metadata: authors: 0: author: Mitchell,Olivia
docna: 0: docna: Public pension governance and performance :
            lessons for developing countries
docty: Policy Research Working Paper
subtopic: Pensions & Retirement Systems,Administrative & Civil Service Reform,Public Sector Administrative & Civil
            Service Reform,Educational Institutions & Facilities,Inflation,Employment and Unemployment,Effective Schools and Teachers,Democratic Government,Public Sector Administrative and Civil
            Service Reform,De Facto Governments
teratopic: Finance and Financial Sector Development
abstracts: cdata!: The author examines the relationship
            between public sector pension plan performance and
            management practices to improve the design and governance of
            public pensions in developing countries.  Understanding this
            relationship is important because better yields on public
            pension plan investment reduce the need for additional taxes
            to support retirees - and well-funded plans stand a better
            chance of paying promised benefits.  The author's model
            relates investment returns on public pension assets, as well
            as plan funding status, to features characterizing the
            pension systems' governance structure and authority,
            using new data set on U.S. state and local public sector
            plans. The following findings stand out.  The higher the
            fraction of retirees elected to the pension board, the
            stronger the negative effect on investment return in 1990,
            and the more variable the returns.  Systems fared about the
            same whether they had in-house or external money managers,
            or independent performance analysis (even if the external
            managers were drawn from the top 10).  But public pensions
            performed better when fund and actuarial computations were
            done by professional actuarial and investment counselors
            rather than relying on former or current employees to choose
            investment strategies.  Social investment rules hurt public
            pension yields.  Public pension plans which mandated that a
            certain portion of investments be director to instate
            projects generated much lower returns. The data show that
            many public pension systems funded their plans
            satisfactorily but others did not.  The results show the
            following.  Fiscal stress reduced stock funding ratios.
            Stock funding rates were lower, the higher the fraction of
            elected retirees and elected active workers represented on
            the pension system board.  Stock funding ratios were higher
            when a system had in-house actuaries, when the board
            authorized benefit levels, and when board members had
            liability insurance.  Stock funding rates were unaltered by
            state statutes guaranteering that benefits be guaranteed by
            law, or by legally set funding requirements, or by the
            state's ability to carry budget deficits from one year
            to the next.  Nor did they vary when dedicated or special
            taxes were earmarked for pension revenue.  Policymakers in
            developing countries can profit from the mistakes made and
            lessons learned by U.S. pension analysis. Although no single
            package of pension plan practices can optimize investment
            performance for all systems across all time periods, care
            must be taken when designing the regulatory and investment
            environment in which these plans operate.  Developing
            countries should study the work of the U.S. Government
            Accounting Standards Board.  The author discusses some of
            the complex issues that must be confronted when establishing
            funding norms for defined benefit pension plans in the
            public sector.
repnme: repnme: Public pension governance and performance :
            lessons for developing countries
display_title: Public pension governance and
            performance : lessons for developing countries
listing_relative_url: /research/1993/10/698800/public-pension-governance-performance-lessons-developing-countries
topicv3: Teachers Management m1326119 1523,Pension Arrangements m1326319 2087,Inflation m1326709 0870F4727ACED1CF8525815C00471347,Retirement m1504007 2896,Unemployment m1504051 2747
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Finance and Financial Sector Development
origu: UNKNOWN
no_of_pages: 79
author_keys: 0: author_key: 87446
model_extractions: Mi)'§i;|ni'kWN , v: ~ ~ ~ ~ ~ _PRG I,_ go

# **Finsimnd** ot_nSwr **ovonnn**

# WPS 1199

- This paper a product of the Finc and Private Sector Development Division, Policy Research - Department is part of a larger effowt in the department to Investigate the complex issues related to old age security amngements. The study was nded by the Bank's Research Support Budget under research prject"Income Security for Old Age" (RPO _677-45)._ Cepies ofthe paperare available free from the World Bank, 1818 H StreetNW, WWhington, DC 20433. Plee contact Daniele Evans, room N9-057, extension 37496 (October 1993,73 pages).

Mitbell examircs the elaionshp between public sector pension plan performance and managemat practices to improve the design and govenace of public pensions in developing countries. Understanding this relationship is important because better yields on public pension plan investments reduce the need **for** additional taxes to support retirees - and wellfunded plans stand a better chance of paying promised benefits.

Her model relates investnent returns on public pension assets, as well as plan funding status, to features characterizing the pension systems' governance structure and authority, using a new data set on U.S. state and local public sector plans. Certain findings stand out: The higher the fraction of retirees elected to the pension board, the stronger the negative effect on investment return in 1990, and the more variable the returns.

systems funded their pluas stisfactorily but others did not. The results show that:

* Fiscal stress reduced stock funding ratios.

***** Stock funding **rates** were lower, the higher the fraction of elected retirees and elected active workers represented on the pension systemn board.

S* tock funding raldos were higher when a system had in-house actuaries, when the board authorized benefit levels, and when board members had liability insurance.

* Stock funding rates were unaltered by state statutes guaranteering that benefits be guaranteed by law, or by legally set funding requirements, or by the state's ability to carry budget deficits from one year to the next. Nor did tiiey vary when dedicated or special taxes were earmarked for pension revenue.

* Systems fared about the same whether they had in-house or extemal money managers, or independent performance analysis (even if the extemal managers were drawn from the "top 10"). But public pensions perforned better when fund and actuarial computations were done by professional actuarial and investment couselors rather than relying on former or current employees **to** choose investment strategies.

* Social investment rules hurt public pension yields. Public pension plans which mandated that a certain portion of investments be directcr to instate projects generated much lower returns.

Policymakers in developing countries can profit from the mistakes made and lessons learned by U.S. pension analysts. although no single package of pension plan practices can optimize investment performance for all systems across all time periods, care must be taken when designing the regulatory and investment environment in which these plans operate. Developing countries should study the work of the U.S. Government Accounting Standards Board.

Mitchell discusses some of the complex issues that **i.ust** be confronted when establishing funding norms for defined benefit pension plans in the public sector.

Thc data show that many public pension

**Toe Woricing Policy Research Papei Seriesdisinates the rinding** of **workxlud way** m **theBankc Anobpaive of** the **series** **_is_ to get tlsse findings out quickldy, even if presentations are less than fully polished.i The findings, interpretations, and cawncuions in** thes **pape dD not noceafly rvepsent of ficial Bulik policy**

J ~~~~~~~~~Pro&ced **by the Policy Resech Dimaionak Center**
# **Public Pension Governance and Performance: Lessons for Developing Countries**

# **by**

## **Olivia S. Mitchell**

with **the assistance of Ping-Lung** Hsin

**Department of Labor Economics Comell University - ILR**

This paper was prepared for the Public Sector IManagement and<sup>Private Sector Development</sup> Division of the World Bank. Excellent research assistance was provided<sup>bv Pirig Lung Hsin.</sup> Useful comments were offered bv Estelle James.
# Table of Contents

|||Page No.|
|---|---|---|
||Intrcduction|1|
|I.|TheDeterminants<br>of Public Pension Investment Performance|2|
|II.|The Determinants<br>of Public Pension Funding Practices|8|
|III.|**Empirical Analysis**of Public Pension**Yields**and Funding|15|
||Evidence on the Investment Performance<br>of State and Local Pension Systems|19|
||Funding Patterns Among State and Local Pension Plans|23|
|**IV.**|**Sensitivity**<br>of Results|27|
||Conclusions<br>and**Discussion**|29|
||Tables|36|
||Figures|59|
||References|64|

Olivia S. Mitchell - Public Pension Governance and ?erformance
# **Public Sector Pension Governance and Performance: Lessons for Developing Countries**

## Olivia S. Mvitchell

The cost of supporting retirees has risen quickly in both developed and developing nations, and promises to become ever greater in decades to come. Policymakers seek to prepare for these costs by designing better functioning pension plan structures. One item or. the policy agenda is to improve pension plan investment and funding performance. This paper examines public sector pension plans in the United States, asking why some plans appear to have been well-managed, and what structural design features are associated with good pension management outcomes. A new data set on more thau 200 state and local public sector plans in the U.S. indicates that many of these pensions experience decent investment performance, and some are relatively well-funded. Offsetting these successful plans is the experience of other pension systems who report poor investment performance and underfunding difficulties. Our analysis examines the relationship between public sector plan performance and management practices, seeking to draw lessons which might improve the design and governance of public pensions in developing countries.

The two pension plan performance outcome measures of central interest in this paper are the yields on public pension system assets, and the public pension plans' funding status. Investment performance is important since higher yie!ds reduce the need for additional taxes to support current and future retirees. Pension funding is important since better funded plans stand a better chance of having assets on hand to pay promised benefits.

Olivia S. Mitchell - Public Pension Governance and Performance
2 This study relates these two pension plan outcomes to a variety of features characterizing each pension system's govemance structure and authority, reporting requirements, and other factors affecting the environment in which the pension funds operate.

Section I of the paper develops a series of hypotheses regarding public pension plans' investment performance, linking pension governance, while Section TI axamines determinants of funding patterns. Empirical analysis in Section III suggests that investnent performance in 1990 was reduced by having a heavy representation of elected retirees serving on the public pension Board, and by mandates that a specified portiLn of pension assets be earmarked for in-state projects. Systems fared about the same irrespective of whether they had in-house or extemal money managers, or independent performance enalysts. The empirical aialysis also shows that fiscal stress was found to systematically and powerfully reduce pension funding, as did having a large representation of elected retirees and active workers on the pension system Board. Pension funding was higher when the system employed in-house actuaries, when the Board was required to authorize benefit levels, and when Board members had liability insurance. Section IV evaluates these results in light of slightly different empirical specifications. Finally, Section V draws lessons from this research for policymakers in developing countries, in the hope that they may benefit from the experience of public pension plans in the United States.

**I. The Determ..jants of Public Pension Investment Performance**

Often referred to as "public employee retirement systems" (PERS), retirement systems established for individuals employed by state and local governments Olivia S. Mitchell - Public Pension Governance and Perfonnance
3 have become large and powerful institutio-is in the last three decades. Typically these are defined benefit pension plans, which provide workers an annual benefit accrual (usually a function of pay and years of service). This accrual converts into a retirement annuity payment when the employee attains a specified age and service under the plan. Recent surveys (see Table 1) show that there are approximately 2,400 public pension systems in the U.S., coveting about 10 million full-time public sector employees and about 3 million pension beneficiaries -- mainly employees of state and local 'overnments, and often teachers and other school employees, police and firefighters, judges, correctional officers, and other public servants.' These plans pay relatively generous benefit levels, amounting to some 40% of pre-retirement pay at relatively young retirement ages; usually PERS retirement benefits are at least partially indexed to inrlation.

Benefit promises which accrue under PERS plans are liabilities that the sponsor is expected to pay retirees at some future date. Practice varies as to whether public employers back up these promises by making payments to a segregated pension trust fund, which are then invested to generate eventual benefit payments. Many PERS plans have succeeded in amassing substantial funds: in the U.S., public pensions held about $730 billion at the end of the 1980's, accounting for _5%_ of the country's total financial assets, 13% of all domestic bonds, and almost 8% of all domestic equities (Hoffman and Mondejar 1992).

A major responsibility of those charged with managing public sector pensions is to direct the inves .nent of these assets. Research suggests that PERS funds have been Olivia S. Mitchell - Pu, c Pension C ance and Performance
4 managed somewhat differently from thos in private sector pensions. Thus Table 2 indicates tnat until 1960, corporate equities -2yistituted only a negligible fraction of state and local plan assets, while government securities and corporate bonds were much more heavily favored than private plans. This pattern of asset holdings was in part motivated by state and loe"al government rules prohibiting pension managers from investing in what were perceived to be "risky" assets including equity, venture capital, and foreign holdings.

Though these strictures have been curtailed ocr the last decade, yields on public pension fund assets have frequently been low, with puv!ic plans earning rates of return substantially below those of other pooled funds, and of:en below leading market indices.<sup>2</sup> Table 3 demonstrates this for the eighteen year perio i 1968-86, and the pattern persists in more recent statistics. More recently, state and local pension plans reported annual returns averaging 11.13%, during a time when bonds rose by 15.5% and securities by 13.9% (Table 4).

One explanation for why public plan investment yields are often low is that they are operated according to principles different from those adopted in the private sector. Specifically, many public pensions are managed by staff which must respond to political as well as economic incentives and pressures. A typical public system is governed by a Board of Directors comprised of eight members, on average, with three elected members, three appointed members (often by the Governor), and two serving _ex officio_ (e.g. the State Treasurer, the superintendent of schools, etc). Those elected to public pension Boards are frequently active employees, which is quite uncomrnon in the private sector; in addition, in Olivia S. Mitchell - Public Pension Govemance and Performance
_5_ many **cases** retired workers are also included as Board members (Zorn 1991).

Because pubiic pension Boards are mi-naged by political appointees and covered pension members, it is at least plausible that they may select investments different from those chosen by private-sector professionals cL. npeting in the capital market. There is little direct evidence on this point in the public sector, but in the private sector, pension participants appear to invest more conservatively than do profess onal pension managers (EBRI 1993). Hence it is hypothesized that better performance from public pensions could be observed when public systems manage their funds professionally, instead of rclylng on fonner or current employees.

Another way that pension governance structures might alter PERS investment yields is due to the fact that Board authority varies a great deal across public pension plans, depending on laws which vary from state to state, and also deperding on custom and tradition (Zorn 199i). For example, some PERS Boards have a great deal of responsibility for investment decisions, the- control actuarial inflation and interest rate assumptions, and direct the system's reporting practices. In other cases, external professional money managers and actuaries manage investments and reporting, leaving day-to-day benefit payments and record-keeping functions to the Board. The latter tasks are substantial: public sector pension plans reported an average of 42,000 active members per plan and $2.8 billion in assets, with annual administrative costs totalling about 1-4% of assets.<sup>3</sup> Large plans can service many of these needs in-house, employing on the average one staff member per 1,000 plan participants. Smaller plans are more likely to use external actuarial, Olivia S. Mitchell - Public Pension Govemance and Performance
legal, and accounting firms, and frequently employ professional money manar,ers and/or investment consultants as well (Zorn 1991).

When re sector pension systems manage their benefits administration and investmnent in-house, researchers have found substantial evidence of economies of scale in larger plans (Mitchell and Andrews 1981). It is therefore reasonable to expect that larger gubli pension plans might also experience higher yields, and perhaps less variability in yields, than would smaller plans. It is, of course, possible that small plans could capture most of these scale economies by hiring external professional noney managers and consultants. For this reason, it would be important to determine whether investment returns vary with having outside money managers. Furthermore, some private sector money managers are more successful than others, as discussed by Lakonishok et al (1992). Thus investment management firrns in the Top 10 performance group tend to do relatively well as investors; as others have pointed out, however, the Top 10 group is costly to empl 3y, and might not produce higher net returns (after subtracting commissions). Hence it may be hypothesized that public plan performance will depend positively on plan size if scale economies prevail (conditional on managing the money in-house), and may be higher if outside managers (especia'ly Top 10 performers) can generate higher net returns conditional on plan size.

Offsetting the hypothesis that external investment advice might result in higher and less variable pension asset yields, is the recent finding that net investment returns are sometimes lower when investment managers are subjected to frequent Olivia S. Mitchell - Public Pension Governance and Performance
7 performance reviews. This is because of a principal/agent problem: money managers appear to altez their portfolios in ways which systemPatically mak: them look better over the short run, but which in the long run prove costly for the fund.<sup>4</sup> Applying the argument to the PERS sector, it might be predicted that systems using extcrnal money managers and who employ frequent valuations might experience lower net rates r f retu-n than would systems using only in-house managers, 'articularly if they are evaluated relatively infrequently _(ceteris paribus)._ Thus in empirical analysis of pension asset yields it wil' be important to control not only on who is inanaging the portfolio, but also on how often tl y report how they are doing.

Pension plan asset performance clearsy depends on other factors in addition to the ones just described, with perhaps the most important one being the fund's portfolio mix. As noted earlier, public plans tend to hold fewer stocks than do private pensions, in part because the federal government requires private pension fiduciaries to invest in a well-diversified portfolio of assets chosen for traditional financial reasons. Furthermnore, ERISA regulations governing private plans specifically require pension fiduciaries to behave according to generally accepted financial principl-;, a philosophy summarized as the "prudent man rule". In the public pension arena, no federal legislation controls FERS investment patterns. As a result, there are no legal constraints on those who wish to dtploy public pension assets for nontraditionai investment purposes, and several groups have become increasingly voca.<sup>5</sup> For example, the Governor of New York argues that public pension assets be loaned advantageously to firms "conducting business" within his state. Olivia S. Mitchell - Public Pension Govermance and Performance
8 Other states have asked their pension tfid managers to only invest in so-called "socially responsible" companies (defined variously as firms who avoid investments in South Africa, f;rms which do not pollute, etc). While these unconventional investment practices have their appcea.!, retirees and active workers have expressed concern that their pension assets rmay eam low returns, and perhaps be insufficiently diversified (New York State Industrial Cooperation Council 1989 and 1990; New York Retired Public Employees Association 1989; Snell and Wolfe 1990).

These differences in PLRS investment practices imply that public pension **plan** returns may vary because of strictures placed on the plans by the political process, strictures which may not be in evidence in privately-run pension plans. As a result, empirical analysis of PERS performance should take into acLount whether investors operate under constraints wbich might inc' Je ceilings on the fraction of assets in bonds or stocks, rules requiring fiduciaries to diversify their portfolios in a manner which might be deemed "prudent" by impartial financial experts, and requirements that money must be directed to "socially acceptable" ventures. If these strictures are effective, they may lower returns, and possibly increase risk.

# **II. The Determinants of Public Sector Pension Funding Practices**

U.S. law requi-es private employers to explicitly recognize their accumulating pension liabilities, and then set aside contributions in an orderly fashion so as to build up assets sufficient to meet benefit promises when workers retire. The rationale for full pension funding in the private sector is that sponsoring companies may go bankrupt, and Olivia S. Mitchell - Public Pension Governance and Performance
9 unless the pension plan has received assets sufficient to cover benefit promises, retirees could face curtailed or terminated benefit payments.<sup>6</sup> In the public sector, pension funding practice has been much more variable, both in the U.S. and elsewhere. This is partly because many deem the risk of government bankruptcy to be low, and thus less persuasive as a rationale for prefunding. As a result, partially funded or completely unfunded (pay-as-you-go or PAYGO) plans have been the norm for most O.E.C.D. nations (James 1992). At the state level in the U.S., funding practices also vary: in some cases, state laws do require prefunding for accumulating pension liabilities, but in other cases they do not. (For con3titutional reasons, the Federal government has not regulated state-level public pensions).

Despite the PAYGO tradition, there are many arguments favoring substantial pension prefunding in the public sector. Funds invested earn the pension plan investment income, which "can substantially reduce +he employer's ultimate payment for such benefits" (Bleakney 1972: 16) -- a particularly inmportant matter in view of the aging of the public sector workforce over the next two decades (Mitchell 1991). Also, underfunded pensions impose an implicit future liability on taxpayers, reducing the ability of states and localities to raise funds in other -.ays (Epple and Schipper 1981). In addition, public sector retirees' income security can also be reduced by underfunding; indeed some public employees have sought offset the risk of underfunded pension promises by demanding higher pay (Smith 1981; Mitchell and Smith 1992b). Some have also contended that PAYGO systems decrease savings and impose politically unpalatable rsdistributive burdens across coho.'ts Olivia S. Mitchell - Public Pension Governance and Performance
10 (James 1992).

Despite thee arguments favoring prefunding of benefit promises, public sector pension plans have typically accumulated fewer assets relative to benefits, than have their private sector counterparts (Table 5). In the 1980's, many public employers contributed less to their public employees' pension accounts than they were required to according to actuarial computations. This is in part due to shortfalls in tax revenue collected by American states and cities during the last recession, leading some public employers to fall behind on their pension contribution schedules. Many public pensions are therefore underfunded, meaning that plan assets are insufficient to cover benefits promised to retirees. A study of 1989 data showed that state and local employer pension conaibutions were about 10-15% below target, and the pattern of shortfall was most persistent for systems where unemployment was higher than it had been for some time. This effect persisted even when controlling for habit persistence, holding constant past cumulative funding levels (Mitchell and Smith 1992 a and b). Therefore a full analysis of funding must take into account the possibility that fiscal stress undermines PERS plans' fiaiancial stability.

Previous research suggests several reasons that the structure of PERS Boards might have an effect on pension fundi..g. One consideration is that a Board composed of political appointees may feel differently about funding requirements than would a Board heavily weighted with pension-covered elected members. As an example of this, consider the court case recently filed by Califomia state retirees against Govemor Pete Wilson. State budget deficits at the end of the 1980s drove the Govemor to propose raising the Olivia S. Mitchell - Public Pension Governance and Performance
II public pension plan's assumed interest rate from 8.5% to 9.5%, a position opposed by retirees who argued that "...manipulating the rate of return on plan investments, though within legally 'reasonable limits', can substantially reduce employer contributions to the point where a pension plan can be substantially underfunded and put at high risk." (Hemmerick 1991b: 39). When the partly-elected PERS Board refused to implement it, he then moved to dissolve it and construct a Board more conducive to his needs. Hence it is should be determined whether Board composition has a potent effect on pension funding patterns, with the expectation that plan participants, particularly retirees, might be expected to exert a positive influence on funding (other things equal).

Working counter to this hypothesis is the fact that pension funding is an extremely complex and difficult area, which elected workers and retirees may be unable to fully scrutinize. Their lack of adequate technical training is exacerbated by the fact that data are difficult to obtain, and figures depend a great deal on underlying assumptions used to evaluate future benefit obligations as well as assets on hand. While little research in the funding area has been conducted, studies have shown that covered pension participants typically have very poor understanding of thei- pension plan's rules and features (Mitchell 1988) For this reason, having professional representatives on the PERS Board could improve funding, especially as compared to relatively nontechnical pension participants. Which effect dominates is an empirical matter.

In addition to Board composition, other PERS management practices can also influence funding outcomes directly. Specifically, some systems use in-house staff Olivia S. Mitchell - Public Pension Governance and Performance
12 actuaries, increasing funding if these staffers are relatively rree from political suasion, but decreasing it otherwise. When the PERS Board is required to authorize benefit increases, rather than simply passing on increases negotiated by state and local employees independently, this could translate into higher funding rates -- after all, authorization to provide future benefits would be required from those managing thn funding process. It is also worth investigating whether funding is improved when Board members have liability insurance, which if true suggests that the private insurance market may enforce funding stringencies on PERS Boards when political tensions pull in other directions.

.

Another set of factors influencing funding may be the reporting requirements to which pension managers respond. While public pension accounting practice embraces some common assumptions and standards across states and localities, the remaining differences make it difficult to compare public plan investment performance and funding outcomes in some cases. This problem has been recognized by many pension analysts over the years, and is slowly being remedied by the Governmental Accounting Standards Board which is devising a framework for public pension financial reporting (GASB 1992). The majority of large state and local plans now conform to GASB Statement No. 5 (GASB 1986) which specifies that public pension plans must report assets at market value, and liabilities measured according to a concept known as the Pension Benefit Obligation (PBO).' As a result of this increasing standardization, it is now much more likely that stock funding ratios are accurate, by which is meant that pension assets are correctly computed as a fraction of liabilities. This contrasts with practice a decade ago when most Olivia S. Mitchell - Public Pension Govemnance and Performance
13 PERS plans reported assets at cost, and used a variety of different methods to compute liability measures (Schmitt et al. 1991). Despite this progress, a cross-plan analysis of funding still requires paying attention to different approaches used in reporting assets and funding.

Along the same lines, it might be expected that more frequent reporting would tend to induce standardization, so that better funding would be expected of a PERS required to report to its sponsoring employer and participating members more often. Audits and actuarial valuations are also carried out at different intervals, and the reporting standards themselves vary. These different reporting methods may simply affect data quality without altering investment and funding performance, but many fear they have more potent effects altering plan outcomes materially. These cross-plan differences should be controlled in empirical analysis, and examined to see if they influence PERS funding outcomes materially.

Other variations in pension reporting are also important, particularly in the case where flow funding measures are considered. For the purpose of this discussion, flow funding is defined as the ratio of annual actual employer contributions, to annual required contributions. Variations in flow funding measures are partly due to laws governing pension funding practices which differ across states. As an example, the fire and police pension plans in Portland, Oregon, obey a law which sets the public employer's annual contribution rates as a fraction of payroll, and this contribution rate is generally met. C1ziseque.itly the pension financial statement indicates that the employer's actual Olivia S. Mitchell - Public Pension Governance and Performance
14 contributions are exactly equal to required contributions, resulting in a flow funding rate of 100%. In fact, however, the system has virtually no assets since it is operated on a PAYGO basis.' Therefore the flow funding figure reported by this plan does not represent the actuarial figures that the accounting standards profession would prefer under its proposed reporting rules. A related problem arising in the reporting context arises when a system uses the PBO measure to report GASB-sanctioned funding measures, but uses some other actuarial method to compute annual required employer contributions. It is possible that a plan would then appear well funded by the officially recommended PBO measure, but would be less than fully funded by the system's own accounting measure. This has apparently occurred in several instances over the last two years, where employers were able to dramatically cut their contributions after converting to new actuarial methods consistent with the PBO measure.<sup>9</sup> As a consequence, it is important to investigate whether differences in funding patterns are related to different methods of computing liabilities for reporting, versus funding, purposes.

Funding differences may also result from other factors. In computing pension obligations, for instance, actuaries employ a variety of assumptions to compute promised future benefits. Unbiased estimates of the factors of central interest require that these assumptions be controlled in the empirical analysis, by including plan-specific estimates of expected future price and wage increases, assumed discount rates and retirement ages, integration of benefits with Social Security, whether benefit levels were guaranteed by law, and portability of pension accruals. Pension systems also have some Olivia S. Mitchell - Public Pension Governance and Performance
_15_ leeway with regard to their past service liability amortization period, which refers to the time period over which unfunded pension promises from the past are covered from current contributions. Since it is possible that poorly funded plans strategically select an amortization period to improve the funding report, this too should be controlled on in a multivariate funding analysis.

To this list of pension funding determinants must be joined several indicators of the regulatory and fiscal environment in which PERS Board members make funding decisions. Most obviously linked the pension funding outcome is the existence of state-level legally mandated funding requirements. One would anticipate that if such law is binding, it would enhance funding in those states. A variant of this point is that states experiencing severe fiscal stress tend to reduce funding, suggesting that this too should be taken into account in multivariate analysis. Based on previous work, we include a variable indicating fiscal stress, which is the deviation of the state's unemployment rate from its long term trend (Mitchell and Smith 1992a). It is anticipated that greater fiscal stress would reduce funding, perhaps offset if contributions are derived from a special or dedicated tax. In addition other "political economy variables" are explored including an indicator of whether a state has a balanced budget requirement, to assess whether pension underfunding serves as a "safety valve" in cases where the balanced budget rule is taken seriously. Finally, there may be differences in plan participants' ability to exact full funding ra<sup>t</sup> es, so it is important to control for the presence of unionized employees and teachers.

# **HII. Empirical Analysis of Public Pension Yields and Funding**

Olivia S. Mitchell - Public Pension Governance and Performance
16 The data used for empirical analysis are obtained from a cross sectional survey of 201 pension systems conducted in 1991, covering a total of 269 separate retirement plans. The PENDAT file created from this survey was provided by the Government Finance Officers' Association (Zom 1991). As of this writing, there s no larger, more up-to-date, and more representative survey of state and local pension plans in the country; the federal government collects no centralized information of this type (though many have suggested it should). Respondent systems in..iuded in the PENDAT file represented 73% of state and local active pension plan participants, and 71% of state and local plm assets in 1990 (Zom 1991). These systems represent the vast majority of the PERS-covered population, but are not necessarily representative of all plans since they are among the largest in the nation, and probably better managed and funded than many smaller plans; as a consequence, interpretation of results must bear this caveat in mind. PERS plans responding to the survey accounted for about a tenth of the estimated universe of state and local pension plans nationally.

The PENDAT datafile is quite extensive, including variables reflecting all aspects of the systems' management, investment, and funding practices as well as plan participant and benefit mixes.'° Two indicators of investment performance are used as dependent variables for the multivariate analysis -- the actual investment yield rates, and the variability of plans' investment yields -- and two measures of pension funding -- stock and flow funding patterns.

Taking the investment outcomes first, three different ways were chosen to Olivia S. Mitchell - Public Pension Governance and Performance
17 measure public system's asset performance. Virtually all PERS report one datum for 1990 -- that year's total portfolio return (referred to as YIROR), and most also reported their annualized average return over the period 1986-199U (referred to as Y5ROR). Both variables are reported in nominal dollars (the analysis therefore assumes that all plans experienced identical inflation rates). The fact that the investment yield is a-<sup>eraged over the</sup> 5-year span makes it impossible to compute traditional measures of pension performance variability over time, so precise estimates of this concept must await development of panel data. An alternative variability measure used here is the root of the squared deviation beitween YIROR and YSROR as a fraction of Y5ROR, defined here as RETURNSD.

Two dependent variables were developed for the funding analysis. The concept which best captures a plan's stock funding rate in the PENDAT survey expresses pension plan assets as a fraction of the Pension Benefit Obligation, and for<sup>ease of</sup> reference this stock funding measure is termed AST_PBO. An alternative measure focuses on the plan's current funding practices, a concept captured here as FLONVFUND,<sup>or the</sup> ratio of actual to required employer contributions for the year.

Explanatory variables in the analysis are grouped into five main categories: pension Board composition, Board management practices, investment practices, reporting requirements and assumptions, and other factors which reflect regulations at the state<sup>level</sup> governing budget and funding practices. Controls are also included for plan size, type of plan and covered employees, and in some cases portfolio composition is incorporated<sup>on the</sup> grounds that plans with less risky holdings will have lower returns.

Olivia S. Mitchell - Public Pension Governance and Performance
18 Most of these variables were directly derived from the PENDAT file, but outside sources were used in a few instances. The variable called TOPIOMG indicates whether the pension system used a money manager in the Top 10 performance group as identified by Lakonishok et al (1992). The term UNEMPD represents the degree of fiscal stress experienced by the state proxied by the deviation of the unemployment rate in 1990 from the mean of the previous nine years; previous analysts suggest that this type of fiscal stress reduces funding possibilities (Mitchell and Smith 1992b). The variable DEFPOS is also derived from outside sources, and indicates whether a state is permitted to carry over a budget deficit frem one year to the next. Public pension funding may be seen as an off-budget safety-valve, relieving the pressure of having to meet state balanced budget requirements. Hence pensions may be better funded when state budget deficits can be carried through time, while underfunding may prevail more often when state budgets must be balanced, by law, at year's end." Summarizing this discussion in a multivariate framework, the following model is postulated: (l)Y, = a, + a, X, + a2 X2 + a3 X3 + **a,** X4 + a, Z + e, (2) Y2 = b, + b, X, + **_b,_** X2 + **_b3_** X3 + **_b4_ X4 +** b5 Z + **_e2_** where Y, represents a vector of variables reflecting public pension investment performance: Y,represents a vector of funding variables; X, - X,represent vectors of variables reflecting pension Board composition, Board management practices, investment practices, reporting requirements and assumptions; and Z represents a vector of other Olivia S. Mitchell - Public Pension Governance and Performance
**19**

factors including state regulations governing budget and funding practices, controls for plan size, type and in some cases portfolio composition. In this section the disturbance terms are assumed to be distributed normally with zero mean; in Section IV this assumption and others, are discussed in more detail.

Evidence on the Investment Performance of State and Local Pension Systems In 1990, the annual investment yield reported by the 168 PERS systems was 7.74% (Table 6). This compares favorably with market data showing a +6.8% return for securities that year, and with the 1990 inflation rate of 6.1%. However, not all plans performed this well -- one plan reported a -5.5% return that year, while at the other extreme a plan reported a yield of +24.5%. **12** This range (see Figure 1) is almost certainly due to different portfolio composition patterns across the plans; in the market as a whole, the +6.8% return for securities that year was offset by an average -3.2% yield on bonds, which suggests the importance of holding constant the portfolio composition of pension plans when comparing their investment yields. A narrower frequency distribution of pension yields characterizes YR5ROR, returns averaged ove; the period 1986-1990 (see Figure 2). Across the 128 plans reporting the figure averaged 11.58%, with the lowest return reported of -2.54% and the highest being 31%.'3 The overall mean was lower than the annualized return on bonds for the same period of 13.5%, but exceeded the average stock return of 10.1% as well as the annualized inflation rate of 3.3%. The pattern of RETURNSD is sketched in Figure 3: this variable increases when there was a larger gap between the 1990 one-year return and C!ivia S. Mitchell - Public Pension Govemance and Performance
20 the average return over the 5-year period. Put differently, since most investment yields were low in 1990 as conmpared to previous years, the plans with a higher value of RETURNSD were those whose 1990 return fell most quickly, relatively speaking.

Table 7 provides multivariate linear regression estimates of equation (1) above, indicating the determinants of pension plan investment yields. The findings show that the composition of the public pension Board appears to matter: specifically, lower yields in 1990 were tied to greater retiree representation on the public pension Boards. This is probably not due to more conservative investment choices made by retirees, since the model controls for the portion of the portfolio held in stocks and bonds. It may be the result of inexpert retiree Board members becoming increasingly activist of late, an explanation buttressed by the fact that the retiree effect was negative but not statistically significant in the five-year yield equation. Another troubling finding is that pension systems with more retirees on the Boards also experienced larger return variability between 1986 and 1990, suggesting that the lower yields in retiree-managed plans were apparently not offset by less risky assets. Before concluding that state governments should move to prohibit retiree participation on pension Boards, it should be noted that appointed members might also reduce asset yields (if improperly selected). Future surveys should focus attention on the new 1990's-brand of pension Board activism and its negative effect on pension plan yields.

Of the several pension management practice variables used in the investment performance equations, few had a powerful effect on pension yields or variability. One Olivia S. Mitchell - Public Pension Gcvernance and Performance
**21**

influential practice which did make a difference was a system's practice of permitting administrative costs to be charged to investment incol **ie** (ADINVST), rather than being covered from state or local budgets directly. This reduced the 5-year average return figure at statistically significant levels, though neither the 1990 return nor the variability measure were powerfully affected. The PENDAT survey does not indicate whether the systems reported net or gross investment returns, but tne negative significant effect of ADINVST suggests that the figures given were net of expenses..

This surmise is strengthened by the resultq of the next three management practice variables reported in Table 7. Many pension systems managed at least some of their pension investments in-house, but this p.actice apparently had no substantive effect on any of the investment yield outcomes. Some state and local systems used outside money managers and financial counsellors, either in concert with internal management, or exclusively. In al.' cases, the results indicated that plans investing in-house, or using external money managers fared about the same, even if the external managers were drawn from the "Top 10" group identified by Lakonishok et al. (1992). This is not surprising if the investment yield figures supplied in the PENDAT survey were net returns, since higher gross yields produced by active money managers tend to be equalized after commissions (Ippolito 1989).

Only a few of the rules regarding investment practices proved statistically significant in Table 7. In no case was the prudent man requirement statistically linked to returns or investment variability, though it may be that all pension Boards follow some Olivia S. Mitchell - Public Pension Governance and Performance
22 variant of this policy 'which would explain why no significant effect was discerned). The data also showed no si ,nificant effect of state-mandated limits on stockholdings on any of the three investment performance variables. More serious is the powerful negative return observed in pension systems which were required to direct a fraction of their investments in-state. This policy has grown iinereasingly popular in the last few years among those who propose to use pension funds to build a stronger job and tax base.'<sup>4</sup> Unfortunately, there is emerging evidence that such a poicy was associated with lower investment returns in 1990 -- by 7 to 8 percentage jsoints. This ffect was not detected using the 1985-90 average return, but since it reflect., recent trends which may not have been in effect in earlier years, the effect is large eiiough that it should not be ignored.

Two factors were used to quantify state and local pension system reporting practices in the analysis presented in Table 7; numerous other variables were examined but none proved especially significant. It will be recalled that having independent investment performance analysts and more frequent performance valuations could be predicted to either improve or depress investment yields, depending on whether more reporting is seen as beneficial, or harnful (Lakonishok et al 1992; Benartzi and Thaler 1992). The data do not support either position, however, since neither variable was strongly statistically significant.

Summarizing the findings, the empirical models examined indicate that some pension governance and management factors systematically affected yields and variability, at least for the sanple of plans considered here. Three findings stand out: (1) The frac'ion of retirees elected to the pension Board had a strong negative effect Olivia S. Mitchell - Public Pension Govemance and Perfonnance
23 on investment return in 1990, and increased return variability.

(2) Systems fared about the same irrespective of whether they had in-house, or external money managers, or independent performance analysis (even if the external managers were drawn from the "Top 10" group).

(3) Social investment rules hurt public pension yields; specifically, public pension plans which mandated that a certain portion of investments be directed to in-state projects generated much lower returns.

Funding Patterns Among State and Local Pension Plans: As noted earlier, many state and local pension plans follow GASB advisory rules when reporting their pension assets and liabi!ities. This makes it possible to place some credence in funding figures, particularly with regard to the ratio of the pension plan's assets to its promised benefit liabilities (AST_PBO). As indicated in Figure 4, the stock funding ratio averaged 91% in 1990 (for the 220 plans reporting). There is ample evidence of wide dispersion in funding practice: the minimum stock funding ratio was approximately 0 (for PAYGO plans), and 18 plans were seriously underfunded, having less than half the assets needed to meet pension obligations. " On the other hand, the maximum funding ratio was 3.2, and or.e-third of the plans had sufficient assets to meet projected benefits. For this reason the average stock funding rates of more than 90% should not be taken as evidence that public plans were uniformly well-funded on an accumulated basis.

Annual funding measures capture whether the employer is contributing enough each year enough to cover new benefit accruals and amortization needs from past unfunded obligations. As mentioned earlier, however, there are serious reasons to believe the FLOWFUIND figures are biased upward; an employer reporting full compliance with Olivia S. Mitchell - Public Pension Governance and Perfornance
24 required contribution levels may sometimes receive monies inadequate to meet eventual benefit promises. This probably explains why the average FLOWFUND ratio in 1990 was 93% (across 187 plans; see Figure 5). The range about the mean is large: at one extreme a plan reported receiving 3.4 times the amount required, while at the other extreme a plan indicated receiving -4.3 times what was required.<sup>6</sup> On the whole, the vast majority (137 of 187) reported receiving contributions less than 100% of required, suggesting that most public sector employers' contributions do not meet required levels. This is troubling, particularly because of the concem that the FLOWFUND variable is biased upward.

Multivariate evidence linking public pension governance and funding patterns according to equation (2) is summarized in Table 8, where both stock and funding pattems are examined. A first hypothesis was that public pension Board composition variables are related to stock funding ratios, and there is support for this position. Specifically, the results show that having more elected members on the Board lowered pension funding rates, with elected retirees having a particularly depressing effect.'" No composition effect was found in the flow funding equation, however.

Pension management practice also proved informative in explaining funding patterns: three of the four variables used were positively related to stock funding patterns. For instance, the plans appeared better funded when a PERS had in-house actuaries, and the effect was statistically significant. Likewise, if the Board was required to authorize benefit levels, stock and flow funding were higher. There was a positive significant relationship between funding levels and Board members having liability insurance: perhaps this is due Olivia S. Mitchell - Public Pension Govemance and Perfornance
25 to the increased oversight imposed by private insurers. (On the other hand, flow funding was negatively related to liability coverage -- which may indicate reverse causality, if plans which underfunded on a flow basis were required to purchase insurance in order to induce Board members to serve.) Pension reporting and assumptions also affected funding outcomes as expected. Pension systems differed according to the frequency and format of funding reports, and stock funding ratios were lower where longer amortization periods were selected -- indeed, it is possible that amortization periods were strategically chosen to improve the funding report. Supporting this view is the finding that plans which did not report their amortization period were even more seriously underfunded than average.

Clearly it is necessary to standardize on reporting in order to obtain a clear picture of stock funding practices. Assumptions to compute promised future benefits also played a role in the empirical analysis: the model included variables indicating expected future price and wage increases, assumed discount rates and retirement ages, integration of benefits with Social Security, and portability of pension accruals. Of this set, only the portability factor proved statistically significant at conventional levels, and was negative. This is probably due to the fact that asset accruals did not always follow employees who were permitted to take benefit accruals with them when they changed jobs (usually this is limited to in-state moves). As such, it would be incorrect to conclude that labor mobility _per se_ reduces stock funding ratios; rather, funding was low when systems permitted mobile workers to claim benefits with no concomitant asset accumulation backing up the promise.

Olivia S. Mitchell - Public Pension Governance and Performnance
26 Of the other factors controlled in the empirical funding analysis, very few had potent effects. Somewhat surprising was the null effect of state requirements that pension plans had to be funded, requir-nents that benefit levels had to be guaranteed by law, and requirements that states must balance their budgets from one year to the next. Nor were funding levels different when dedicated or special taxes were earmarked for pension revenue.<sup>8</sup> Employee type (i.e. teachers) and unionization status also had no effect. In fact, only one other variable was found to systematically and powerfully reduce stock funding: namely, fiscal stress, measured here by the deviation of recent unemployment from the levels experienced over the last decade. The effect was substantial, suggesting that a 1 percentage point increase in a state's unemployment rate over the long run average would cut stock funding by 6 percentage points. It appears that economic recessions have long as well as short term effects on public budgets through pension plan funding. This effect is consistent with previous studies on public plans (Mitchell and Smith 1992a).

In summary, there is reason to believe that the stock funding figures are of superior quality than the flow funding data, so it is appropriate to emphasize those models and findings. In this dataset, pension underfunding patterns are explained by several factors pertinent to the environment in which the pension Board operated. The most important findings were:

- (1) Fiscal stress reduced stock funding ratios.

- (2) Stock funding rates were lower, the higher the fraction of elected retirees and elected active workers represented on the pension system Board.

- (3) Stock funding ratios were higher when the system had in-house actuaries, when the Board was required to authorize benefit levels, and when Board members had

Olivia S. Mitchell - Public Pension Governance and Performnance
27 liability insurance.

(4) Stock funding rates were unaltered by state statutes guaranteeing that benefits were guaranteed by law, or by legally set funding requirements, or by the ability of states to carry budget deficits from one year to the next. They also did not vary when dedicated or special taxes were earmarked for pension revenue. **IV. Sensitivity of Results** Several sensitivity tests were conducted to judge the robustness of the results. One concern has to do with potential endogeneity of particular variables in the Z vector. For example, both the yield and variability equations included in the Z vector the PERS portfolio mix, because the plan's stock and bond holdings were expected to have affected the plan's investment performance. On the other hand, the system's 1990 return and 1990 portfolio mix were probably simultaneously determined in a complex structural system involving expectations over variables not available in the data set. As a test of the model, the potentially endogenous portfolio composition variables were purged and the model reestimated, which produced estimates virtually identical to those reported in Table 7 (results available on request). In a similar vein, it might be asserted that the pension assumptions in equation (2) were endogenously determined by politicians setting funding targets. Hence a reduced-form equation was estimated which excluded pension assumptions from the model. Here too, coefficient estimates for the remaining variables were virtually identical to those reported here (results available on request). Hence it appears that this form of simultaneity does not exert a potent effect on the outcomes of most interest here, namely the pension governance and authority terms.

An additional question examined in some detail, but summarized here for the sake of Olivia S. Mitchell - Public Pension Governance and Performance
28 brevity, pertained to the issue of biased reporting due to selective missing data. This was handled in two ways. First, if a pension plan had valid data on all but one (or a few) right hand side variables, the missing datum was assigned a value of 0 and a missing-value indicator was given a value of 1. This permitted maintenance of sample size due to incomplete reporting for pension assumptions, in particular. A second approach was taken if the plan lacked a report for a dependent variable, since this raised a question about whether the data were missing randomly. Specifically, it might be that that those plans who were performing less well than the market, or those who were more poorly funded than average, might not be reporting. For this reason, several models were also estimated accounting for the probability of some plans not reporting investment yields and funding ratios. In each case, a sample selection term derived from a Probit nonreport equation (inverse Mills ratio) was incorporated in the regression equations (I and 2). The selection controls proved to be not statistically significant in general, andc6ther coefficient estimates were quite similar to those reported hele (results available on request).

The conclusion from the sensitivity analysis is that the results appearing in Tables 7 and 8 are quite robust to a reasonable range of alternative formulations. They also confirm the important role of several pension governance features in public pension plan outcomes."<sup>9</sup> It must be emphasized that these behavioral patterns are derived from the data at hand, however, and are not necessarily representative of those plans excluded from the PENDAT sample. Specifically, the findings are most applicable to relatively large state-run plans, rather than the smaller local and municipal public plans covering a few officers or other Olivia S. Mitchell - Public Pension Governance and Performance
29 uniformed public sector workers. As a result, the data are not yet good enough to know whether these smaller plans have the same problems, and same strengths, as their larger counterparts.

# **V. Conclusions and Discussion**

After a decade of strong growth, public pension plans in the United States are at a crossroads. A few state and local retirement systems are in serious straights, having earned large negative rates of return on assets, or in some cases having virtually no assets by 1990. Already some retirees have confront cuts in benefits: in 1991, for example, the California state legislature disallowed two cost-of-living clauses in its public pension plan, earmarking **the** funds thus generated to "reduce employer contributions in fiscal year 1992-93 and subsequent fiscal years until those amounts are depleted" (court documents cited by Melbinger 1992: 23). In the future, retirees may face more serious cuts, if fund assets prove too meagre to meet benefit promises.

In contrast to these problems experienced in pension plans where employers were subject to most fiscal distress, many public plans have done quite well. The strong capital markets of the 1980's boosted many pension systems' investment portfolios substantially. Increased assets combined with careful money management and adequate employer contributions covered all or most of the benefits promised to current and future retirees. This research shows that better performance from public pensions was attained when plans managed their funds and actuarial computations professionally, instead of relying on former or current employees, and by eschewing investment rules directing funds Olivia S. Mitchell - Public Pension Governance and Performance
**30**

to in-state projects.

These conclusions may not be popular with policymakers confronting budgets in distress. Indeed a great deal of effort has recently been directed to developing new ways of _reducing_ public pension contributions, and where possible, directing pension assets so as to generate local jobs and investment. A critically important question which is only beginiing to be asked is whether the social costs of underfunding and below-market return investments are sufficient to offset their social benefits. In other words from a public finance viewpoint, "socially targeted" infrastructure investments could be justified when the social gains to such investment outweigh the social costs, taking care to note that the costs include potential retiree insecurity when public pension underfunding leads to pension and other benefit cuts. It would be useful to design and implement such a cost/benefit framework when evaluating public pension asset allocation and performance practices. In order to do this, more timely data must be collected which can be examined using a common reporting and accounting framework. Policymakers and researchers in the United States have begun to recognize this need, and have recommended standardization of pension data gathering, probably under the aegis of a federal agency (Melbinger 1992; Mitchell 1991; Munnell 1983).

Fiscal analysts in developing countries may profit from the mistakes and the lessons gleaned from public pensions in the United States. This paper shows that pension systems are extremely complex institutions, so that care must be taken when designing the regulatory and investment environment in which such plans operate. This study did not Olivia S. Mitchell - Public Pension Governance and Performance
**31**

seek to identify an optimal package of pension plan practices for all systems across all time periods. However, it did indicate that professional actuarial and investment counsellors must be sought, rather than relying on employees to chose investment strategies which will guarantee eventual benefit payments. (There was no persuasive evidence that hiring a money manager from the most active segment of the market would generate much better portfolio performance). The research also suggested some of the enormously complicated issues that must be confronted when seeking to establish funding norms for defined benefit pension plans in the public sector. The Government Accounting Standards Board in the U.S. has devoted several years to the development of a standardized framework to be used for reporting public pension plan liabilities and assets; their work would be beneficially reviewed by those designing public pensions in developing countries.20 In general, if full, or near full, funding of public pension plans is contemplated, it would appear useful to require standardization of pension reporting practices. This is particularly true regarding the myriad assumptions needed to cost out a defined benefit plan's promised obligations, including the amortization penod over which past liabilities must be met. This is often a difficult task, inasmuch as defined benefit pension rules determining benefit eligibility and amounts frequently differ from one group of employees to another, as well as across cohorts. Sometimes benefit and contribution regulations have internally inconsistent objectives. Frequently in a developing country there may be insufficient actuarial data to derive assumptions needed for projecting expected labor force patterns, and forecasts of economic trends are also inherently uncertain. For all Olivia S. Mitchell - Public Pension Governance and Performance
32 these reasons, it is a fairly laborious task to improve reporting and disclosure patterns for public plans. In many cases pension systems are not computerized, making it even more difficult to track investments and participant data. In other cases, there may be substantial evasion of public pension payroll taxes, which can make projections of contribution flows politically disputatious.2' This raises a more general concern: how should public pension policies in developing courtries be evaluated? For example, mandatory retirement savings programs in most are generally subject to numerous government restrictions -- about where the funds can be be invested domestically and whether any can be invested abroad, about the fund's exposure to inflation and financial market risk, and related questions. Those contemplating mandating retirement savings programs must recognize that these restrictions are a means of reallocating the risks of retirement income security between the public and private sectors, which should be explicitly acknowledged in designing pension funding and investment policy. Whether the social costs of such programs offset their social benefits should be a question explicitly asked, and at least partly answered.

A way to reframe this question is to ask why state and local public pensions tend to be relatively fully funded, at least as compared to most OECD nations which have employed PAY&GO financing for some time. One explanation may be that states and localities are prevented from total underfunding because of their relatively mobile populations, who recognize that underfunded plans will impose eventual tax burdens on them. While this is an attractive theory, there is little empirical support showing that Olivia S. Mitchell - Public Pension Governance and Performance
33 underfunded pension promises are capitalized precisely in property values (Epple and Shipper 1981). There is, however, some suggestion that public sector workers demand a wage premium to compensate them for their underfunded pension promises (Smith 1981; Mitchell and Smith 1992), and other constraints resulting from underfunded pensions might be low bond ratings, for example. These constraints will probably become increasingly binding at the national level, with more flexible intemational labor and capital mobility, and may begin to restrict national governments' ability to underfund public pension plans as well.

Some analysts suggest that the myriad reporting and funding issues surrounding publicly managed pension plans can be dispensed with, if a defined contribution plan is established, rather than a defined benefit plan. In this latter case, the employer promises only to deposit some contribution rate into an investment account, which then is invested, usually with the proviso that funds cannot be withdrawn until retirement. In the United States, deferred compensation plans of this sort have become increasingly popular since enabling tax law regarding these plans was clarified during the 1980's. All states currently offer such plans to their public sector employees, generally in the form of voluntary supplemental tax-deferred savings plans offered in addition to the conventional defined benefit pension plan. A recent study indicated participation rates of about 24% of eligible workers in the public sector. These plans are even more popular among private employees, where 57% of eligible employees participate in 401(k) defined contribution offerings. The difference in participation rates between public and private Olivia S. Mitchell - Public Pension Governance and Performance
34 sectors is attributed to the fact that public employees must make the entire contribution themselves and the limit is currently $7,500 per year, (or one-third of compensation) while in the private sector, the contribution limit is higher and companies generally offer workers matching funds (EBRI 1993).

One appeal of these savings plans is that they are self-directed, which means participants can often tailor their own investment portfolios to their individual preferences. In recent years, however, analysts have become concerned that employees participating in deferred pay plans tend to overconcentrate their investment portfolios in low-risk, low-return assets. As a consequence of their conservative stance, future retirees may find that their retirement incorr. is inadequate to meet needs (EBRI 1993). This objection is linked to a broader criticism of these plans, which is that they do not necessarily generate subsistence income for retirees, inasmuch as eventual benefit amounts are linked to contributions, not need (James 1992).

The appeal of miandatory defined contribution plans has been spurred by the recent experiences of Chile's new retirement system. A decade ago, several private investment houses were awarded the management rights over workers' pension plans created as a replacement for the country's foundering PAYGO social security system. The Chilean system's popularity is in part due to the finding that the investment returns under this plan exceeded those of other public retirement systems in Latin America (Mesa Lago 1989 and 1991). While this is laudatory, little is yet known about how well the plans performed relative to an internationally diversified portfolio, which is in principle the Olivia S. Mitchell - Public Pension Governance and Performance
**_35_**

standard which employees and retirees might wish to use. During the firht several years of the Chilean pension plan's operaticn, for instance, the pension system's investment portfolio was limited almost exclusively to government bonds, and only gradually has private domestic equity been permitted. Even more recently, the Chilean defined contribution system has begun to introduce international asset holdings, though are still limited to a fraction of the pension portfolio.<sup>22</sup> In conclusion, policymakers all over the world confront an aging population. Better functioning pension plan structures must be devised to meet the retirement needs of older persons in both developed and developing countries. A key element in meeting these needs will be the improvement of pension plan investment and funding performance. The U.S. experience cannot be generalized to other countries in every instance, but it does demonstrate that public pension performance is responsive to the financial and admninistrativ **e** nvironment in which these plans operate. Retirement income security of tomorrow requires designing better pension systems today.

Olivia S. Mitchell - Public Pmnsion Governance and Perfonnance
**36**

# **Table** _i._

# **State and Local Pension Plan Characteristics**

|**1. Public Pension Plan Ch**|**aracteristics Through**|**Time**||
|---|---|---|---|
|||Year||
||**1980**|**1985**|**1989**|
|Total Participants|NA|15,234|16,684|
|(000)||||
|Active Participants|NA|10,364|11,357|
|(000)||||
|Total Assets|$162|374|629|
|($B current)||||
|Total Contributions|$21|37|44|
|($B current)||||
|Total Benefits|$11|22|33|
|($B current)||||
|Number of Plans|NA|2,589|2,387|

Source: Piascentini and Foley (1992).

Olivia S. Mitchell - Public Pension Governance and Perfornance
37

# **II. Survey of Public Pension Plan Participants in 1989**

|Pe|nsion Feature|
|---|---|
|Mean Retirement Benefit'|$9,31°|
|Median Retirement Benefit'|$7,200|
|Median Public Pension as % of Pre-retirement Earnings (total)<sup>2</sup>|42%|
|Median Public Pension as % of Pre-retirement||
|Earnings for those not receiving Social Security<sup>3</sup>|50%|
|Fraction Receiving Any Post Retirement Benefit Increases'|34%|
|Fraction of Participants Covered by Defined Benefit Plan<sup>5</sup>|70%|

Sources:

|'Phillips (1992), Table 14.9, p. 367.|
|---|
|'Phillip' (1992), Table :4.13, p. 371.|
|'Phillips (1992), Table 14.7, p. 375.|
|4Phillips (1992), Table 14.20, p. 379.|

'Phillips (1992), Table 14.25, p. 384. Fraction excludes more than 10% of respondents unable to identify their plan type.

Olivia S. Mitchell - Public Pension Governance and Performance
38

# Table 2.

# Size and Allocation of Pension Plan Portfolios:

## 1950-1989

||||Fraction o|f Assets in:||
|---|---|---|---|---|---|
||Total Assets<br>($B Current)|Corporate<br>Equities|Corporate<br>Bonds|**US**G;ovt<br>Securities||
|Other||||||
|I. State a|nd local government plans|||||
|1950|$4.9|0.0%|12.2%|_51.0%_||
|36.7%||||||
|1955|10.8|1.9|25.0|43.5|29.6|
|1960|19.7|3.0|36.0|29.9|31.0|
|1965|34.1|7.3|50.4|22.3|19.9|
|1970|60.3|16.7|58.2|10.9|14.1|
|1975|104.8|23.2|59.0|7.4|10.4|

Olivia S. Mitchell - Public Pension Governance and Performance
39

|1980|198.1|22.4|47.7|20.2|9.7|
|---|---|---|---|---|---|
|1985|404.7|29.7|31.9|30.5|7.9|
|1989|727.4|39.9|27.3|27.2|_5.5_|

# **II. Private plans**

Noninsured:

|1950|$7.1|_15.5%_|39.4%|32.4%||
|---|---|---|---|---|---|
|12.7%||||||
|1955|18.3|33.3|43.2|16.4|7.1|
|1960|38.1|43.3|41.2|7.1|8.4|
|1965|74.4|54.8|_30.5_|4.0|10.6|
|1970|112.0|59.9|26.2|2.7|11.2|
|1975|225.0|48.0|18.6|8.0|25.4|
|1980|469.6|47.6|16.5|10.8|25.1|
|1985|848.4|46.4|14.3|12.3|27.0|
|1989|1,163.5|57.3|12.4|12.3|18.0|
|Insured:||||||
|1950|4.8|4.2|41.7|22.9|31.2|
|_1955_|10.1|4.0|43.6|9.9|42.6|
|1960|16.8|4.8|43.5|6.0|45.8|

Olivia S. Mitchell - Public Pension Governancc and Performance
40

|1965|25.5|6.3|41.6|3.5|48.6|
|---|---|---|---|---|---|
|1970|37.5|13.6|37.6|2.4|46.4|
|1975|64.6|18.6|37.5|2.2|41.8|
|1980|152.2|16.0|39.9|3.7|40.3|
|1985|337.9|13.0|35.7|12.9|38.4|
|1989|525.8|12.3|39.8|11.6|36.3|

Note: Insured plans are pension plans whose assets are held by insurance companies. Source: Hoffman and Mondejar (1992), T. 16.9 and 10, pp. 438-441.

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41

# **Table 3.**

# **Historic Pension Plan Investment Yields**

# **(1968-1986)**

||US State & Local|US Large Private|Pension Plan|<br>Canadian Large|||US|
|---|---|---|---|---|---|---|---|
||Pension Plan|Investment|Return|Private Pension Plan|Market|Indeces|Inflation|
||Investment Return'|SEI data<sup>2</sup>|5500 data'|Investment Return<sup>4</sup>|Stocks'|Bonds'|Rate'|
|1968|7.75&|8.4%|-|9.4%|11.1%|2.6%|<br>4.7%|
|1969|-7.94|-5.2|--|-3.2|_-8.5_|-8.1|6.1|
|1970|5.63|1.3|--|_1.3_|4.0|18.4|_5.5_|
|1971|14.76|17.5|--|12.5|14.3|11.0|3.4|
|1972|12.58|15.3|--|18.4|19.0|7.3|3.4|
|1973|-9.32|-15.1|-|-2.1|-14.7|1.1|8.8|
|1974|-13.03|-20.3|--|-12.7|-26.5|-3.1|12.2|
|1975|19.14|23.1|--|13.2|37.2|14,6|7.0|
|1976|18.03|17.2|-|12.4|23.8|18.6|4.8|
|1977|0.31|-2.2|1.6|8.7|-7.2|1.7|6.8|
|1978|3.16|5.8|6.0|13.5|6.6|-0.1|9.0|
|1979|6.36|13.7|10.1|15.0|18.4|-4.2|13.3|

Olivia S. Mitchell - Public Pension Governance and Performance
42

|1980|11.58|20.2|21.9|18.3|32.4|-2.6|12.4|
|---|---|---|---|---|---|---|---|
|1981|3.00|2.7|_5.4_|1.5|-4.9|-1.0|8.9|
|1982|27.22|23.0|18.2|21.1|21.4|43.8|3.9|
|1983|12.89|15.9|9.4|20.0|22.5|4.7|3.8|
|1984|-|--|9.9|8.8|6.3|16.4|4.0|
|1985|--|--|20.0|23.5|32.2|30.9|3.8|
|1986|--|--|14.1|12.8|18.5|19.8|1.1|

Notes: 'Public pension plan data from SEI Financial Services reported by Berkowitz & Logue (1986), T. AIII-3.

2 Large U.S. private plan data from SEI Financial Services reported by McCarthy & Tumer (1992) T. 12.1, p. 253.

'Large U.S. private plan data from 5500 Repo-ts reported by McCarthy and Tumer (1992) T. 12.1, p. 253.

'Large Canadian private pension plan data from SEI Financial Services reported by Pesando and Hyatt (1992) T. 1, p. 21.

'McCarthy and Tumer (1992), Table 12.1, p. 253.

Olivia S. Mitchell - Public Pension Govemance and Performance
43

## Table 4.

## Recent Public Sector Pension Plan Yields:

# Annual Averages, 1984-1990

|Sta|te & Local Pension Plan|Marke|t Indeces|Inflation|
|---|---|---|---|---|
||Investment Return|Bonds'|Securities'|Rate'|
|Average**1984-199**|**0:**<br>**11.13%**|**15.51%**|<br>**13.91%**||
|**4.11%**|||||
|1990|6.85'|-3.17|6.78|6.11|
|1988|_3.95'_|16.81|10.70|4.42|
|Average 1988-90|9.553|15.04|11.24|5.06|
|Average 1986-90|11.984|13.77|10.66|4.14|
|Average 1986-88|13.885|13.50|10.09|3.32|

Olivia S. Mitchell - Public Pension Governance and Perfonnance
44 3.54 15.79 12.076 _15.51_ Average 1984-88 Notes: 'Zom (1991), T. VII-7, p. 34; 129 plans.

2Zom (1990), T. 34, p. B34; 108 plans.

3Zom (1991), T. VII-8, p. 35; 85 plans.

> 4 Zom (1991), T. VII-9, p. 36; 85 plans.

> 5Zom (1990), T. _35,_ p. B35; 113 plans.

6Zom (1990), T. 36, p. B36; 85 plans.

> 7 lbbotson Associates (1992), T. 13, p. 34.

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45

# **Table** **_5._**

# **Pension Plan Stock Funding Ratios** in **1991**

# **Ratio of Pension Plan Assets**

# **to Pension Plan Liabilities**

# **Fraction of Plans**

|I. State and Local Plans'||
|---|---|
|_< 50%_|8%|
|50-74|21|
|75-99|39|
|3100%|33|
|II. Private Sector Plans<sup>2</sup>||
|_<50%_|1%|
|50-74|4|
|75-99|10|
|100-124|_25_|
|125-149|22|

Olivia S. Mitchell - Public Pension Governance and Performance
46 _2!_ 150% 38 Sources: 'Author's adaptation of unpublished data from GAO. 2EBRI (1992), Table 4.20, p. 153.

Olivia S. Mitchell - Public Pension Governance and Performance
47

# **Table 6.**

# **Descriptive Statistics and Variable Definitions**

|**1. Dependent Variables**<br>MeanSt.**Dev.**|||
|---|---|---|
|YR I ROR|7.74|4.9|
|YR2ROR|11.58|2.9|
|RETURNSD|0.44|0.3|
|AST_PBO|0.91|0.3|
|FLOWFUND|0.93|_0.5_|
|II.**Explanatory Var:ables**|||
|BDELAC|0.31|0.3|
|BDELRT|0.03|0.1|
|LIABINS|0.42|_0.5_|
|BDACTOK|0.83|0.4|
|BDBENOK|0.72|_0.5_|
|ADINVST|0.51|_0.5_|
|INVINHS|0.42|0.5|
|ACCINHS|0.61|_0.5_|
|TOPIOMG|0.41|_0.5_|
|TOPIO*EXT|0.18|0.4|
|PRUDMAN|0.85|0.4|
|INSTATE|0.01|0.1|
|STKMAX|0.83|0.4|
|INDINVPF|0.75|0.4|
|FREQVAL|1.23|0.8|
|REPSOLO|0.59|_0.5_|
|GIVERPT|0.90|0.3|
|AMORTPER|22.29|13.8|
|AMORTMS|0.10|0.3|
|ACTUARUC|0.10|0.3|
|COLA|0.77|0.4|
|WDOT|4.81|2.5|
|WDOTMS|0.19|0.4|
|PORTABLE|0.35|0.5|
|EXPROR|7.68|1.2|
|EXPRORMS|0.01|0.1|
|INFL|3.53|2.5|
|INFLMISS|0.32|_0.5_|
|AVRETAGE|46.80|24.4|
|AVRETAGEMS|0.21|0.4|
|SSINT|0.12|0.3|
|FLJNDLAW|0.58|0.5|

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48

|DEFPOS|0.40|_0.5_|
|---|---|---|
|TCHRPLAN|0.12|0.3|
|ASSETS (*10-3)|496.44|7.0|
|ASSETSSQ (* 10-9)|0.05|0.2|
|BOND|33.16|28.1|
|STOCK|36.09|17.3|
|BENNOCUT|0.52|0.5|
|BENTIERS|0.28|0.5|
|ISUNION|0.67|0.5|
|SPECTAX|0.15|0.4|
|UNEMPD90|-1.73|1.2|

(continued) Olivia S. Mitchell - Public Pension Govemance and Performance
49

## **Table 6 (continued)**

## **Variable Definitions**

Note: All variables are derived from the PENDAT file described in Zorn (1991) unless otherwise indicated. All variables are qualitative (0,1) unless speci;ied.

## **Dependent Variables**

|YRIROR|Annual rate of retmun reported in 1991 survey (%).|
|---|---|
|YR5ROR:|Average annualized rate of return 1986-90 reported in 1991 survey (%).|
|RETURNSD:|Return Variability (%) = (([1990 Return- (1986-90 Average Return)J*2)*l/2)<br>/<br>(1986-90 Average Retum)|
|AST_PBO:|Ratio of reported pension system assets to PBO rr.asure of cumulative plan<br>liabilities (%).|
|FLOWFUND:|Ratio or annual actual to required employer plan contributions (%).|

# **Independent Variables**

## _A. Pension Board Composition_

|BDELAC:|Fraction of pension Board elected by active employees (%).|
|---|---|
|BDELRT:|Fraction of pension Board elected by retired employees (%).|
|BDBENOK:|Board is required to authorize benefit amounts.|
|BDACTOK:|Board is required to authorize acruarial assumptions.|
|LIABINS:|Board is covered by liability insurance.|
|_B. Pension Man_<br>ADINVST:|_agement Practices_<br>Administrative cost charged to pension investment income.|
|INVINHS:|Investment staff of pension portfolio is partly (or fully) managed in-house.|
|ACCINHS:|Accounting staff needs of pension system partly (or fully) met in-house.|
|TOPIOMG:|Plan investments are handled partly (or fully) by external money managers in the|

Olivia S. Mitchell - Public Pension Governance and Performance
_50_

||top 10 performance bracket as per Laknonishok et al. (1992).|
|---|---|
|TOPIO*EXT:|Plan investments exclusively handled by ton 10 money managers.|
|_C. Pension Inves_<br>PRUDMAN:|_tment Practices_<br>Pension Board required to act according to "prudent man" rule.|
|INSTATE:|Fraction of pension investments which must be directed in-stae**_(%)._**|
|STKMAX:|There is a maximum limitation on the assets in the pension portfolio.|
|_D. Pension Repo_<br>INDINVPF:|_rting Practices_<br>Pension system obtains independent investment performance evaluafiors.|
|FREQVAL:|Frequency of independent performance evaluations.|
|REPSOLO:|System issues own financial report (not integrated with other budgets).|
|GIVERPT:|Plan participants receive annual financial report.|
|AMORTPER:|Amortization period for past service liabilities.|
|AMORTMS:<br>ACTUARUC:Pensi<br>_E. Pension Assum_<br>|Amortization period not stated.<br>on system uses unit credit method of computing pension liabilities.<br>_ptions_<br>|
|COLA:|Benefits are partially (or fully) indexed after retirement.|
|WDOT:|Future salary growth assumption required to compute PBO.|
|WDOTMS:|Salary growth assumption not stated.|
|PORTABLE:|Employees moving within state may carry benefit accruals to new plans.|
|NEXPROR:|Interest rate assumption used in computing PBO**_(%)._**|
|EXPRORMS:|Interest rate assumption not stated.|
|INFL:|Cost of living assumption required to compute PBO.|
|INFLMS:|Cost of living assumption not stated.|
|AVRETAGE:|Average retirement age used in computing PBO (yrs).|
|AVRETAGEMS:|Average retirement age not stated.|

Olivia S. Mitchell - Public Pension Governance and Performance
_51_

|SSINT:|Plan is integrated with Social Security.|
|---|---|
|_F. Other Factors_||
|FUNDLAW:|State has legal funding standard for pension system.|
|DEFPOS:|State law does not prohibit carryover of state budget deficit from one year to the<br>next (National Association of State Budget Officers 1992)|

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52

# **Table 6 (continued)**

|TCHRPLAN:|System covers at least some teachers and other school employees.|
|---|---|
|PTCHR:|Plan exclusively covers teachers and other school employees.|
|ASSETS:|Actuarial value of pension system assets, typically (though not always) reported at<br>market value (million S).|
|ASSETSQ:|Squared value of ASSETS.|
|BOND:|Fraction of pension system portfolio held in corporate and government bonds (%).|
|STOCK:|Fraction of pension system portfolio held in stock (%).|
|BENNOCUT:|State has law guaranteeing benefit amounts.|
|BENTIERS:|Benefits differ according to worker hire date (usually more recent hires receive<br>somewhat lower benefits).|
|SPECTAX:|A special or dedicated tax is the source of employer contributions.|
|ISUNION:|A: least some of the employees covered by the pension system are unionized.|
|U'NEMPD:|Recent (1990) level of unemployment minus the long run (1981-89) average level of<br>unemployment level in the state (US Bureau cf the Census 1991).|

Olivia S. Mitchell - Public Pension Governance and Performance
_53_

# **Table 7. Determinants of Investment Returns in State and Local Pension Plans** (standard errors in parentheses)

||Dependent Variable<br>|<br>|
|---|---|---|
|**YRlROR**|**YRSROR**|**RETURNSD**|
|Explanatory Variable<br>1990 Return|1986-90 Return|Retum Variability 1986-90|
|_A. Pension Board Composition_<br> <br>|||
|BDELAC<br>-0.71<br>|_-1.65_<br>|0.12<br>|
|(1.76)|(1.20)<br>|(0.14)<br>|
|BDELRT<br>- 17.08"<br>|-0.23<br>|0.96'<br>|
|(7.14)|(4.68)|_(0.53)_|
|_B. Pension Management Practices_|||
|ADINVST<br>-0.34|-1.23"<br>|0.01<br>|
|(0.89)|(0.58)<br>|(0.07)<br>|
|RNVINHS<br>0.80|0.60<br>|-0.04<br>|
|(1.36)|(0.92)<br>|(0.16)<br>|
|TOP1OMG<br>-0.49|-0.32<br>|0.07<br>|
|(1.3 1)<br> <br>|(0.86)<br>|(0. 1 0)<br>|
|TOP10*EXT<br>-0.08|-0.33|0.13<br>|
|(1.31)<br>|(0.86)|(0.13)|
|_C. Pension Investment Practices_|||
|PRUDMAN<br>0.83|0.33|-0.001<br>|
|(1.20)|(0.84)<br>|(0.10)<br>|
|INSTATE<br>-7.74'|-1.63|0.46|
|(4.09)|(2.45)|(0.28)<br>|
|STK.MAX<br>-0.03<br>|0.57<br>|0.004<br>|
|(1.18)|(0.86)|(0. 1 0)|
|_D. Pension Reporting Practices_|||
|:NDINVPF<br>-1.16<br>|-0.57<br>|0.12<br>|
|(1.00)|(0.68)<br>|(0.08)<br>|
|FREQVAL<br>0.70<br>|0.13<br>|-0.07<br>|
|(0.54)|_(0.55)_|(0.06)|
|_E. Other Factors_|||
|TCHRPLAN<br>-1.27<br>|-0.32<br>|-0.01<br>|
|(1.28)|(0.86)|(0.10)|
|ASSETS<br>-0.31|0.001|0.001|
|(*10-3)<br>(0.165)<br>|(0. I 1)<br>|(0.0 1)<br>|
|ASSETSQ<br>2.30|0.82|-0.07|
|(*I 0-9)<br>(4.86)|(3.08)|(0.40)|

Olivia S. Mitchell - Public Pension Govemance and Perforrmance
54

|BOND|0.02|0.03"|-0.001(0.02)|
|---|---|---|---|
|(0.01)|(0.001)|||
|STOCK|0.03|0.03|-0.001|
|**Constant**|(0.03)<br>**_6.56'_**<br>|(0.02)<br>**9.88-**|(0.002)<br>0.44"|
||(2.27)|(1.88)|(.21)|
|R<sup>2</sup>|11.3|12.4|13.6|
|N|158|132|132|

**Notes: *t k** 1.96, ***t** 2 1.65 (< 1.96).

Olivia S. Mitchell - Public Pension Governance and Performance
**_55_**

# **Table 8. Determinants of Stock and Flow Funding in State and Local Pension Plans** (standard errors in parentheses)

||Dependent Variable|
|---|---|
|Explanatory Variable|**AST_PBO**<br>**Flow Fund**|
|_A. Pension Board Composition_||
|<br>BDELAC|-0.20"<br>0.08|
||(0.08)<br>(0.17)|
|BDELRT|-0.61'<br>0.27|
||_(0.35)_<br>(0.72)|
|_B. Pension Management Practices_|<br>|
|<br>BDBENOK|-0.01<br>-0.01|
||(0.06)<br>**(0.1 1)**|
|BDACTOK|<br> <br>0.13'<br>0.30"|
||(0.07)<br>**_(0.15)_**|
|LIABINS|0.13"<br>-0.19"|
||(0.05)<br>**(0.09)**|
|ACCINHS|<br><br>0. ! 1<br>-0.02|
||(0.05)<br>**(0.09)**|
|_C. Pension Reporting Practices_||
|<br>REPSOLO|_0.05_<br>-0.01|
||(0.05)<br>**(0.09)**|
|GIVERPT|<br><br>0.09<br>0.003|
||(0.08)<br>**_(0.15)_**|
|AMORTPER|<br><br>-0.001''<br>-0.002|
||(0.01)<br>(0.004)|
|AMORTMS|<br><br>-0.31<br>-0.34"|
||(0.09)<br>(0.16)|
|ACTUARUC|<br><br>0.03<br>-0.13|
||(0.08)<br>(0.17)|
|_D. Pension Assumptions_||
|<br>COLA|-0.03<br>0.10|
||(0.06)<br>(0. 1)|
|WDOT|<br> <br>-0.04<br>0.02|
||(0.04)<br>(0.07)|
|WDOTMS|<br><br>-0.35<br>0.08|
||(0.24)<br>(0.44)|
|PORTABLE|<br><br>-0.13'<br>0.02|
||(0.05)<br>**(0. 0)**|
|NEXPROR|-0.01<br>0.02|

Olivia S. Mitchell - Public Pension Governance and Performance
56

||(0.04)|(0.04)|
|---|---|---|
|EXPRORMS|0.12|0.77|
||(0.33)|(0.77)|
|INFL|-0.03|0.05|
||(0.03)|(0.06)|
|INFLMS|-0.21|0.28|
||(0.18)|(0.34)|
|AVRETAGE|-0.0003|0.001|
||(0.01)|(0.01)|
|AVRETAGMS|0.08|-0.18|
||(0.31)|(0.57)|

Olivia S. Mitchell - Public Pension Governance and Performance
57

**Table 8 (continued)**

||Dependent|Variable|
|---|---|---|
|Explanatory Variable|AST_PBO|**Flow Fund**|
|SSINT|0.02|0.16|
||(0.07)|(0.16)|
|_E. Other Factors_|||
|FUNDLAW|0.001|-0.07|
||(0.05)|**(0.10)**|
|BENNOCUT|0.03|-0.10|
||**_(0.05)_**|**(0.09)**|
|BENTIERS|-0.03|0.03|
||(0.05)|**(0.10)**|
|DEFPOS|0.08|-0.003|
||_(0.05)_|(0.10)|
|SPECTAX|0.04|-0.01|
||(0.06)|(0.13)|
|TCHRPLAN|-0.04|-0.02|
||(0.07)|(0.12)|
|ISUNION|0.07|-0.13|
||_(0.05)_|(0.10)|
|UNEMPD|-0.06'|0.002|
||(0.02)|(0.04)|
|Constant|1.33"|0.44|
||(0.45)|(0.84)|
|R<sup>2</sup>|29.0|19.0|
|N|217|184|

Notes: "t 2 1.96, **'t** a 1.65 _(<_ 1.96) Olivia S. Mitchell - Public Pension Governance and Perfornance
58

# **Appendix Table. Total Administrative Costs as a Percent of Pension Plan Assets by Asset Size Class**

||Entire<br>Samnple (N)|No External<br>Managers (N)|With Extemal<br>Managers (N)|
|---|---|---|---|
|Asset Size Class ($Million)||||
|< 100|4.52% (40)|18.50 ( 6)|2.05 (34)|
|2100 to <1,000<br>|1.08% (50)|0.36 (12)|1.30 (38)|
|Ž1,000 to <10,000<br>|0.33% (48)|0.49 (17)|<br>0.25 (31)|
|210,000|0.10% (20)|0.06 ( 4)|<br>0.12 (16)|

Source: Computed from PENDAT data file.

Olivia S. Mitchell - Public Pension (Govemance and Perfornance
DJSTRIB. OF ANNUALIZED MARKET RET'URN ON INVESTMENT 1 YEAR PERCENTAGE 40 <!-- Start of picture text --> 30<br>20<br>o11Nii<br>-4 -2 0 2 4 6 8 10 12 14 16 18 __E0g 20 22 24 26 ___ 28 30<br>RATE OF RETURNM( ) 01<br>IF AATE OF RETURN LE --4 THEN MIDPOINT=-4<br>IF llAIE OF RETURN bi 30 THEN MIDPOINT=30<br><!-- End of picture text -->
Figure 2.

DISTRIB. OF ANNUALIZED MARKET RETURN ON INVESTMENT 5 YEARS ---PERCENTAGE 40 <!-- Start of picture text --> 30.<br>20-<br>10-<br>-4 -. 2 0 2 4 6 a t0 12 14 16 la 20 22 24 26 28 30<br>RATE OF RETURN (%) a'0<br><!-- End of picture text --> IF RIATE OF RETURN LE -4 THEN MIDPOINT--4 IF RATE OF AETURN GT 30 THEN MIDPOrNTh30
Figure 3.

# VARIABILITY OF RATE' OF RETURN ON INVEST'MENT

PERCENTAGE 17 16. 1545 **14-** 13- _12-_ 11100 •; 3~ xx 7- 6- 5 15 25 35 45 55 65 75 85 95 105 **115** 125 135 145 155 VARIABILITY OF RATE OF RETURN (
Figure 4.

# DISTRIB. OF STOCK FUNDING RATIO

<!-- Start of picture text --> PERCENTAGE<br>60<br>50<br>40<br>30-<br>20-<br>10-<br>o 1-0 '<br>-20 o 20 40 60 80 100 120 140 160 IBO 200 220 ___240 260 280 300 320 340<br><!-- End of picture text --> STOCK FUNDING RATIO (1) IF RATIO LE -20 THEN MIDPOINT--20
# DISTRIB. OF FLOW FUNDING RATIO

<!-- Start of picture text --> PERCENTAGE<br>60-<br>50<br>40-<br>30<br>20<br>10-<br>-20 0 20 40 60 80 100 120 140 160 180 200 220 240 260 280 300 320 340~,<br>FLOW FUNDING RATIO (%)<br>IF nATIO LE -20 THIEN MIDPOINT-20<br><!-- End of picture text -->