Pension Oversight Boards are getting some press recently, and in many cases the coverage is pretty negative. Many US states have adopted independent oversight boards to monitor the activities of state-sponsored defined benefit pension systems. As an example, Ohio has what is known as the Ohio Retirement Study Council (ORSC) and according to their website, “the general purpose of the Ohio Retirement Study Council is to provide legislative oversight as well as advise and inform the state legislature on all matters relating to the benefits, funding, investment, and administration of the five state retirement systems in Ohio.” That is a lot of responsibility, especially given the fact that the 5 DB plans that they oversee have combined assets >$200 billion and more than 2 million participants. So, how do they do that?

I’m not looking to pick on any one oversight board because these committees have great responsibility and, in many cases, lack the tools necessary to provide appropriate oversight. That said, I think that generally their focus is misplaced. In the case of Ohio, each fund has a substantial team supported by consultants, actuaries, investment managers, custodians, etc. These paid professionals should be permitted to do their job. If they fail, it should be up to the individual boards to act. There is no way that an oversight board has the knowledge or time to monitor investment decisions originating in each of these funds.

The most important job for the oversight board should be to make certain that the plan’s liabilities (the promise to participants) are in focus. At the end of the day this is the only reason why a pension plan exists. They should insist that these plans are run in such a way that the promised benefits are secured at both reasonable cost and risk. In order to monitor these funds appropriately, the oversight boards should get a quarterly update on how each fund’s assets are performing relative to the plan’s liabilities (funded status). Each liability stream is unique to that particular fund and it is imperative that a custom liability index (CLI) is produced on a regular basis (quarterly), as liabilities are bond-like in nature and move with changes in the interest rate environment. The CLI should value the liabilities at both the ROA and ASC 715 (AA corporate yield curve) discount rates so the oversight board can see the difference between actuarial valuation and economic valuation of the funded status. It should be noted here that Moody’s has chosen the ASC 715 discount rates to assess credit ratings.  As a reminder, asset allocation should be driven by the funded status and not the return on assets assumption (ROA).

In addition, the oversight committee should ensure that the annual required contribution is being paid in full. Why have an actuary go through this annual exercise only to have someone decide not to make the ARC? Public pension systems that are struggling with poor funded status can often attribute their issues to a lack of discipline in making the required contributions. By habitually underfunding their plans, they force the assets to try to work harder. This ensures greater risk without the promise of greater return.

I believe that independent oversight boards are an essential part of our defined benefit landscape, but until they focus their attention on liabilities and cash flows, they are not going to be as effective as they could be.