Powerful political incentives and weak governance structures have played a strong role in undermining many public pension plans in the US. A recent paper by the Center for State Fiscal Reform at the American Legislative Exchange Council (ALEC) provides a deeper look into how political cronyism weakens public pension funds’ investment performance. The paper identifies three major kinds of cronyism: economically targeted investments, political kickbacks, and political crusades.
Economically targeted investments (ETIs), according to the paper, are “local investments that have been selected for their economic or social benefits in addition to the investment return to the employee benefit plan”. Research shows that ETIs tend to underperform their alternative counterparts. Using the Retirement Systems of Alabama (RSA) as a case study, the paper demonstrates how the pension fund’s ETIs, especially those in the real estate sector, have substantially impaired the fund’s returns. Alabama is among states that have the highest allocations of ETIs in the nation, and one main reason for that is its weak fiduciary standards compared to other states. Specifically, the state only meets two of the six most relevant fiduciary provisions set out by Uniform Law Commission’s Uniform Management of Public Employee Retirement Systems Act (UMPERSA). Additionally, RSA’s poor pension board composition, which is dominated by ex-officio members and elected plan participants, contributes to the ETIs allocation.
Political kickbacks, the second kind of cronyism, are about directing pension investment funds to “politically connected businesses and other interests.” The paper presents research showing that public pension funds do not only overweight local firms that engage in political contributions and lobbying, but also retain investments in these firms over much longer time periods compared to those firms that do not engage in these activities. The results, according to the paper, are twofold: investment performance is diminished due to overweighting riskier local investments, and the negative effects are greatly compounded over time due to the higher retainment rates of these investments.
The third kind of cronyism, political crusades, is about using public pension funds to address political causes, such as environmental concerns, public health, political speech, and income inequality. Many public pension funds (notably in California) have been divesting from fossil fuel industries to combat climate change. Divestment has also been used to punish fund managers that hold different political viewpoints. The paper shows that such divesting does not only negatively affect investment returns but also fails to reliably achieve its goals.
Another avenue used by public funds to promote political objectives is shareholder activism: using equity stakes in invested companies to pressure those firms to disclose political spending, adopt more “environmentally sustainable” practices, or reduce executive-worker pay gaps. All these activities divert pension funds from focusing on their main goal: earning enough returns to provide retirement benefits. Moreover, political crusades, by employing public money to advance certain political agendas, fail to respect pensioners’ and taxpayers’ personal political positions.
The paper provides a number of solutions to tackle political cronyism, revolving around three major categories: fiduciary standards, transparency rules, and pension board reforms. Some of the most important recommendations are:
– Trustees should be charged with managing the pension fund for the exclusive purpose of providing retirement and other post-employment benefits to plan members and beneficiaries. Trustees thus must follow the prudent investor standard, and should be required to pursue the best long-term risk-adjusted returns for the pension fund.
– Investment performance should be reported by asset classes and individual assets over a 20-year time horizon. Trustees should be required to fully disclose any affiliations or campaign contributions that may create conflicts of interest.
– Pension board should be diversified to provide representation of all stakeholders, including taxpayers, and should include independent financial professionals.
Perhaps, the most fundamental solution to public pension cronyism is to replace the defined benefit pension structure with defined contribution retirement plans, where the employees are responsible for their own investments. On top of that, shifting away from traditional defined benefit pension plans also removes the perverse incentive structure that encourages underfunding, excessive risk taking, and reckless expansion of benefits at the expense of both future retirees and taxpayers.