Governance Of Public Pension Funds: Lessons From Corporate Governance And International Evidence

## **INTRODUCTION**

Governments are paying increasing attention to the management of their public pension fund reserves. Rather than cutting benefits or increasing contributions to enlarge these reserves, they are focusing on the more politically appealing alternative of improving their investment performance (Palacios 2002). They are, however, facing growing pressure to use these funds to improve the local economy or achieve other social goals, and such use obviously can have a significant negative impact on investment performance. There consequently is a strong need for public pension reform to focus on the governance structures and practices of these funds.

There is extensive research on the governance of corporations. The field of corporate governance generally is concerned with the basic issue of instilling investors with the confidence that will permit them to hand over their money to managers. As noted by Davis and Useem (2000), corporate governance deals with the basic issue of "the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment" (Shleifer and Vishny 1997: 737), as well as the broader cultural and institutional arrangements affecting the governance of firms. Over the past two decades, corporate governance has become a leading topic of discussion for researchers in finance, management, and law. Their goal is to find the optimal organizational arrangements to both protect shareholders' rights and at the same time increase economic efficiency.

A leading theory used to analyze corporate governance and provide prescriptions on govemance structures and incentives is the agency theory. This paper examines the applicability of such theory to the governance of public pension funds. Section I discusses the application of agency theory to corporations. Included in this discussion is the problem of the separation of ownership and control, where certain inefficiencies result when those making the decisions for the organization do not fully bear the risks of those decisions. Corporations use various mechanisms to attempt to control these problems. Section II discusses the agency problems that may exist in public pensions. Section III provides an analysis of the control of agency problems that impact the management of pension funds, and demonstrates the need for a strong, well-functioning board of trustees. Section IV discusses the implications of using behavioral controls (as opposed to outcome controls) to solve agency problems associated with the structure and functioning of the board of trustees. This section also presents the results of a survey of governance 26 public pension funds from various countries. Conclusions follow in Section V.

## **I AGENCY THEORY AND CORPORATE GOVERNANCE**

# **_l.A Agency Problems: Separation of Ownership and Control and Moral Hazard Problems_**

Agency theory deals with the problems that can arise when one person (an agent) acts on behalf of another (the principal). Specifically, the delegation of authority to the agent may result in the agent taking actions that are not in the principal's best interests (i.e., that are acts of self-interest on the part of the agent) but which are unknown to the principal. The

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