Public pension funds underperformed their own return assumptions built into their funding calculations for the fiscal year ended June 30. During this period, state and local pension plans with more than $1 billion in assets earned a median return of 6.79%, as compared to their projected median long-term return of 7.25%, according to the Wilshire Trust Universe Comparison Service.
As a result of lower investment returns together with insufficient contributions by sponsoring governments, public pension plans are facing a funding crisis. State and local pension plans are reporting assets less than 73% of what's needed to meet their projected obligations to pay retirement benefits.
The Federal Reserve has estimated that state and local governments have unfunded accrued pension entitlements of more than $4 trillion.
In an effort to bridge this funding gap, public pension funds have shifted more assets to riskier investments and from traditional bond portfolios. In the year ended June 30, TUCS data show, large public pension plans held a median of 11.5% of their assets in alternative investments such as private equity and another 4.5% of their assets in real estate.
However, a careful study by three distinguished academics has shown that alternative investments by public pension plans systematically underperform if their boards of trustees are dominated by state officials, and to a lesser extent by trustees elected by plan participants. To improve the performance of their pension funds, state and local governments should increase the percentage of independent public trustees with investment expertise.
This study analyzed alternative investments by 212 public pension funds in 3,959 limited partnerships, which raised capital starting in the years 1990 to 2011. Alternative investments were defined to include private equity, venture capital and real estate.
The study focused on alternative investments for several reasons. Over the past decade, public funds have been upping allocations to alternative investments, which typically are organized as private limited partnerships. Due to that format, alternative investments have a low level of transparency so they are particularly vulnerable to political and other non-financial influences. Finally, there is a big difference between the top and bottom performers in each type of alternative investment.
The study divided the boards of public pension plans into multiple categories. The four key categories were: state ex officio (25.4%) — state officials serving due to their government positions; state appointed (7.6%) — state officials appointed by other state officials; participant elected (27%) — generally, current or former employees of the governmental unit; and public appointed (24.6%) — generally, professionals from the local finance industry.
The study found that three of the four key categories of board trustees were significantly correlated with a lower net internal rate of return on the fund's alternative investments. The one bright spot was the category of public appointed trustees. In specific, the study found that:
- A 10% increase in the portion of state-appointed board members was significantly associated with almost a 1% lower annual IRR on fund alternative investments.
- A 10% increase in the portion of state-ex officio board members was significantly associated with over a half of a percent lower annual IRR on fund alternative investments.
- A 10% increase in the portion of participant-elected members was significantly associated with over a quarter of a percent lower annual IRR on fund alternative investments.
What factors explained the underperformance of public pension funds with a high portion of trustees who are state officials, either ex-officio or appointed by other state officials?
Most importantly, such pension funds tend to overweight in-state investments — which provide support to local economic development, but deliver lower returns than other investments of comparable risk. Such pension funds also tend to invest in partnerships of smaller size, managed by less experienced general partners.
In addition, political contributions from the finance industry were a significant cause of underperformance for public pension funds with a high portion of trustees who were state officials. For example, for every $100,000 in political contributions from the finance industry, pension funds experienced a worse net IRR of 0.28%. Those contributions seem to have adversely affected the choice of alternative investments by such boards.
By contrast, less financial expertise explained most of the underperformance for public pension funds with a relatively high percentage of trustees elected by plan participants.
Most of these trustees held non-financial jobs in the relevant governmental unit, such as teachers or firefighters. This explanation is supported by other studies concluding that low financial expertise of board trustees is associated with weak pension fund performance.
In short, the governance structure of a public pension fund is a critical driver of its financial returns, especially its choice of alternative investments. More politically connected trustees tend to favor investments attractive to local constituencies, even if such investments have subpar financial performance. To improve the annual returns of public pensions, state and local governments should recruit more trustees who are independent of these governments and familiar with institutional investing.
Robert Pozen is a senior lecturer at the MIT Sloan School of Management, Cambridge, Mass., and former president of Fidelity Investments.