How Politicians Hurt Your Public Pension Plan

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Researchers traced a direct link between campaign contributions and poor investment performance. | iStock/Martin Barraud

At first glance, it might seem like a smart idea to have politicians serve on the boards of public employee pension funds. After all, according to a recent Pew Charitable Trusts analysis, these organizations hold $3.8 trillion in assets and are responsible for the retirement security of 19 million current and former government workers.

Who is better suited to handle and be trusted with that lofty responsibility than elected officials? Not only are they accountable to voters, but they also possess influence and some degree of financial expertise that they can use to guide the funds into high-performing investments.

That’s the theory, at least. But in practice, as Stanford Graduate School of Business professor Joshua D. Rauh explains, politicians tend to do a bad job of picking winners compared with other types of trustees, such as rank-and-file members and financial professionals chosen as public representatives.

In fact, “the more state officials that serve on the board, the worse the performance of the private equity investments made by the pension fund,” says Rauh.

That disconcerting insight emerges from a paper recently published in the Journal of Finance by Rauh and colleagues Aleksandar Andonov of University of Amsterdam and Yael V. Hochberg of Rice University. The trio of researchers gathered data from thousands of investments made from 1990 to 2011 by 212 public pension funds. The pension systems invested in private investment vehicles with an average size of $2.2 billion. The researchers focused on higher-risk “alternative” investments — private equity, venture capital, real estate, distressed-debt funds, and the like — on which pension funds increasingly place their bets.

A Shift to Alternative Investments

They also analyzed the makeup of the pension funds’ boards and found that 25% of the members were ex officio — that is, entitled to seats at the table because they also held government offices such as state treasurer or controller. Another 8% were state officials, such as members of state legislatures, who had been appointed to the boards.

Part of the dilemma, Rauh notes, is that over the past decade, the nation’s public pension funds have become overly reliant on relatively precarious alternative investments, which now make up 25% of their holdings. “Rather than fund benefits in a way that would give a very high likelihood or certainty to having enough money on hand when it comes time to pay these pensions, they take a much riskier approach,” he says. “They set aside a lot less money than they need, and then they invest the money very aggressively, hoping that the risk will pay off.”

The researchers discovered that investment boards with a higher proportion of political representation have a measurably worse internal rate of return (IRR), the standard metric for the profitability of private equity investments. A 10% increase in the proportion of politicians on a board correlates to a 0.7% decrease in net IRR.

Politicians on public pension fund boards had a more negative effect on investment performance than representatives elected by their fellow rank-and-file pension plan participants. When Rauh and his colleagues studied the backgrounds of board members, they discovered that the plan participant representatives’ shortcomings generally could be explained by lack of financial education and background. But the politicians, who did even worse, didn’t have that excuse. “They’ve generally got good financial experience, and they’re more likely to have an MBA,” Rauh notes.

The Influence of Politics

The problem, the researchers found, is that state officials don’t just rely on their training and experience to make investment decisions. Officials, they found, also tend to be influenced by political considerations, such as the possibility of increasing their support among voters by investing in local businesses. Such choices may be more politically beneficial than they are profitable.

“They’re making economically targeted investments, the ones meant to stimulate economic growth in the state or to support the local economy and local employment,” Rauh explains. As a result, a 10% increase in state ex officio board members is associated with a 1.4% increase in allocation to local investments. These investments in local real estate and venture capital deliver lower returns.

Rauh and his colleagues also tracked officials’ campaign contributions from the financial industry and found that the flow of donations tainted investment decisions. Each additional $100,000 in contributions to board members of a $10 billion public employee pension fund results in a 0.28% decrease in return and a 1.2% lower multiple of invested capital.

“We definitely find a link between political contribution to the politicians and bad performance,” Rauh says.

The Risk Goes Beyond Retirees

But while politicians aren’t good at making investment decisions, they do better at selecting public representatives for boards, the researchers found. “Before this study, people might have assumed there wouldn’t be anything better about a politician picking a board member, because they would just appoint their friends or somebody who would misappropriate the assets,” Rauh says. “But empirically, that’s not what happens. They’re typically appointing an outside director with financial expertise, somebody who’s not conflicted.” Those independent professionals tend to make the best investment decisions.

Rauh says that the researchers’ findings point to potential peril looming for public pension funds — and for taxpayers, who may have to endure cuts in services or tax hikes to cover the funds’ shortfalls and pay for retirement benefits for police, firefighters, and other public employees.

“It’s time to change the way we pick these boards,” Rauh says. “That’s particularly true in light of how pension systems around the U.S. are not in great shape from a financial perspective. It’s not as if they have a lot of slack here.”