Trust But Verify: The Role of the Fiduciary Board

The content of this post was adapted from the Talk, “The Role of the Fiduciary Board,” authored and narrated by Rick Funston.

The vast majority of the approximately 5,300 public pension boards in the US are lay boards, and their trustees are mostly part-time volunteers.  Public pension boards are creatures of state and local governments.  By design, these boards are comprised of individuals representing various constituencies (elected, appointed, and ex officio) and are not typically investment or pension administration experts. Even if they consider themselves expert, they usually don’t have the time to be involved in day-to-day management.

These fiduciary boards are responsible for setting direction and policy, approving key decisions and plans, overseeing execution, and verifying the reliability of reporting.  Despite being lay persons, as fiduciaries they are held to the highest legal standard of care - higher than that of a corporate director.  The issues they are asked to address are long-term, highly complex, rapidly changing, and uncertain, and in many cases involve billions of dollars and affect millions of people.

Despite being lay persons, as fiduciaries they are held to the highest legal standard of care - higher than that of a corporate director. 

These lay boards must therefore rely on their professional staff and independent advisors for guidance, execution, and verification. Based on such advice, each trustee has a duty to vote their conscience as to what is in the best interests of the beneficiaries regardless of how they came to be on the fiduciary board. 

Boards need to take the long-term view of policy issues through the lens of what’s in the best interests of the beneficiaries, i.e., to see the forest and the trees. To understand the critical role of the board, it is important to explore how boards fulfill their fiduciary duties, how they set direction and policy, when and how to delegate, and how to measure the efficacy of the board.

Exercising Powers to Fulfill Fiduciary Duties

There are typically up to four vital functions performed by a public retirement system: invest the system’s assets; deliver pension benefits; deliver health and other insurance benefits; and administer the system.  Pension plan boards must act for the exclusive benefit of all fund participants, not for themselves or any other stakeholder.  Board governance structures, policies, and practices should be designed to facilitate and enable the execution of the board’s fiduciary obligations.  In addition, the board must ensure that there are capable people, processes, systems, and adequate resources to operate the organization.  Turning a blind eye to any red flags might result in a breach of the board’s fiduciary duty.

Turning a blind eye to any red flags might result in a breach of the board’s fiduciary duty.

Setting Direction and Policy

There are many important questions boards should ask of their professional staff and independent advisors to appropriately set direction and policy for the system.  The questions range from what are the key decisions and who gets to who makes them; what are the organization’s top priorities; what is the highest and best use of the board’s limited time; how often will progress be reported; how does the board know if the information they receive is trustworthy, timely, and reliable; and who is accountable? The board should seek diversity of opinion and understand the options available and the related pros and cons to be in the best position to make an informed decision.  Those decisions need to provide unified and clear direction to the staff and key stakeholders.

To Delegate or Not to Delegate: An Evolution

Since the mid-1800s until the 1990s, the standard for pension plan boards was the “prudent man or prudent person” rule, which limited the authority of the fiduciary to delegate.  Since the 1990s, the “prudent expert” rule has become more pervasive, in part, as the result of rising expectations of system investment performance and the growing need to rely on professional staff and external investment experts.  The board’s role, however, remains one of oversight, not close supervision or involvement in day-to-day management.  In fact, the most effective boards operating under the “prudent expert” or “prudent investor” standard are those that delegate to the Chief Executive after first establishing robust processes for selection, oversight, and independent verification.

Questions to Help Measure the Efficacy of the Board

• Do fiduciaries have sufficient authority to carry out their fiduciary duties?  Sometimes the power over matters such as operating budgets and capital expenditures, the types of permissible investments, the setting of expected rates of return, and staff compensation remain within the purview of legislative bodies.  This can limit the board’s ability to help the system adapt to changing circumstances.

• How well do trustees engage and function as a team?  Factions of board members can undermine the ability of the board as a whole to impartially represent all beneficiaries when making decisions.

• Is there a unified direction from the board to the staff?  At the staff level, conflicting direction from the board and unclear authorities can create extra work, increase time spent preparing for and participating in meetings, and cause confusion, delay, and demoralization.

• Has the board clearly defined its role and responsibilities and those of its committees?  On effective boards, committees often do the heavy lifting, in conjunction with staff and consultants.  Effective delegation demands trust.

• How effective are the board and its committees?  High performing teams are engaged, delegate to those with time and expertise, consist of individuals with passion and commitment, consider diverse opinions, but agree on a direction, and continually evolve.

• Finally, trust should also be accompanied by independent verification. The board needs independent reassurance that it can rely on the reports of management. Such reassurance can come from the investment consultant, the internal and external auditors, legal counsel, and other third parties.

Overall, fiduciary boards that are responsible for the governance of public pension plans have the power to set the direction and oversee the execution.  They conduct the business of the board, determine key policies, approve important decisions, and provide oversight and verify the successful adherence to the system’s policies.  Under the widely held standard of the prudent expert or investor, boards should delegate operations to executives, staff, and consultants while maintaining oversight controls.  In the end, the most successful boards are those that evaluate their efficacy and regularly engage in any necessary course correction.   

The full Talk and the supplemental materials are available as part of the Governance Matters Series of the Board Smart governance e-learning system.  Click here to review the full curriculum.  For more information about Board Smart subscriptions, please visit www.boardsmart.com or contact info@boardsmart.com to schedule a demo.