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David Hess
  David Hess

Member-Elected Trustees Help to Reduce Public Pension-Fund Abuses

11/8/2005 --

Trustees of public pension plans who are elected by plan members rather than appointed by politicians may help to reduce or prevent pension-fund abuses.

ANN ARBOR, Mich.—A new Ross School study suggests that political problems plaguing public pension fund performance arise from governments using pension assets as safety valves against other budgetary problems—not from shareholder activism or social investing, as some critics claim.

Often government misuse occurs through the subtle manipulation of poorly understood accounting assumptions that can make funds appear more fully funded than they are, says David Hess, assistant professor of business law at the University of Michigan's Stephen M. Ross School of Business.

He says that pension-board trustees who are elected by plan members, instead of appointed by state or local executives, may be able to reduce or prevent public pension fund abuses.

"Member-elected trustees are motivated, accountable to plan beneficiaries, and are independent of political influence," Hess said. "A growing body of empirical evidence suggests they are potentially good stewards of pension assets."

Hess draws his conclusions from an analysis of the impact that boards of trustees and different governance practices have on pension-fund performance. His study, forthcoming in the University of California-Davis Law Review, uses surveys of state and local pension systems conducted by the Government Finance Officers Association and the Public Pension Coordinating Council every other year between 1990 and 2000.

About 90 percent of public pension plans today are structured as defined-benefit plans where employee and government contributions are pooled and these assets are used to pay retirees a benefit based on a set formula. The state or local governments sponsoring the plans are responsible for ensuring that fund assets are sufficient for current and potential liabilities.

However, when economic times are tough and government budgets are pinched, these sponsors often look for ways to reduce their annual contributions, resulting in underfunding of the plans, Hess says. In 2003, 93 percent of all state pension plans were underfunded.

Hess' study finds that controversial investment strategies, such as engaging in shareholder activism (aimed at improving corporate governance at portfolio companies) or using economically targeted investments (intended to benefit the local community), have no effect, positive or negative, on pension-fund performance. Pension systems, he says, are more likely to be shareholder activists when the board is directly responsible for investments, more trustees are member-elected and some of the plan members are unionized.

In contrast, Hess reports that governance structures and practices do have a significant impact on results. He suggests that while member-elected trustees may improve a fund's performance because they are independent of political influence and have greater incentives to perform their duties, they also may lack the expertise necessary to manage a large portfolio. Thus, member-elected trustees generally have a positive impact on fund performance until they hold a certain percentage of board seats, at which point they provide diminishing returns.

Hess finds that executive-appointed trustees (who are most susceptible to political pressures) positively impact fund performance, possibly because they have more investment expertise and are less conservative in their approach. This situation, he says, underscores the need for a well-balanced board rather than one dominated by any particular class of trustees. Pension funds perform worse, study results indicate, when the board is directly responsible for setting the portfolio's asset allocation than when a subcommittee of qualified managers makes those decisions.

"This evidence shows that public pension funds are being abused for political reasons, but that careful consideration of the composition of the boards of trustees, especially the role of member-elected trustees, and their investment practices can lead to positive improvements in performance," Hess said. "There will not be a one-size-fits-all solution to pension governance because the size of the fund, presence of a union and other factors will make a difference."

For more information, contact:
Bernie DeGroat
Phone: (734) 936-1015 or 647-1847