Paying for performance

Public pension funds face the challenge of competing with the private sector to recruit and retain investment talent.

Trustees overseeing billions in pension assets have a constant struggle to find and hire staff in investment positions that command much greater compensation in the market than typical public-sector pay levels.

These trustees must make the case to politicians and the public that competitive salaries for public fund investment professionals are likely to pay off in the long run in lower contributions from taxpayers.

Investment returns provide most of the funding to finance retirement benefits, according to National Association of State Retirement Administrators. Reaching investment objectives makes pension promises more secure by lifting the level of funding, and might reduce needed contributions.

Trustees have a responsibility to make sure their funds perform well by taking advantage of the opportunities in the investment markets to achieve return goals at acceptable risk levels.

Funds need to take some risk to meet their investment objectives, especially in the current investment environment of low fixed-income returns and volatile equity markets. Many seek to meet their investment return assumptions by diversifying into alternative investments, from real estate and private equity to hedge funds and real assets.

As Bernard J. “Jerry” Allen, executive director of the $4.6 billion City of Milwaukee Employes' Retirement System, said, without appropriate professionals overseeing assets, “it's like riding on a freeway in a tricycle. You don't belong there. You don't have the wherewithal to keep up with traffic.”

Funds need to navigate against the headwinds of the markets to reach their destination, their goals. They risk major losses, or at least failing to meet actuarially assumed returns — and thus the need for higher contributions — by sailing in volatile seas without modern navigation equipment, sails, rudder, radar, anchor and the crew to use them effectively.

But pay at many public pension funds hasn't kept up with the market, putting the funds at risk of losing needed talent. To address the situation, some systems have put into place, or proposed, new compensation structures, including incentive pay, to better align the interests of the investment staff and the objectives of the funds.

The $168.5 billion Florida State Board of Administration, Tallahassee, is considering a restructuring of its pay for its 194-member staff. Most of them haven't had a pay raise since 2009. Ashbel C. Williams Jr., executive director and chief investment officer, hasn't had a change in pay since he rejoined the system in October 2008. In 2009, Mr. Williams scrapped the FSBA's incentive pay program because it wasn't well aligned with the interests of the board or staff. The proposed structure could raise the combined annual base salary and incentive award of Mr. Williams by 70.3% to $553,500. That would place him only in the middle of the pay scale for the chief investment officers of the five largest U.S. public funds, excluding the FSBA.

Last December, the $52 billion Massachusetts Pension Reserves Investment Management Board, Boston, approved a compensation structure geared toward helping recruit and retain investment professionals, as reported in Pensions & Investments. And in April, as P&I also reported, 22 staff members of MassPRIM received raises. In a letter about the raises, Michael Trotsky, executive director and CIO, noted “there have been no across-the-board staff compensation adjustments at PRIM since 2006.”

Some public funds face more challenges than others in recruiting and retaining staff. In New York and Boston, among centers of the money management industry, public fund talent can walk across the street to much-higher-paying positions without disrupting their personal lives.

Mary Hobson, executive vice president and managing director of the Colorado office, pensions and benefits practice, EFL Associates, said it's hard to generalize about the competitiveness of pay at public funds. Some public systems pay at competitive levels, while others don't, she said, describing FSBA's current compensation as “incredibly low.” Pay isn't the only driver in attracting talent, Ms. Hobson notes. Public systems can promote their job security and retirement benefits.

Gary Findlay, executive director of the $8.1 billion Missouri State Employees' Retirement System, Jefferson City, wrote in an e-mail in response to a request for comment: “The biggest challenge is competing with the private sector for the talent you need to generate good nominal and risk-adjusted return levels. Maintaining the right talent is critical because every additional dollar in return is one dollar less that is needed from the taxpayers to properly finance retirement benefits. ... The conflicting irony is that it's generally viewed as being OK to pay private-sector people at private-sector rates but not pay comparable talent inside a quasi-governmental organization at even a fraction of those levels.”

Well-structured, competitive compensation is part of good governance. Public funds with less qualified investment staffs risk not meeting their objectives in an environment of ever more complex investment strategies in markets that trade faster.

To meet objectives in investments and funding, trustees have to decide what resources they can bring to bear to compete in the capital markets for talent. Public fund trustees need to develop appropriate governance budgets of necessary resources to oversee their assets, from compensation to system technology. If funds don't have the appropriate governance budgets, they shouldn't move to more sophisticated asset allocations.

Simpler asset allocation might be more appropriate, although it could come with the cost of lower results and lower actuarial assumptions, causing higher contributions. Talent not up to the appropriate level of a fund's structure can raise funding cost by underperforming benchmarks.

To ease public concern, trustees ought to move more of total compensation to performance-based pay. Trustees must take care in designing compensation structures, properly aligning all the interests, especially in incentive compensation, so as to encourage only prudent risk taking. Incentive pay can promote better accountability and oversight of assets and it compels trustees to think intently about investment performance and risk levels.

In addition, trustees need to be more transparent to the public about the design of pay programs and should explain why competitive pay for investment professionals makes sense.

High pay doesn't guarantee outperformance, but without competitive pay, funds become more vulnerable to the costs of underperformance and higher employee turnover, leading to higher contributions.

When funds do outperform, “virtually all excess value (is) retained by the pension fund,” according to a 2009 report by McLagan, a compensation consulting firm and unit of Aon PLC.

That is good for taxpayers and beneficiaries alike. n

This article originally appeared in the June 10, 2013 print issue as, "Paying for performance".