PROTECTION FOR STATE RETIREMENT FUNDS
By Pew Trusts
State and local pension plans hold over $3.6 trillion in retirement fund investments for participants and their beneficiaries, with returns on these investments accounting for an estimated 60 percent of the money paid out in pension benefits each year.
In recent decades, public pension funds, in a bid to boost returns, have shifted funds away from low-risk, fixed-income investments—such as government and high-grade corporate bonds—to a greater reliance on equities and alternative investments. This strategy change can provide higher returns, but it increases the complexity of fund portfolios, as well as the risk of losses.
The rules governing plan trustees and administrators—those individuals, known as fiduciaries, with the authority to invest and manage these assets—have not always kept pace with this trend.
Fiduciaries have a legal duty to exercise “great care” in managing plan assets. The origins of these duties date back centuries to what is known as the common law of trusts, which is widely recognized but uncodified law.
The common law of trusts provided adequate regulation when state and local pension funds were primarily invested in low-risk and fixed-income investments. But the increased complexity and risk associated with contemporary retirement system portfolios has created a need for clear standards governing the investment decisions made by those responsible for doing so. These more complex investments also require more expertise.
Research shows that when compared with private pension funds in the United States and all pension funds in Canada and Europe, U.S. public pension funds underperform by about 50 basis points per year, tend to invest more in risky assets, and use higher target rates for investment returns.2 Also, U.S. public pension plans— particularly those whose trustees have limited financial expertise—can be ill-equipped to make these types of investment decisions, which can have a negative impact on fund performance.
Following the shift in the 1990s toward more complex pension investments, legal experts from all 50 states drafted several model laws, including the Uniform Management of Public Employee Retirement Systems Act of 1997 (Model Act). In 1997, the National Conference of Commissioners on Uniform State Laws recommended that every state adopt these measures. Some states followed the guidance, but many have proved slow to act.
Pew identified eight key fiduciary duties and standards included in the Model Act that are particularly important to state and local pension plans.
The six core duties spelled out in the act require trustees or other fiduciaries to discharge their responsibilities with respect to a retirement system.
(1) solely in the interest of [retirement system] participants and beneficiaries;
(2) for the exclusive purpose of providing benefits to participants and beneficiaries and paying reasonable expenses [for] administering the system;
(3) with the care, skill, and caution under the circumstances then prevailing which a prudent person acting in a like capacity and familiar with those matters would use in the conduct of an activity of like character and purpose;
(4) impartially, taking into account any different interests of participants and beneficiaries;
(5) incurring only costs that are appropriate and reasonable; and
(6) in accordance with a good-faith interpretation of the law governing the retirement program and system.”
The Model Act also identifies two other key responsibilities for trustees as they consider how to manage their systems’ assets. Among their duties, trustees:
“Shall diversify the investments of each retirement program or appropriate grouping of programs unless the trustee reasonably determines that, because of special circumstances, it is clearly prudent not to do so.”
“May consider benefits created by an investment in addition to investment return only if the trustee determines that the investment providing these collateral benefits would be prudent even without the collateral benefits (i.e., what are known as economically targeted investments (ETI).”