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Board make-up matters

There is a relationship between the type of trustee on the board and the riskiness of a pension fund’s investments, according to research that supports the idea that governance and board composition matter.

In particular, there is a relationship between the riskiness of a US public pension fund’s assets and the proportion of trustees on the board who are political appointees and worker representatives elected by member schemes.

Under the rules of the Government Accounting Standards Board, US public pension funds are allowed to discount their liabilities by the expected return on their assets. This is a perverse incentive to invest in more risky assets, according to work by Rob Bauer, academic director of the International Centre for Pension Management, along with Martijn Cremers and Aleksander Andonov.

Their paper, “Pension fund asset allocation and liability discount rates”, compares public and private pension funds in the US, Canada and Europe, and finds that US public pension funds do act on their regulatory incentives.

Bauer, who is a professor of finance at Maastricht University, says the regulatory link between the liability discount rate and the expected return gives US public plans an incentive to increase their allocation to risky assets.

In particular, these funds have an incentive to increase the allocation to risky assets when expected returns decline, and Bauer contends that board composition, and especially stakeholder representation, will be a driver of the funds’ response to these incentives.

The research also shows that funds with a higher representation of state and participant-elected trustees respond more to the regulators’ incentives (and perform worse).

“Our empirical results show that funds with a higher percentage of board members from these categories take more risk, use higher discount rates and perform poorly,” Bauer says.

So the research has shown not only that US public pension funds have become the biggest risk-taking pension funds around the globe, but also that the increased risk-taking by US public funds has a negative correlation with their performance.

US public pension funds, on average, underperform their strategic benchmarks by about 55 basis points per year, the research shows.

This means the regulatory framework matters and, moreover, the pension fund board composition matters in a profound way, too.

Bauer is also the executive director of the International Centre for Pension Management, which runs a board effectiveness program (BEP) that he programs as academic director of BEP, which is a joint initiative between Rotman and ICPM. The week-long course is held twice a year, and the next event (April 3-7) will mark its 10th iteration.

Board composition and dynamics are discussed during the program, which instils best practice in key areas such as organisational mission, fiduciary duties, investment styles, the role of the board versus management, risk management, and human resources management, including compensation.

In essence, it focuses on the higher level responsibilities of board members to provide oversight of what is essentially a complex financial institution.

Over the years, more than 250 trustees from 64 organisations and 12 countries have attended the BEP. Participants consistently say meeting other trustees with different experiences and backgrounds and from different types of funds and countries is invaluable.

“What the 250-odd alumni like is we discuss real strategic issues relevant to the board of a pension fund,” Bauer explains. “It’s not about, for example, investments; it’s about not interfering with management but having the right tools to deal with management.”


More information about the board effectiveness program can be found here.

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