Effects of Governance Practices and Investment Strategies on State and Local Government Pension Fund Financial Performance

Abstract

Recent statistical studies concerning state and local government pension funds’ boards of trustees have focused on two complementary issues. First is the influence governance practices have on administration of fund assets. Second is the impact of investment strategy choices on funds’ total rates of return. Reported results indicate that the primary effects of governance practices on pension outcomes are indirect via asset allocation decisions. This study re-examined these issues using abnormal return as an inherently valued measure of risk adjusted financial performance. An innovation of the investigation is that “process analysis” was used to decompose the direct and indirect effects of governance practices on financial performance. Results suggest that while both types of effects exist, direct impacts dominate relative to mediating processes.

Keywords:

• Governance
• Public pensions
• Financial performance
• Asset allocation

Acknowledgment

The authors wish to thank John Nofsinger for his helpful comments and suggestions during the preparation of this manuscript.

Notes

^aIn their final analysis, the investigators do attempt to account for risk with an exogenous variable defined as the standard deviation of a system's annual return over the previous five years. They find a positive but not statistically significant coefficient for the variable. Interpretation is problematic in that risk and return are generally considered to be complementary in nature.

^bThe comment here applies to specific time periods. Historically, equity investments have outpaced other vehicles over long periods of time.

^cEquity investments include domestic stock, international equities, real estate equity, and other equities (excluding real estate). International investments include international equities and international fixed income.

^dThe direction of influence would ultimately depend on whether or not systems actually capture higher total returns for higher levels of assumed risk. If they did not, the influence of equity investments on abnormal return (in terms of systematic explanation) could be expected to be negative.

^eOne way ANOVA did not reveal significant differences within groups (e.g., board sets the allocation only vs. board and investment council set the asset allocation jointly) for any of the governance practice variables in relation to abnormal return.

^fIn order, each regression amounts to the estimation of a path coefficient for paths “C,” “A,” and “B,” respectively.

^gActually, the summation of a direct effect plus an indirect effect for any governance practice exactly equals the total effect. Differences in Table 4 exist because of rounding.

^hAs a comparison, Useem and Mitchell, as cited in reference note number two, find an indirect yet positive influence for this governance practice in relation to total return.

ⁱA limitation here is that 1998 investment activity expense information was available for only 153 (81%) systems.

^jThe investigations referred to here are listed in the first reference. For these studies, governance and investment strategy variables were obtained from a 1992 PPCC survey. Total return data were obtained from a 1993 PPCC survey.