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SPECIAL REPORT FUND GOVERNANCE

Public fund trustees facing host of difficult challenges

Keith Ambachtsheer, KPA Advisory Services
Keith Ambachtsheer believes it’s vital that trustees base stewardship on a long-term outlook and always be ready to ask questions.

U.S. pension boards are under scrutiny — from fees to salaries to investment performance.

Critics frequently point to the composition of the board as a key factor in system effectiveness, while defenders point to crippling legislation or meddling politicians. The list goes on and on.

Out of those discussions, governance has become a hot topic at conferences, retirement boards and statehouses alike.

Every public pension system and trustee is unique, and only the pension system itself can determine what governance approach works best for it, sources said. However, common questions must be asked, they added.

"Fundamentally, governance is decision-making," said Rick Funston, Naples, Fla.-based partner at Funston Advisory Services LLC. "What are the key decisions? Who makes them? What intelligence and insights do (you) need to make ​ the best decisions under the circumstances?"

"Good governance is decision-making aligned with fiduciary duties, and that means having the authority to carry (those duties) out," Mr. Funston said.

Put another way, good governance is a four-legged stool, he said. The first leg is setting the direction of the organization, followed by directing staff and prudently delegating, overseeing what has been delegated, and correcting course when needed.

When it comes to trustee selection, "you want a board that has the requisite skills and experience plus people who can think strategically," said Keith Ambachtsheer, Toronto-based director emeritus of the Rotman International Centre for Pension Management and president of KPA Advisory Services Ltd.

It's important to find trustees who focus on long-term issues, think them through and question management about the degree to which they're doing things, Mr. Ambachtsheer said.

That includes asking questions, he said, such as, "What kind of people are you hiring? Why?" In investments, "Are you insourcing or outsourcing? Why?" In audits, "Are we getting the information as an organization we need to satisfy stakeholders? What kind of information is required to do my fiduciary duty?"

In the past year, governance concerns have been raised at New Mexico Educational, Dallas Police & Fire and Kentucky Retirement Systems.

One concern at the $12 billion New Mexico Educational Retirement Board, Santa Fe, is the system's limited role in investment staff hiring and salary decisions. Currently, the state Legislature sets the headcount, and the state personnel system approves job postings, sets application criteria and gathers applications before passing candidates to the pension fund.

A bill proposed by the pension fund for the 2017 legislative session would have given the executive director the ability to hire and set the salaries of various investment staff members, including the chief investment officer, investment analysts and investment division supervisors, within ranges approved by the fund's board of trustees. The bill died in committee.

"For someone who is in the field, it's easier to assess what we need and how candidates fit into what we need," said Bob Jacksha, chief investment officer at NMERB.

The salaries for the pension fund's investment staff also lag those of other comparable state pension plans "quite severely," which has hampered investment staff retention and the fund's recruitment efforts, Mr. Jacksha said.

One of the fund's two core fixed-income portfolio managers left about a year and a half ago and it has taken that long to find a replacement, Mr. Jacksha said. Although several candidates were offered the position, they turned it down partly because the salary was not competitive, he said. Pension fund executives would like to raise investment salaries to the level of other states.

Mr. Jacksha added the current situation has "definitely constrained (the pension fund) from going any further in internal management or more sophisticated approaches."

Investment staff currently manages internally about $1 billion in fixed income, $2.2 billion in domestic equity and also makes some private market co-investments.

If changes were to be approved by the Legislature, the pension fund would expand its internal management, which could help reduce fees and produce better results, Mr. Jacksha said.

However, "the first goal here is to maintain what we're already doing," he said. Other investment positions outside of fixed income have taken a long time to fill, and the pension fund is not fully staffed, he said.

Jan Goodwin, executive director of the educational retirement board, said the board is determining its next steps.

The experience at New Mexico Educational is not unique and does raise governance concerns, sources said.

When a legislature establishes authority to set a full-time employee count, limit salaries, or restrict the ability of the system to make appropriate decisions, "it makes it difficult to hold the system and its trustees accountable," said Keith Brainard, Georgetown, Texas-based research director at the National Association of State Retirement Administrators.

Rebuilding trust in Dallas

To address concerns about board composition at the $2.1 billion Dallas Police & Fire Pension System, the Texas Legislature last month made major changes. Among them: non-members will make up a majority of the new board. Previously, there were 12 trustees — eight were pension fund members and four were City Council members.

Kelly Gottschalk, the pension fund's executive director, said she believes legislators sought to limit the number of plan participants on the board because of concerns over some of the investment and plan design decisions made under previous boards. She expressed concern, however, that members might now have too little representation.

"Typically it's those people (who) their life depends on their pension in the future that are most conservative and most thoughtful," whereas outsiders might only be involved for a short time and lack a long-term view, Ms. Gottschalk said.

The new board will have 11 trustees — six appointed by the mayor, two who are members of the plan, and three appointed by a nominations committee made up of representatives from each of the pension fund's 11 labor associations, but who cannot be system participants. Elected officials and current city employees — outside of the two member trustees — are prohibited from serving on the new board and all trustees must have demonstrated financial, accounting, business, investment, budgeting, real estate or actuarial expertise, which has yet to be defined. Previously, there were no expertise requirements.

A new investment advisory committee made up of non-members also will be established; its role also has yet to be determined. Currently, investment staff and consultant recommendations are sent straight to the board for their approval.

Ms. Gottschalk said the prohibition on active city officials serving on the board was driven by pension fund participants.

"There is a lot of distrust right now" between the city and pension fund participants, she said. The members believe outside trustees, even those appointed by the mayor, "will do the right thing," while city employees could be conflicted if the mayor wants them to vote in such a way that is not in the best interest of the pension fund, she said.

Sources shared participants' concerns about elected officials or city employees presenting potential conflicts of interest and were in favor of their exclusion on the new board.

Robert D. Klausner, Plantation, Fla.-based principal at law firm Klausner, Kaufman, Jensen and Levinson, said that it remains to be seen if having six mayor-appointed trustees will reopen political issues, but he was optimistic those trustees would focus on their fiduciary mission.

Mr. Funston agreed with Ms. Gottschalk on the importance of having participant trustees, provided that they are thinking not only of their own retirement security, but the retirement security of future generations, he said.

Kentucky moves uncertain

Citing governance and transparency concerns at the $15 billion Kentucky Retirement Systems, Frankfort, Gov. Matt Bevin issued an executive order last year overhauling the retirement system board. The future of those changes, which were mostly codified by the Kentucky Legislature earlier this year, remains uncertain, however, in light of a pending lawsuit against the governor's actions and anticipated recommendations from PFM Group.

PFM Group was hired by the state earlier this year to provide a performance and best practice analysis of all of the state's retirement plans, not just KRS. Final recommendations are expected this summer.

Through his executive order in June 2016, Mr. Bevin disbanded the Kentucky Retirement Systems Board of Trustees, replacing it with the Kentucky Retirement Systems Board of Directors. The new board has 17 directors: the 13 who were on the previous board of trustees and four new appointments by Mr. Bevin, which includes the state budget director. On the previous board of 13, six were appointed by the governor, six were members and one was secretary of the personnel cabinet.

Shortly after the reorganization, two board members and state Attorney General Andy Beshear filed a lawsuit against the governor challenging his power to restructure the board.

While a ruling is pending, the Kentucky Legislature earlier this year codified most of Mr. Bevin's order, including the part of his order that called for six of the 17 directors to have investment experience. Under the previous board, two trustees were required to have investment experience.

David L. Eager, interim executive director for KRS, said he was pleased with the increased number of directors with investment experience.

As a result of their addition, the board now has an asset allocation subcommittee of two trustees interacting with staff almost weekly, he said.

Mr. Eager said he did not consider this micromanagement by the board. The board is providing "very intelligent oversight and guidance," he said.

Mr. Eager was also positive on the expanded size of the board. The retirement system has several committees. On a larger board, it's easier to spread committee responsibilities out so trustees are not overtaxed, he said.

Keith Johnson, Madison, Wis.-based chair of institutional investor services at law firm Reinhart Boerner Van Deuren s.c., said the governor's expansion of the KRS board through an executive order was "highly unusual."

Messrs. Brainard and Klausner said they could not recall any other governors taking the actions Mr. Bevin took last June.

A 'balancing act'

The big governance issues today are "balancing acts," Mr. Funston said.

"How do you balance autonomy with stakeholder engagement? How do you balance oversight by the board with prudent delegation?"

According to Randy Miller, Bloomfield Hills, Mich.-based principal at Funston Advisory, one of the big challenges trustees have is learning to trust, which "culminates in whether trustees have confidence in their staff and their consultants," and see that as a prudent way of carrying out their fiduciary duties, he said.

"Largely in my experience, I find boards of trustees try to do the right thing," Mr. Klausner said. "As long as they are assisted by competent professionals, and as long as the plan sponsor isn't an absentee in the governance of the plan and stakeholders (plan participants) aren't absentees in the management of the plan, it will succeed," Mr. Klausner said. "When one of the major players is uninvolved or disinterested, that's where I see a governance problem." Mr. Klausner's law firm represents more than 150 U.S. public pension plans.

KPA's Mr. Ambachtsheer said while some plans are not addressing governance challenges, he believes that pension funds, overall, are moving in the right direction.

"I think we've gathered enough evidence that makes it increasingly clear that bad governance is very costly, and good governance creates value," Mr. Ambachtsheer said.