Governance and Public Pension Returns
Pension boards have an important role in governance, but how does board composition impact returns?
A recently released academic paper by Stanford University's Ashby Monk and Dane Rook argues that institutional investors' identity, or organizational capability, is the key driver of investment returns. They describe three ‘enablers'—governance, culture, and technology—as the differentiating factors that can be used to improve the quality of the inputs—capital, information, people, processes—that drive returns. To test this, they apply this framework to five different traditional “models” (i.e. the Yale model and Canadian model) of institutional investing.
Monk and Rook argue that “to improve long-term performance, investors absolutely need to examine their governance, culture, and technology, as well as ways in which these enablers can be better utilized to improve the quality and combination of their inputs.”
How does US pension governance stack up?
Despite the strong investment performance of most US public pension funds, the governance structure of public pensions is often questioned by the media and public. For example, a recent Bloomberg story inaccurately and simplistically portrayed the current system of governance--where boards are comprised of ex-officio, union and retiree members--as ineffective and leading to subpar performance. Comparing US funds' governance structure to those more common with large, aggregated funds in Canada, the author criticized US trustees broadly for lacking an investment or academic background.
Contrary to the Bloomberg article's conclusions, U.S. public retirement systems governed by members from key stakeholder groups (e.g. unions, retirees, government officials, appointees) are as likely, if not more likely, to be effectively managed than are large, aggregated funds in Canada, Holland and other countries where boards are often comprised of academics and “investment professionals” whose proximity to members and stakeholders may be remote.
US public pensions are hardly overseen by ‘investing novices,' as the Bloomberg article suggests. Nearly 70 percent of US public pension's revenue comes from investment earnings, according to the most recent NCPERS Public Retirement Systems Study.
Authors of the 2019 study, Does Public Pension Board Composition Impact Returns?, noted that “adequate stakeholder representation – i.e., plan participants, government officials, and general public members with a voting presence on the board – contributes to board efficacy by promoting board legitimacy to various stakeholders.”
While it's vital to have the appropriate skill sets to execute fiduciary duties on a board, the growing consensus from researchers is that it's not the only factor in driving returns. Further, investment professionals do not have a crystal ball, as evidenced by the dot com and FTX crashes. Results are not guaranteed.
Public funds' median returns measurably outperformed the vast majority of target date funds that are offered under 401(k) plans, which are of course managed by professionals, for the year-to-date through September 30, 2022 amid volatile markets.
Due to better diversification (and impacts of corporate plan de-risking), the public fund median return outperformed the corporate pension fund median returns by one percent over the 10-years ended June 30, 2022, returning 7.4 percent vs. 6.4 percent respectively. On average, state and local government pension plans returned 8.7 percent for the 30-year period ended in December 2021.
And through effective governance, the majority of state and local plans recovered assets within six years of the Great Recession and have strengthened their long-term sustainability, according to new research from the National Institute of Retirement Security.
How does board composition impact returns?
Pension boards have an important role in governance, but how does board composition impact returns? A 2019 study from the Center for Retirement Research at Boston College looked to answer this question. The study cites existing research that demonstrates having both adequate stakeholder representation and appropriate skills sets and expertise to execute fiduciary responsibilities are key to success.
Researchers created a ‘Board Effectiveness Index' by scoring plans based on implementation of best practices for board structure, composition, size, and member tenure to analyze the relationship between these factors and a plan's 10-year investment returns.
They found a positive relationship between the score and investment performance, with a 1-point increase in a plan's score correlating with a 14-basis point increase in its 10-year investment return. “Given these results, public pension funds may be best served by taking a holistic view of the many aspects of a board that contribute to its effectiveness, rather than focusing on any single feature,” researchers conclude.
No matter the composition of the board, however, ongoing trustee education is important to ensure board members are equipped with the skills needed to effectively fulfill their fiduciary duties. NCPERS offers two programs specifically for trustees—the Trustee Educational Seminar (TEDS) and NCPERS Accredited Fiduciary (NAF) program. Both will be held May 20-21 in New Orleans in conjunction with the 2023 Annual Conference & Exhibition (ACE).