esm7i Stanford University’s study shows that they are influenced too much by political and campaign donations when making investment decisions.
At first, it might appear a good idea to have politicians on the boards for pension funds for public employees. According to a Pew Charitable Trusts report, these organizations have $3.8 trillion of assets. Among other things, they are responsible for the retirement security and income of 19,000,000 current and former public employees.
Who better to be trusted and to manage this lofty responsibility than elected officials? They are accountable to the voters and have some financial expertise and influence that can be used to direct funds to high-performing investments.
At least, that’s the theory. In practice, however, Stanford Graduate School of Business Professor Joshua D. Rauh says that politicians are less likely to pick winners than other types of trustees, such as members of the public and financial professionals.
Rauh says, “The more officials from the state who serve on the board of directors, the worse performance of the private equity investment made by the pension funds.”
This disconcerting insight comes from an article that Rauh, Aleksandar, Antonov of the University of Amsterdam, and Yael Hochberg of Rice University published recently in the Journal of Finance. Researchers collected data on thousands of public pension fund investments from 1990 to 2011. Pension systems invested an average of $2.2 billion in private investment vehicles. Researchers focused on “alternative investments” with higher risks, such as private equity, venture capitalism, real estate, distressed debt funds, etc., on which pension funds increasingly place their bets.
Alternative Investments: A New Wave of Investments
The researchers also looked at the composition of the boards of pension funds and found that 25% were ex-officio, that is to say, that they had seats in the table due to their government positions, such as a controller or state treasurer. 8% of the members were appointed state officials such as state legislators.
Rauh says that the problem is partly because, over the last decade, public pension funds in the United States have been overly dependent on alternative investments. These now account for 25% of their assets. He says that the funds take a riskier approach instead of funding benefits in a manner that ensures a high probability or certainty of having enough money available when it’s time to pay pensions. “They put aside much less than they need and then invest it aggressively in the hope that the risk will pay off.”
Researchers found that boards with higher levels of political representation had a lower internal rate of returns (IRR), the standard measure of profitability for private equity investments. A 10% increase in politicians on an investment board corresponds to a net IRR decrease of 0.7%.
Politicians who sit on the boards of public pension funds have a greater negative impact on investment performance than representatives chosen by pension plan participants. Rauh and colleagues found that, when they studied the backgrounds and education of board members of plan participant representatives, their shortcomings could be partly explained by a lack of financial knowledge and experience. The politicians, however, did worse and had no excuse. Rauh says they have a good deal of financial experience and are likelier to hold an MBA.
The Influence Of Politics
Researchers found that officials rely not only on training and experience when making investment decisions. They found that other factors, including political considerations, also influence officials. For example, the potential to increase their support with voters by investing locally. These choices could be more profitable than they are politically beneficial.
Rauh explains that “they’re making economically targeted investments. They are meant to stimulate the state economy’s growth or support local economies and employment.” A 10% increase in the number of state ex-officio boards is associated with an increase of 1.4% in local investment. These investments in real estate and venture capitalism are associated with lower returns.
Rauh and colleagues tracked campaign donations from officials in the financial industry and discovered that this flow of contributions tainted investments decisions. For every $100,000 more in contributions made to the board of directors of a $10 Billion public employee pension fund, there is a 0.28% drop in returns and a 1.2% decrease in multiples of invested capital.
Rauh: “We find a direct link between the political contributions to politicians and poor performance.”
The risk goes beyond Retirees
Researchers found that politicians were not good at investing but were better at choosing public representatives to serve on boards. Before this study, some people may have thought that a politician would only appoint friends or someone who would misappropriate assets. But empirically, this is not the case. The outside director usually has financial experience and is not in a conflict of interest.
Rauh said that the findings of the researchers point out a potential danger looming over public pension funds – and the taxpayers who could be forced to suffer service cuts or tax increases to pay for the shortfalls in the funds and to pay for retirement benefits to police, firefighters and other public workers.
Rauh: “It is time to change how we select these boards.” This is especially true given the fact that pension systems in the U.S. do not look great from a financial standpoint. It’s not like they have much slack.”
