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Public pension funds for state and municipal workers in the United States have accumulated, by most recent estimates, approximately $4 trillion in obligations—roughly one-fourth of U.S. GDP and almost 130 percent of state and local governments’ annual budgets—to fund government workers’ retirements. Actual assets available to fund these obligations, however, total only about $3 trillion, leaving a $1 trillion shortfall that threatens to jeopardize public employees’ retirement security and/or burden the public fiscal situation—potentially squeezing out vital spending on health, education, and infrastructure. In 2014, for example, California governor Jerry Brown signed legislation that will require school districts to increase funding for teachers’ pensions from less than $1 billion in school year 2014–15 to $3.7 billion by 2021. The City of Peoria, Illinois, has seen the share of property-tax receipts that it spends on pension costs swell, from 18 percent in the early 1990s to 57 percent in 2015.
Rather than scale back promised obligations or require current governments to account properly for promised future benefits, public pension plans have often shifted toward riskier asset classes and made aggressive assumptions about investment returns, in the hopes of making up the difference. Unfortunately, public pension funds’ investment strategies in such risky asset classes may have been suboptimal. In a 2015 study for the Manhattan Institute, University of Tennessee finance professor Tracie Woidtke finds that the valuations of publicly traded companies in which public pension funds disproportionately invested their funds departed significantly from those in which private pension funds invested; and that public pension funds’ portfolio companies tended to have lower valuations subsequent to the funds’ investment decisions.
One neglected area of attention in America’s government-worker pension crisis has been the role that pension boards have played in managing—and, in some cases, mismanaging—the retirement systems of states and their localities. A number of prominent failures can be attributed to pension boards. In Detroit, even as the city spiraled toward bankruptcy, its pension board paid out nearly $1 billion in bonuses to retirees. In 1999, the board of the California Public Employee Retirement System (CalPERS), the largest state/municipal public-employee retirement plan in the country, lobbied aggressively for benefit enhancements—money that ultimately contributed to the steep underfunding of California’s public pension system.
To date, little attention has been paid to how board composition and governance might increase the likelihood of such mismanagement: there has been some research (with somewhat inconclusive findings) on governance in the public sector, mostly focusing on the composition of the boards that run state and local pension systems, but almost no research on how the allocation of substantive powers to boards might influence the performance of government retirement systems.
The lack of academic scrutiny of such issues is surprising. Large pension plans are among the investors most actively focused on corporate-governance matters relating to the publicly traded companies in which they invest. Sometimes, such funds have pushed aggressively for procedural-governance mechanisms designed to increase the influence of beneficial equity owners, by eliminating staggered board structures or modifying director-election rules. In other instances, public pension funds have advocated for changes in publicly traded companies’ board structures designed to mitigate agency costs between management and beneficiaries—such as eliminating “inside” director chairmanships or mandating increased director diversity. Finally, state and local pension funds have looked to impose actual substantive limits on governing boards’ powers designed to lower agency costs, typically in the area of executive compensation.
The governance structures of public pension funds also often lack many features that such funds champion for private companies. In some instances, board diversity is completely nonexistent—as in New York State, where the public-employee pension plan’s sole fiduciary is a single elected official. In other cases, governance boards are wholly dominated by “insiders”—in this case, public-employee union members, whose interests may diverge from plan beneficiaries’ and taxpayers’. Board members charged with countering such inside interests on behalf of the broader public are often elected officials with larger mandates that may conflict with plan soundness and public protection, particularly in light of conflicting incentives brought about by public-employee unions’ electoral influence.
In addition to questionable board composition, the boards of government retirement plans often wield considerably more substantive power than their counterparts in the private sector. One survey found that 68 percent of public retirement boards have some control over benefit decisions. The survey also found that 88 percent of government pension boards exercised direct authority over the investment decisions of their funds, and 89 percent controlled the funds’ actuarial assumptions, which are key components in calculating the funding levels and risks that a plan faces. In contrast, under the federal Pension Protection Act, private-employer pension plans must discount projected future liabilities using market-based discount rates based on high-quality corporate bond yields; benefit payouts are limited for any plan less than 80 percent funded (deemed “at risk”); plan assets cannot be valued over more than a two-year “smoothing cycle”; and plan sponsors have to make up shortfalls within seven years. As such, private-employer sponsors of defined-benefit pension plans’ actuarial and benefit decisions are sharply cabined, while plan sponsors have powerful incentives to limit investment volatility risk in their portfolios.
Public-employee pension-fund board members have sometimes lacked the expertise to make sensible decisions in these crucial areas. In other cases, boards have based their policies not on the best interests of those they are supposed to represent, including taxpayers, but on the influence exerted on boards by prominent special interests, including powerful elected officials and unions. Some of the largest public pension funds, including those for California employees and teachers and those for New York City and state employees, have placed substantial emphasis on social, political, and environmental concerns in managing their portfolio investments. Woidtke’s research shows that public pension funds that embrace such strategies through shareholder-proposal activism have seen significantly lower company valuations in their portfolios than those that have not, at least for certain periods.
In the past several years, states and localities have passed dozens of pieces of legislation seeking to reduce their pension debt. But little of this legislation focuses on reforming the way pension systems are governed. Crucial reforms are still needed.
James R. Copland and Steven Malanga are Senior Fellows at the Manhattan Institute. This article is a summary of a larger study with the same title, available here.
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