The Causes of Pension Fund Mismanagement

Commentary

The Causes of Pension Fund Mismanagement

How pension funds make go wrong when making private investments

In one of the most sordid scandals to rock the public-sector pension world, the manager of the New York State Common Retirement Fund (NYSCRF) was indicted last month in a “pay-for-play” scheme where he directed more than $2 billion in business to the firms that bribed him. Included in his graft were a $17,000 watch, a ski trip, crack cocaine, and money for prostitutes.

The specifics of this scheme are exceptional, but corruption by pension fund officials is not unheard of. In 2012, Alan Hevesi, the former New York State Comptroller, was released on parole after being incarcerated for investing $250 million in Markstone Capital Partners in exchange for $75,000 in travel benefits and over $500,000 in contributions to his political campaign. In 2007, a chief of staff for a Detroit City Council member pleaded guilty to accepting bribes in exchange for a $15 million real estate investment in the Turks and Caicos. And last month, Dallas Mayor Mike Rawlings announced he would pursue a criminal investigation into the management of the city’s public safety pension fund.

Any time public funds are invested in the private sector, there is a risk of impropriety, but quid-pro-quo corruption isn’t the only form of mismanagement that could sink pension funds. Bad policymaking or lack of skill on the part of managers also puts systems at risk. The causes of mismanagement are myriad, and it’s important to understand them to avoid future misuse of taxpayer money.

First, of course, are public officials eager to line their pockets by abusing their power. But these instances appear to be relatively rare, and the mechanism for corruption is more complicated than simply meeting in a smoke-filled room and exchanging a watch for investments.

Second, are the “placement agents” —intermediaries between public-sector pension funds and opportunities in the alternative investments space, usually private equity. They are paid on commission to bring investments to various funds managed by the firms they represent.

In theory, using middlemen as experts seems like a good policy. Investing in alternatives is a complicated business, and expertise would help pension systems make the best investments with the taxpayers money. And sometimes that’s how it works; top-notch placement agents are useful for producing high returns. But, because the placement agents typically represent the firms they want pension systems to invest in, the conflict of interest becomes clear and opportunities for outright corruption emerge.

Unfortunately, there can be a negative feedback loop where underfunded pension plans plagued by poor investment yields seek to book their returns by pushing increasing amounts of money into the non-transparent, illiquid, non-standardized market that is alternative investments. A 2016 study measuring the effects of placement agents on both the funds they represent and investors found that the negative relationship between the use of placement agents and investment returns was largely driven by negative performance for public pension funds.

Part of the reason researchers found a negative relationship between the use of placement agents and returns for investors across the board was “investor capture,” the ability of a placement agent to abuse an investor’s trust. The researchers found that, “stronger ties to a given agent are detrimental to…investors.”

While this analysis is troubling, it does not fully explain why public pensions perform so poorly relative to other investors using placement agents. Rules issued by the SEC may marginally reduce access to politicians and other pension officials, but these rules were likely unnecessary; the study found that, “the size of the donations to be relatively small on average, and unlikely to have substantially altered investment decisions.”

Clearly, there’s a supply of investment firms eager to make a buck from public sector pension systems. The widespread use of these bridges between private equity and other alternative investment funds cannot be explained exclusively by officials looking for a Rolexes or ski trips, so where does the demand for such services come from?

A probable contributor to mismanagement is the inability of the public sector to attract talented employees with professional degrees. While lower-skill (less than a bachelor’s degree) employees receive compensation at or above levels earned in the private sector, those with post-graduate degrees earn less than their counterparts in the private sector.

How does this apply to pension fund staff? In 2011, the average state chief investment officer (CIO) made $130,000 per year, while private sectors CIOs made $210,000. This disparity leads to high turnover among pension fund employees whose employers can’t compete with other compensation packages.

But pension funds wouldn’t need to attract such talent to manage sophisticated investments if they maintained a low-risk portfolio in the first place. As the economy enters a new normal of low growth and low investment returns, pension funds unwilling to lower their assumed rates of return for fear of increased contribution rates invest more of their assets into alternatives like private equity.

Pension funds don’t need placement agents to invest in index funds, treasuries, or other less-exotic assets. By reducing their reliance on alternative assets to buoy their investment returns, they could avoid paying the fees that come with placement agents, in addition to reducing the investment risk that comes with investing in volatile assets. Whether the source of pension mismanagement is from a lack of talent, knowledge, or outright corruption, the risk of misusing the taxpayers’ money can be minimized by more conservative investment policies, but only if policymakers are willing to match this change with an appropriate change in funding policy.