Mismatched Incentives: Are Trustees to Blame for Pension Underfunding?

Public pension boards are tasked with supervising the investment of the funds raised from the contributions from state employers and employees. But the way the pension boards are staffed discourages a focus on the long term health of public pension plans.

Manhattan Institute Fellow Daniel DiSalvo elaborates on the Pension Board Problem in this excerpt from Governing:

The problem is that both the political appointees and the elected representatives have incentives to ignore the long-term health of the funds. Political appointees are responsive to constituencies, such as the governor who appointed them or local businesses, (which) distract them from managing the fund strictly in its beneficiaries’ long-term interest. Meanwhile, public employees and their union representatives are tempted to trade pension savings tomorrow for higher salaries today.

How do these incentives play out? To hold down short-run costs, political appointees are likely to favor high assumed rates of investment returns, which keep employer contributions lower and avoid throwing a wrench in the governor’s budget. Political appointees also tend to favor investing in local industries — whether or not they are actually profitable. Two Texas funds were heavily invested in Enron before it went bankrupt, for instance. And in 1990, Connecticut’s state-employee fund lost $25 million investing in Colt’s, the firearms manufacturer, to preserve local jobs.

Likewise, public employee representatives respond to workers’ demand for higher salaries today by keeping the assumed rate of investment returns high. In a recent study, political scientists Sarah Anzia and Terry Moe found that elected representatives of public employees did not seek to impose more realistic — that is, lower — assumed rates of investment returns. Rather, they found, more worker representation on boards and stronger public unions led to more fiscally irresponsible decisions.

The larger consequence of the misaligned incentives of pension boards is that they don’t protect employees and taxpayers from major financial risks. Poorly managed pension systems are now consuming the politics – and much of the budgets — of Connecticut, Illinois, New Jersey and other states.