only in the long run and not in the short-term. However, the need for leadership based on expertise and on constant communication with the pension’s stakeholders might only be obvious in times of crisis, making most board members and staff unaware of its importance today.

Today’s US pension funds’ boards have their specific advantages: a strong commitment to protecting the welfare of plan beneficiaries and knowledge and connections among the government, which is often necessary to support the well functioning of the fund. As long as the funds are part of government, these characteristics are likely to be the most helpful, and the board might be better off playing a political role and gathering the expertise at the executive directors’ and staff’s levels. Nevertheless, having a counsel of experts advising the board could be a solution to decrease information asymmetry, increase innovation and access to expertise. Some Sovereign Wealth Funds, whose boards are highly political, use these councils of experts to increase access to expertise. An opposite way to increase investment innovation and governance efficiency in these funds would be to separate them from government, as was done in Australia and Canada. There is still government oversight, but there is also a fully professionalized board, and an internal organization that makes these pension funds look more like private funds. Since these funds are detached from government and not connected to plan-holders, there is a risk of misalignment of interests between governance bodies and pension beneficiaries, and additional attention needs to be paid to the incentives of the board and staff, to align them with the long-term interest of the pension beneficiaries.

In conclusion, when working with an inherited form of governance, pension funds should assess whether they might lack in business expertise and experience, or in accountability and ties to the pension holders and stakeholders in the plan. In the first case, the use of a committee of experts to advise the board might be a useful addition. In the second case, adding additional accountability mechanisms building on peer pressure and emotional connections can complement financial compensation to enhance alignment of interests between the fund and its beneficiaries.