Public employee pension funds have begun to embrace the pay-for-performance approach, common in corporate America and in the institutional investment management world.
Some 60% to 70% of the 10 largest public pension systems might offer incentive pay, according to David A. Morris, managing partner, Heidrick & Struggles International Inc. More and more chief investment officers and other investment professionals on public fund staffs are being offered performance-based pay, he said.
That's a positive step, one needed to attract and keep top investment people in a bull market for such talent, and one already adopted by top-performing college endowments and charitable foundations. The rewards can be enormous, as shown by the fantastic growth of the Harvard and Yale endowments in the past decade.
Exceptional pay is good for the fund and, ultimately, for beneficiaries and taxpayers. That's because it makes the pension promise more secure by raising funding levels, and could provide for benefit raises and reduced contributions. Keeping pay relatively low and bound by tradition of public service can raise to critical level the problem of recruiting experienced and talented investment executives. Inexperienced or untalented investment personnel can actually raise a fund's costs by producing poor investment returns.
The State Retirement and Pension System of Maryland appears to be a case where low compensation is contributing to the difficulty in finding a top-notch chief investment officer to oversee its $35.4 billion fund. It has been without a CIO since February 2006. The position's pay is capped at $143,245, and there is no performance bonus.
At the other extreme is the Teacher Retirement System of Texas, which recently hired T. Britton Harris IV as CIO to oversee its $100 billion in assets. With a base pay of $400,000 and performance-based incentives, Mr. Harris could earn a combined $700,000 in 2010. Mr. Harris is recognized as a talented pension investment professional who had an outstanding record as an executive at Verizon Investment Management Corp. and elsewhere.
A performance-based compensation structure is sensible for all stakeholders. After all, the incentive pay is taken out of excess, or above average, returns and therefore costs beneficiaries and taxpayers nothing, while the fund gets the bulk of any excess return.
Boards have a responsibility to make sure these big pools of capital perform well. They have to compete in the market for talented investment professionals with the expertise to understand a complex array of investment instruments and strategies, as well as how to manage external advisers and the agency issues that arise.
Poorly performing funds will cost states and employees far more in extra contributions in the long run than any incentive pay will.
Boards must structure performance-based compensation with great care, seeking advice from experienced compensation consultants to ensure the pay structure encourages only prudent risk taking.
Performance-based pay forces the board to think more deeply about performance benchmarks and attribution. It fosters greater accountability. It requires setting and carefully monitoring diversification standards and risk tolerances to keep staff from bulking up on risk to raise compensation.
Maintaining the status quo and hiring mediocre investment professionals who will work for mediocre compensation and produce mediocre results to oversee the huge pools of assets in public employee pension funds verges on imprudence.