David Hess and Gregorio Impavido substitute for one another. For corporations, this means that where a market for corporate control is not available greater emphasis will fall on the outside directors on the board. Mayers et al. (1997) supported this substitution hypothesis in a study of mutual and stock insurance companies. In mutuals, ownership rights are connected with customer insurance policies and therefore are nontransferable. In stock companies, ownership rights are not connected with policies and are freely transferable. Compared to stock insurance companies, mutuals are significantly more likely to have either a majority of outside directors on the board or a majority of outsiders on standing committees. The presence of outsiders also reduces management's consumption of perquisites, such as salary, while other costs that do not involve a conflict between management and owners are not significantly different.

# **IV IMPLICATIONS FOR THE GOVERNING BODY OF PUBLIC PENSION PLANS**

Public pension funds thus clearly need a strong governing body. Compared to corporations, for which there are available a variety of external and internal control mechanisms, for public pensions the board is essentially the only available control. The following sections provide an initial analysis of the issues that should be addressed when creating a board that has the appropriate incentives to be an effective monitor and manager of a fund. Using Eisenhardt's terminology, these are mostly behavioral rather than outcome controls.

# **_IV.A Board Composition_**

The trustees of U.S. civil service plans generally fall into one of three categories: they are elected by plan participants, appointed by the government, or serve as ex officio members. Trustees may be elected by either active employees or retired plan members, and they themselves may be active or retired members. Appointments are typically made by a chief elected official such as the governor or mayor or by a governing body such as a legislative committee, and often are made to provide representation for stakeholder groups in cases where beneficiary groups are not allowed to directly elect their own representatives. Ex officio trustees will serve on the board by virtue of their holding a particular public office, such as that of state treasurer or controller.

As discussed earlier, corporations have both inside directors and outside directors. Inside directors are also managers of the corporation in question, and can be either the source of moral hazard or lack the incentives to control moral hazard problems originating with the CEO. For public pensions, moral hazard problems (or goal conflicts with plan participants) typically are rooted with those trustees that also are government officials or that are appointed by government officials. A government may be able to bypass the board to use a fund's assets for other social or political goals (Iglesias and Palacios 2000), but it also may be able to achieve the same result if the board is dominated by trustees sympathetic or otherwise allied to it. Government-affiliated trustees are effectively the equivalent of corporate insider trustees.

Member trustees that are elected by plan members are not subject to the same political pressures as ex officio and appointed trustees. In this sense, their political independence makes them analogous to independent, outside directors on corporate boards. Just as

- 19 -