CalPERS board wrestling with how to delegate

The sudden departure of CalPERS' CIO has revealed to some board members that they might have been driving from the backseat — despite actions taken last year.

After an exchange of punches and counterpunches in the form of letters by board members about the timing of meetings — regularly scheduled or emergency — and type — open session or closed session — the board tried during marathon meetings held on Sept. 14 through Sept. 16 to turn the car around.

Using power many board members indicated during the meeting that they didn't realize they had, the board turned information items on the agendas into action items. The board also secured significant governance changes, including giving the board shared responsibility with the CEO for hiring, firing and re-evaluating the CIO and, reversing a decision it made late last year, turning the investment committee back into a committee of the entire board.

And there could be more to come as the board wrestles with the fallout from former CIO Yu "Ben" Meng's departure in August. Mr. Meng is now under investigation by the state Fair Political Practices Commission's enforcement division over potential financial conflicts of interest.

The $417.3 billion California Public Employees' Retirement System, Sacramento, isn't the only asset owner to struggle with governance issues as part of a move toward increasing in-house investment management and more direct investments in alternative investments. These moves can require boards to delegate more discretion to staff so that investment personnel can quickly make tactical decisions, such as co-investments and direct investments in alternative investments.

At CalPERS, Mr. Meng and other staff members argued for increasing the staff's investment delegation in March 2019 when the board approved a private equity investment model for making direct investments through an outside entity. That model has since been moved to the back burner.

Since 2018, the CIO has had delegated authority to commit up to $1 billion per private equity investment and up to $1.7 billion per private equity secondary commitment with no limit on the number of investments the CIO may make per year. Other investment staff were given additional investment discretion for private equity as well as real assets in September 2019.

At the heart of many governance dilemmas — including those at CalPERS — is how the board should monitor and oversee policy decisions that are being carried out by staff, but without micromanagement. There is also a question of trust, between the board and its committees and the board and staff hired to carry out day-to-day business.

The board is not there to manage; the board is to set the direction and make sure it is managed consistently with the board's vision, said Rick Funston, managing partner of governance and risk management advisory firm Funston Advisory Services LLC, Bloomfield Hills, Mich. Indeed, it could be a breach of the board's duty of prudence not to delegate duties to experts, he said.

Mr. Funston declined to speak specifically about CalPERS. He also appeared at CalPERS' governance committee meeting on Sept. 15 when he advised keeping the investment committee a smaller committee for the sake of stability since that change had been made less than a year ago.

"Imagine a sailing vessel in a race. Where is the board?" Mr. Funston said. "They are not on the boat."

Getting the governance right is a high-stakes process.

Various studies suggest that stronger board governance generally correlates positively with stronger pension plan performance, said Keith Ambachtsheer, Toronto-based president of KPA Advisory Services and director emeritus, International Centre for Pension Management in Toronto, in an email.

These studies also show that there is a negative relationship between fund investment performance and funded status in the U.S. and the proportion of board members who are either ex-officio-appointed or election-appointed, he said.

Canadian pension funds are less politicized, he said.

"It should not be surprising that Canadian pension plans end up with superior governance processes and financial outcomes," Mr. Ambachtsheer said. "In contrast, given the high proportion of ex-officio/election board selection processes ... it is also not surprising that short-term politics often win out over the long-term 'best-interests' considerations."

At CalPERS, six of its board members are elected, four are ex-officio and three are appointed, he noted.

In Canada, board members candidates are identified by a nomination committee created for the purpose of identifying candidates, who are recommended based on their skills, experience and strategic thinking capabilities, Mr. Ambachtsheer said.

What set the CalPERS board on the road to re-examining its governance was the abrupt resignation in August of Mr. Meng after he reported earlier in the year that he had investments in the stock of two private equity managers and the business development company of a third manager with which CalPERS had invested in the past. The disclosure came as part of a statement of economic interest form he was required to file with CalPERS.

The reports led to an anonymous complaint with the state's Fair Political Practices Commission and are currently being investigated by that agency's enforcement division.

CEO Marcie Frost, who had sole responsibility for hiring, firing and oversight of the CIO, said in an interview before the last week's board and committee meetings that she informed only Henry Jones, the board president, and two committee chairs in April about an internal investigation involving Mr. Meng, as was her practice.

She said she typically informs the full board when an investigation into an executive team member has been completed.

There is no process set forth in CalPERS' governance policy outlining the CEO's duties to report to the board on personnel matters.

CalPERS is considering making changes to its governance policy to delineate when the full board should be notified about investigations into some of its top executives.

The leading practice among the 57 largest U.S. pension plans is to have only the CEO directly report to the board, with the rest of the staff including the CIO reporting only to the CEO, Mr. Funston said.

The reason for this design is so there is a single point of administrative accountability, he said.

While the CEO has authority to hire, fire and compensate staff, the leading practice is for the CEO to consult with the board at various points of time regarding these decisions so that the board is not surprised, Mr. Funston said.

"That is the important differentiator for any system that we see," he said.

On Sept. 15, the board took back a role it had served before 2011 in which it shared with the CEO responsibility for hiring, evaluating, and terminating of the CIO. It also changed its investment committee back into a committee of all 13 board members.

As is CalPERS' custom, most of the debate on the governance issues last week was held at the committee level.

Board members who attended the governance committee meeting voiced concerns with balancing their need for oversight and sufficient information to provide that oversight while at the same time projecting a stable organization by not making quick changes in response to Mr. Meng's resignation.

They also worried about interfering with the rights of confidentiality given state workers by civil service regulations over hiring and firing that govern all of CalPERS staff except for the CEO, as well as overstepping their duty to prudently manage the system while delegating day-to-day to trusted staff.

"A shared responsibility for the hiring and firing the CIO is an appropriate balance to strike," said board member Lisa Middleton during the Sept. 15 governance committee meeting. "I do think it is important we get to a place where we have some stability."

CalPERS is also considering whether to require the next CIO to sell or place in a blind trust any securities that could potentially give rise to a conflict under the relatively narrow strictures of the California Political Reform Act before joining CalPERS.

On Sept. 16, CalPERS' performance, compensation and talent management committee directed staff to do further research and return in November with a proposal to require its next CIO, as well as board members and some staff, to sell or use a blind trust for assets that give rise to a conflict under the state's reform law.

While board members generally voiced support for preventing perceived or actual conflicts of interest, several questioned the mechanics of a blind trust.

"I feel like this is a knee-jerk reaction to oversight failures," said committee member Margaret Brown. "I think we're way ahead because we haven't done the research here."

She said the performance and compensation committee needs more time and information on how other pension funds in the U.S. and Canada handle such issues, whether the proposal would solve the problem and how the proposal would impact CalPERS' recruiting.