Pension systems are responsible for investing billions of dollars annually.
The investment policies pension boards develop and pension system staff implement have direct bearing on the health of pension funds.
Miller (1987, 49) offers a concise conceptual framework of the pension investment process:
An investor’s opportunities, constraints, preferences, and capabilities must be identified and specified explicitly in written investment policies.
Investment opportunities are identified and strategies are formulated and implemented through the purchase of financial securities and related instruments in the marketplace.
The investor’s circumstances, market conditions and relative values of sectors are monitored; results are documented and reported.
Portfolio adjustments are made in response to new objectives and changing circumstances and results.
While this represents a straightforward conception of investment manage- ment, there a number of considerations that affect pension systems’
performance.
16.3.1.1 Pension Board Composition
Public pension systems are normally governed by a board or commission.
Typically, members of pension boards are a mix of members who are elected by plan participants, appointed by elected officials, and ex-officio members (Zorn, 1997; Coronado, Engen, and Knight, 2003). In some jurisdictions, the pension system may be overseen by an individual such as a state or city treasurer, or by an administrative unit such as the human resources or finance department (Cayer, 1995). Still, the board or com- mission format is most common. According to Eitelbrg (1997), pension boards normally average in size from to five to nine members. The composition and size of pension boards are important considerations. For example, the long-term interests of plan participants (as represented by their elected board members) may be in conflict with the short-term political interests of politically-appointed board members (Coronado, Engen, and Kinght, 2003). Also, research shows that boards composed of member- trustees (i.e., board members who are themselves participants in the plan) have an impact on funds’ actuarial assumptions (Mitchell and Hsin, 1997). As for board size, research suggests that board size is an important consi- deration: systems with larger boards tend to invest more in equities and international holdings, and they are more likely to have in-house manage- ment of fund holdings (Useem and Mitchell, 2000). Smaller boards tend to perform better (Useem and Mitchell, 2000).
Regardless of board size or composition, pension members/trustees have a fiduciary responsibility to represent the interests plan members.
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In the private sector, the fiduciary standard is a requirement of federal law, the Employment Retirement Income Security Act of 1974 (ERISA). Since public employers were exempted from ERISA, their fiduciary responsibi- lities are derived from their respective jurisdiction’s laws and regulations (which often use ERISA as a guideline). Basically, serving as a fiduciary means that board members’ actions must be made in the interests of plan participants. Nationwide Retirement Solutions (2003, 8), a private provider of public pension services, has identified five basic principles that fiduciaries should follow:
Act solely in the interest of the plan’s participants and beneficiaries Maintain the plan and its assets for the exclusive purpose of
providing benefits
Act with care, skill, prudence and diligence as a prudent person would act in a similar circumstance
Diversify the plan’s assets to minimize risk unless it is prudent to do otherwise. For a DC plan, this rule means that you must provide sufficient investment choices to allow participants to diversify their account balance to minimize risk
Maintain the plan in accordance with governing laws and the plan documentation.
In some cases, however, members of pension boards may lack finan- cial expertise (Miller, 1987). This potentially undermines the capacity of boards to meet their fiduciary obligations. To counter this, jurisdictions may develop required qualifications (e.g., financial management, experience) for their board members. Jurisdictions may also attempt to ensure their boards have the capacity to meet their obligations by ensuring all board members receive a thorough orientation when first appointed or elected and ongoing financial education throughout their tenure on the board. As this suggests, the size of boards and the composition and capacity of members are important considerations.
16.3.1.2 Pension Plan Investment Policy
A major role of boards governing pension systems is setting investment policy for their respective pension plans. Simply put, ‘‘an investment policy is the retirement plan board’s strategy for developing an asset base to support the plan’s current and future benefit commitments’’ (Eitelberg, 1997, 35).
Given differences in past investment performance, assets and liabilities, tolerances for investment risk, pension management capacity, and political circumstances, pension policies can be expected to vary from jurisdiction to
jurisdiction and from plan to plan. Generally speaking, though, investment policies perform several important purposes, including (Greifer, 2002, 36):
To formalize investment goals
To establish a method for determining and expressing the pension board’s investment philosophy and risk tolerance to both staff and third parties
To clearly demonstrate ‘‘due diligence’’ (that is, that the pension system adheres to a prudent set of procedures)
To serve as a foundation for internal controls
To provide guidance to staff and third parties in order to ensure both proper execution of the investment strategy and legal compliance As this list suggests, pension policies establish the operational framework for pension systems. In fact, so important are pension investment policies that they have been described as being the ‘‘linchpin of public pension investment programs’’ (Greifer, 2002, 36).
A particularly significant component of an investment policy is the asset allocation policy. Asset allocation refers to the broad categories of invest- ments (stocks, bonds, cash, etc.) in which pension funds will invest their assets. Investment policies, which are now ubiquitous in the public pension world (Greifer, 2002), are created by pension boards through an evaluation and development process that varies in terms of analytical rigor (Greifer, 2001; Eitelberg, 1997). In this process, boards examine the resources needed to meet pension plan requirements (e.g., benefits payments, reducing unfunded liabilities, plan expenses) over the near-term (e.g., the next ten years), analyze the risk and return characteristics of various asset classes and asset-class combinations, and adopt an appropriate policy. The impor- tance of asset allocation is evident in research findings that suggest it explains approximately 90 percent of the variation in pension investment performance (Greifer, 2001; Frank, Condon, Dunlop, and Rothman, 2000). It is important to note that the invest policy and its asset allocation policy set the parameters for investing — decisions as to the actual investments made within these asset categories are normally left to pension fund managers (as discussed in more detail below). Also, boards developing investment policies are, in some cases, limited by ‘‘legal lists’’ which are statutory or regulatory restrictions on the types of investments that pension systems are allowed to make. Given the negative effect such restrictions can have on investment returns (e.g., Peng, 2004), most legislative bodies have removed these restrictions in recent years (Petersen, 2002; Lemov, 1998; Peng, 2004).
From a practical standpoint, Greifer (2002) argues that best practice in investment policy includes policies that have breadth, depth, and clarity.
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Breadth refers to the comprehensiveness of investment policy, including coverage of the following categories: statement of goal, purpose, and/or mission; identification of decision makers; statement on managing port- folio risk; statement on managing the risk of individual investments;
statement of performance measurement; guidelines for money managers;
guidelines for other professionals (e.g., investment consultants); legal standards (e.g., the prudent person standard); cost management; and transacting or brokering trades (Greifer, 2002, 37). Depth refers to detailed guidance for these broad categories. Finally, clarity simply means that the investment policy is written and communicated in such a way that it is easily read, understood, and implemented. As this all suggests, investment policies
‘‘play a critical role in both developing and executing investment programs of public pension systems’’ (Greifer, 2002, 40).
16.3.1.3 Investment Strategies: Active versus Passive
Whereas pension boards define investment policy, the actual investment of assets into specific holdings within classes is typically left to professional money managers. These managers may be staff members of the pension system (i.e., ‘‘in house’’ managers) or externally hired money managers.
Regardless, pension managers also are bound to adhere to the ‘‘prudent person’’ standard, meaning that investments are made with the care, skill, and diligence of a prudent person (Zorn, 1997; Mikesell, 2003; Petersen, 1993; Eitelberg, 1997). As reported by Mikesell (2003, 608), the GFOA defines ‘‘prudent investments’’ as those meeting tests of creditworthiness (do the investments meet the retirement system’s credit standards?), liquidity (are investment maturities matched to the pension system’s cash needs?), and market rate of return (are investment yields commensurate with a recog- nized level of risk?).
Generally speaking, there are two approaches to pension investing:
active and passive. An active investment strategy means that pension fund managers focus effort on selecting high-performing sectors of the market and making individual investments (i.e., within the asset allocation limits of their plans’ investment policies). The goal of such an approach is to ‘‘beat the market,’’ that is to produce investment returns that outstrip measures of overall market return (e.g., Dow Jones, Standard and Poor’s 500, and/or Russell 5000 averages). In contrast, proponents of passive investing argue that pension systems are wiser to follow a passive strategy, investing for example in index funds which mirror the overall market or specific sectors (e.g., small- or mid-cap stocks, technology or biomedical sectors, etc.) of the market. The underlying rationale for this approach is the Efficient Market Hypothesis (EMH) which suggests that investors will not be able to sys- tematically outperform the market and that price variations in markets are
basically ‘‘random walks’’ (Adrangi and Shank, 1999; Miller, 1987). If this holds, then hiring money mangers, who attempt to bring market analyses to bear upon investment selection, adds little to the information already reflected in equity prices (Adrangi and Shank, 1999). And, as Petersen (1993) notes, research suggests that, on average, actively managed funds have underperformed the market. Given this, it is not surprising that interest among pension systems in shifting to passive investing has grown in recent years.
Whether funds are invested actively or passively, pensions systems have faced increased demands in recent years. As mentioned previously, a variety of political, economic, and demographic forces have strained government’s resources. Such fiscal stress often leads to pressure on pension systems to produce greater returns on investments: healthy returns on investment help to hold down contributions required of plan sponsors and participants to fund pension benefits (Zorn, 1997; Petersen, 1993). In contrast, lower returns require greater contributions by plan sponsors if the plans are to remain adequately funded. This, in turn, may force budgetary tradeoffs as legislative bodies appropriate required resources, and/or may require raising taxes in order to meet financial obligations.
The practical implication of this is that pension systems have invested increasingly larger portions of their assets in equities. This marks an important investment change for public pensions systems which have traditionally assumed a less aggressive investment strategy. Indeed, con- cerns over investment risk once led most pension systems to invest conser- vatively — to the point of being ‘‘cautious to a fault’’ (Petersen, 1993) — in government bonds. But, being long-term investors, pension systems actually have a high tolerance for risk: ‘‘[O]ne should not lose sight of the fact that pension systems are long-term investors, can absorb risk like few others, and that the long-term results favor a very heavy allocating to equities and other high-yielding investments’’ (Petersen, 1993).
Government’s position as a long-term investor, coupled with the need to produce greater returns on investment, has had an impact on pension investments. For example, Table 16.3 juxtaposes the average percentages invested by state and local government pension systems in various invest- ments categories in FY 2002 and FY 1993. As the table shows, pension systems have shifted a larger portion of their investment portfolios to corporate stocks, growing from roughly 33 percent in fiscal year 1993 to roughly 38 percent in fiscal year 2002. What really stands out, however, is the increase in foreign investment from zero percent in 1993 to almost 12 percent in 2002. Once taboo for public pension funds, foreign investments are increasingly viewed as an opportunity for strong returns and a tool for investment diversification. And with such diversification comes a hedge against investment risk: ‘‘By investing in multiple asset classes, the plan
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sponsor is attempting to cushion the portfolio from market volatility in any single asset class’’ (Eitelberg, 1997, 37).
16.3.1.4 Outside Advisers
As mentioned earlier, pension systems often hire external expertise to assist with the administration of their various plans. This might occur in those jurisdictions, particularly small local governments, where pension systems lack the expertise needed to effectively manage pension investments and benefits. Even in the largest pension systems, the advice and expertise of external financial advisors is routinely utilized. When and where external expertise is required, the typical approach is to acquire it through a compe- titive request for proposal (RFP) process. In a RFP, the jurisdiction publishes an announcement describing the specific financial services needed. The services desired can range from simple advice to full discretionary Table 16.3 State and Local Government Pension Investments
Investment
2001–2002 1992–1993
Receipts % Receipts %
Total securities $1,875,395,501 86.9 $774,844,444 84.2 Government securities 225,584,917 10.5 203,452,928 22.1 Federal Government 224,762,717 10.4 202,923,476 22.0 United States Treasury 153,870,084 7.1 164,960,892 17.9
Federal agency 70,892,633 3.3 37,962,584 4.1
State and local government 822,200 0.0 529,452 0.1
Nongovernmental 1,649,810,584 76.5 571,391,516 62.1
Corporate bonds 352,193,553 16.3 174,446,987 19.0
Corporate stocks 814,835,143 37.8 301,315,623 32.7
Mortgages 20,765,586 1.0 19,458,912 2.1
Funds held in trust 70,422,530 3.3 0 0.0
Foreign and international 254,662,228 11.8 0 0.0
Other nongovernmental 136,931,544 6.4 76,169,994 8.3
Other investments 172,832,778 8.0 68,813,123 7.5
Real property 42,908,542 2.0 23,635,084 2.6
Miscellaneous investments 129,924,236 6.0 45,178,039 4.9 Source: United States Census Bureau (2002). 2002 State and Local Government Employee-Retirement Systems. Washington, DC: United States Census Bureau. (See Table 4: Cash and Investments by State & Local Government). Data are in thousands of dollars. Available at: http://www.census.gov/govs/retire02.html (for 2002 data) and http://www.census.gov/govs/retire02.html (for 1993 data). (Accessed June 11, 2004.)
management of a plan’s investment portfolio. The GFOA (2000) has adopted a policy statement on the selection of outside investment advisors. The GFOA statement stresses the need for a merit-based RFP approach in which the responsibilities of the external advisor are clearly articulated, the criteria for evaluating proposals are determined in advance, the appropriate pool of potential candidates is identified, due diligence is performed on all can- didates, an appropriate recommendation is made to the pension board regarding selection, and a process for ongoing evaluation of the advisor(s) selected is established.
While the favored approach is the merit-based RFP process, the selection of outside advisors can be marred by political considerations. A good example of the controversy that can be created when political considera- tions clash with the standards of professional pension administrators comes from the state of Ohio. In 2003, the Ohio state legislature considered a bill, HB 227, that, if passed, would require the state’s pension systems to direct 50 to 70 percent of their contracts with investment advisors to Ohio-based companies. The idea, reflecting a local preference as discussed in the next section, was to increase the profits of Ohio-based businesses. HB 227 drew immediate opposition from Ohio pension administrators. The Ohio Retire- ment Study Council issued a recommendation against HB 227, noting that its requirements ‘‘mark a significant departure from well-established legislative principles and past precedents that have guided the investment operations (ORSC, 2003) of the retirement systems over decades’’ (ORSC, 2003, 12). Ohio administrators were joined in their opposition by the National Association of State Retirement Administrators (NASRA) which issued a letter opposing the proposed changes to Ohio state elected officials.
16.3.1.5 Social and Economically Targeted Investing
While pension system administrators serve as fiduciaries for plan parti- cipants, occasions arise when they may be pressured or, in some cases, required to invest funds in ways that promote a government’s socioeco- nomic goals. An abundance of anecdotal evidence exists on socioeconomic investing (e.g., Romano, 1995; Leigland, 1992; Coronado, Engen, and Knight, 2003), suggesting that pressure on pension administrators to engage in this type of investing has increased in recent years (Leigland, 1992).
Socioeconomic investing creates controversy because focus is removed from the total return strategy of investing (Leigland, 1992; Cayer, Martin, and Ifflander, 1986). Given their fiduciary responsibilities, pressure for this type of targeted investing can make pension fund administrators, who are
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concerned with maximizing returns, ‘‘as nervous as a bridegroom at a shotgun wedding’’ (Eitelberg, 1994, 40).
Socioeconomic or ‘‘public purpose’’ investing takes on a variety of forms.
Probably the best known is social investing. Social investing involves making investment decisions according to whether investments promote a social purpose or objective: it attempts to penalize activities investors wish to discourage and support activities they wish to encourage (Cayer, Martin, and Ifflander, 1986). Within this category of investments one can include the well-known prohibitions on investing, or ‘‘blacklisting’’
(Petersen, 1993), in South Africa during the era of apartheid. More recently, the California Public Employees Retirement System (CALPERS) announced that its investment managers had to take into account a country’s political stability, financial transparency, record on labor standards, and workers’
rights, resulting in a ban on investment in publicly traded companies in China, India, and several emerging markets (i.e., Indonesia, Thailand, Malaysia, and the Philippines) (Shorrock, 2002).
A second approach, economically targeted investing (ETI), can be defined as ‘‘investments that are selected for the economic benefits that they create in addition to the investment return to the employee benefit plan investor’’ (GAO, 1995, p. 5). The idea of ETI is that pension funds should invest funds within their respective states or localities as a tool for state and local economic development (Coronado, Engen, and Knight, 2003).
Eitelberg (1994) describes rationales both for and against ETIs. Arguments in favor of ETIs include economic opportunity (allowing investors to take advantage of narrow ‘‘niche’’ investment opportunities), maintaining inde- pendence and control (preempting legislative mandates and maintaining pension system control over investments), and general public good (fulfilling the desire to contribute to the community’s economic health).
Conversely, arguments in opposition to ETIs stress fiduciary duty (percep- tions that ETIs conflict with pension funds’ fiduciary duties), staff and administrative reasons (concerns over the amount of staff time associated with running an ETI), resistance to external pressures (fears of losing fund independence), and poor performance and notoriety (ETIs are politically risky because of the attention given to ETI failures relative to successes).
In sum, social and economically target investing represent an important managerial consideration for public pension systems. Such investments create tension between public pension fund administrators, whose focus is on serving plan participants, and public officials and interests who seek to pursue substantive policy objectives (e.g., environmental protection, social equity, etc.) through pension investments. And, importantly, research exists suggesting that these types of investments can lead to a sacrifice of plan assets (e.g., Romano, 1995; Coronado, Engen, and Knight, 2003).
16.3.1.6 Pension Funding
As discussed in Section 16.2, pension benefits (B) are a product of contri- butions (C), plus returns runs on investments (I), minus the expenses (E) of operating the pension system. To this point, much has been said aboutI,but Cis an equally important consideration. As Table 16.4 shows, governments’
Table 16.4 Contributions from State and Local Government Pension Systems
Year/Level
Total Contributions
From Employees
From State Government
From Local Government
Earnings on investments 2001–2002 $38,792,031 $27,544,022 $17,182,861 $21,609,170 -$72,456,581
State 32,059,268 23,006,094 16,795,329 15,263,939 -63,514,230 Local 6,732,763 4,537,928 387,532 6,345,231 -8,942,351 2000–2001 38,844,791 26,437,534 17,594,431 21,250,360 57,940,554 State 32,621,170 21,893,787 17,136,673 15,484,497 39,773,459 Local 6,223,621 4,543,747 457,758 5,765,863 18,167,095 1999–2000 40,155,114 24,994,468 17,546,723 22,608,391 231,900,075 State 33,846,378 20,665,828 17,179,981 16,666,397 192,833,292 Local 6,308,736 4,328,640 366,742 5,941,994 39,066,783 1998–1999 41,733,650 23,565,910 17,147,617 24,586,033 197,865,311 State 33,467,754 19,786,741 16,878,613 16,589,141 166,415,663 Local 8,265,896 3,779,169 269,004 7,996,892 31,449,648 1997–1998 41,850,145 21,834,567 17,957,604 23,892,541 197,631,263 State 34,620,047 18,334,766 17,619,625 17,000,422 159,182,186 Local 7,230,098 3,499,801 337,979 6,892,119 38,449,077 1996–1997 44,901,913 20,930,879 20,588,392 24,313,521 161,223,433 State 36,893,266 17,435,994 20,170,257 16,723,009 133,689,185 Local 8,008,647 3,494,885 418,135 7,590,512 27,534,248 1995–1996 41,522,538 19,372,415 17,294,964 24,227,574 129,561,810 State 32,986,466 16,406,926 16,896,183 16,090,283 106,926,079 Local 8,536,072 2,965,489 398,781 8,137,291 22,635,731 1994–1995 41,011,466 18,599,641 16,607,351 24,404,115 89,231,680 State 31,608,735 15,721,701 16,230,275 15,378,460 75,967,617 Local 9,402,731 2,877,940 377,076 9,025,655 13,264,063 1993–1994 36,772,434 17,341,286 15,874,213 20,898,221 79,180,260 State 29,116,214 14,738,018 15,521,259 13,594,955 66,219,262 Local 7,656,220 2,603,268 352,954 7,303,266 12,960,998 1992–1993 34,991,684 16,137,931 15,186,886 19,804,798 74,812,951 State 27,493,366 13,431,836 14,820,853 12,672,513 62,178,292 Local 7,498,318 2,706,095 366,033 7,132,285 12,634,659
Source: United States Census Bureau (various years). State and Local Government Employee-Retirement Systems. Washington, DC: United States Census Bureau. (See Table 2: Contributions by State & Local Government). Data are in thousands of dollars.
Available at: http://www.census.gov/govs/retire.html (Accessed June 11, 2004.) The Management of Public Pensions g 445