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BENEFITS BEAT
Pension Board Room Follies
Public pension board employees face an inherent fiduciary conflict when they vote themselves a benefit increase. Here's a cure for the conflict-of-interest ailment.
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The "Saga of San Diego" goes on and on. This month, the SEC filed charges against local officials for failing to disclose pension funding irregularities in the official statements they provided for investors in their bonds. Meanwhile, local officials are sweating over their potential fiduciary exposure to criminal risk under the related Lexin decision of the California Court of Appeals, which held that public pension fund trustees could be criminally liable if they approve a contract that provides them a personal benefit.
I've revisited this conflict-of-interest problem to divine a solution. Nationwide, public pension boards have been populated with employees who face an inherent fiduciary conflict when they vote themselves a benefit increase. Public officials' well-intended gesture to include employee and retiree representatives on the governing bodies of pension funds has become a nightmare. Even ignoring the legal issues raised in the Lexin case, there is a broader problem of excessive influence by employees and employee associations when they sit on pension trust boards — especially when they outnumber the independent trustees. Even management appointees on public pension boards are suspect since some of them have the largest vested individual financial interests in possible benefit sweeteners. The inherent conflict arises because fiduciaries are responsible for a duty of loyalty, which precludes them from putting themselves and their personal financial interest ahead of those of the plan and the trust.
If pension trustees who are eligible for a financial gain are inherently conflicted, then several remedies may be considered:
1. The trustees can recuse themselves from discussion and voting, which may leave only a minority of the full board to make the decision, and perhaps not a quorum in some boards.
2. The boards can be reconstituted with fewer public employee/retiree/beneficiary members.
3. Upon taking office, the potentially conflicted trustees could disclaim any benefit awarded by the board during their tenure. They would presumably be eligible for subsequent cost-of-living increases after leaving office, for example, but would forever lose the benefits increases awarded during their term.
4. The mutual fund "independent director" solution, which dates back to 1940, could be implemented.
The parallels with the mutual fund industry's governance situation and the solution the industry came up with struck me while I was attending a corporate governance summit last month.
In the mutual fund industry, there is an inherent conflict of interest when officers of the sponsoring investment advisor sit on the trust board. The firm that pays their salary is a vendor of the mutual fund trust. This arrangement is as old as the industry itself, and although some argue that the ultimate solution is to rid the mutual fund board of all "insiders," many fiduciary lawyers maintain that "insiders" often have insights that other board members do not and that having one or two on the board ensures that somebody from management is also "on the hook" — along with the independent trustees — if a decision goes sour.
This set-up is a close cousin to the conflict situation we have with public employee trustees. The California municipal league and other governmental organizations have taken a position in amicus court briefs that it's impossible to imagine a collective bargaining environment and pension governance structure without public employees or beneficiaries of some capacity on the board. Although it's not that difficult to conceive of a public pension board with all independent trustees, let's take the governmental groups' premise at face value. What's logically disingenuous is their implied conclusion that because of these inherent conflicts, there is no practical remedy in the pension realm and therefore the courts should reverse the Lexin decision.
In the mutual fund industry, federal laws require that a majority of the directors be independent, and most important, when matters pertaining to the investment advisory agreement are voted upon, the independent directors must meet separately to make their determination. In fact, the independent directors meet on a number of topics in executive session. This ensures that trustees with vested interests cannot unduly influence the deliberations.
In the pension world, it would be prudent to require that when a board of trustees considers a benefit increase for a cost-of-living allowance or an increase in the pension payment formula, the independent ("disinterested") trustees must first approve the proposal by a supermajority vote. An "interested" trustee is one who could personally benefit or who was elected by parties that would benefit from an increase in benefits.
This identical problem will surface soon with hundreds of new trusts now being created for retiree medical benefit (OPEB) plans. Public officials establishing OPEB trusts should build conflict-of-interest safeguards into their founding documents. It is far less complicated to get it right at inception than it is to reshuffle the board once it's populated. Establishing the precedent with OPEB trusts will also strengthen the case for pension plan governance reforms.
Girard Miller, an analyst of benefits and investments with 30 years of experience in the public, private and nonprofit sectors, can be reached at Girardinmalibu@charter.net. His general market observations and institutional investment strategies are his own and should not be construed as investment advice or recommendations concerning specific securities. More biographical information.