Pension investment policies: The state of the art: GFOA reviewed more than 40 pension in vestment policies to identify prevailing practices and to define a best practice for governments developing or modifying such policies.

• Author: Greifer, Nicholas

Pension investment policies are the linchpin of public pension investment programs. This article summarizes the results of an in-depth review of more than 40 investment policies obtained from GFOA members nationwide. The most prevalent practices are identified and compared with GFOA's Recommended Practices for State and Local Governments, and a best practice for pension investment policies is defined.

The Role of Investment Policies

Why do pension investment policies matter? Not long ago, many pension systems functioned without formal investment policies. The Illinois Municipal Retirement Fund, for example, adopted its investment policy in 1986. Similarly, the Chicago Policemen's Annuity and Benefit Fund, the City of Kalamazoo, Michigan, and the Pennsylvania State Employees Retirement System formalized investment policies in 1983, 1982, and 1979, respectively.

Today, however, pension investment policies are universally found. These policies serve a number of important purposes, including the following:

* To formalize investment goal(s) (e.g., to exceed a long-term target rate of return)

* To establish a method for determining and expressing the pension board's investment philosophy and risk tolerance to both staff and third parties

* To clearly demonstrate "due diligence" (i.e., that the pension system follows a prudent set of procedures)

* To serve as a foundation for internal controls

* To provide guidance to staff and third parties in order to ensure both proper execution of the investment strategy and legal compliance.

In addition, many pension systems include an asset allocation statement within the investment policy. As a result, this kind of allocation often is referred to as a policy asset allocation to distinguish it from the actual asset allocation, which fluctuates according to the market.

Pension investment policies are similar in some respects to cash management investment policies. For example, both types of policies address the investment of government assets and the selection of third parties. At the same time, GFOA's review of these policies reveals some important differences. Exhibit 1 compares the differences between pension investment policies and cash management investment policies.

Scope and Methodology

The scope of this study was intentionally broad to include both large and small pension systems. It also was designed to cover multi- and single-employer pension systems. Eleven multi-employer systems and 30 single-employer systems provided investment policies.

The methodology used for this study was "content analysis." Content analysis is a social science technique for systematically assessing a document's content or meaning. It simply entails coding certain topics or categories and then examining whether the investment policy addresses them or not. For example, GFOA selected performance measurement for coding and reviewed each investment policy for content related to this topic. This review was not limited to specific sections of the investment policy dealing with performance measurement (many investment policies include performance measurement criteria in a separate section); rather, it extended to any part of the document that addressed this topic. Indeed, many of the policies included at least some language on performance measurement-usually in the section(s) on overall investment goals. Most of the coding work was verified by a second staff member to ensure accurate categorization.

The categories for coding were selected prior to the analysis based on GFOA's Recommended Practices for State and Local Governments (since one of the research objectives was to determine whether or not recommended practices were being incorporated into the pension investment policies). Exhibit 2 includes excerpts from recommended practices that address pension investment policies. An initial review of the investment policies also was used to identify obvious themes and to select the categories for coding.

Ten broad categories were ultimately selected for coding: (1) statement of goal, purpose, or mission; (2) identification of decision maker(s); (3) statement on managing risk in the overall portfolio; (4) statement on managing the risks of individual investments; (5) statement on performance measurement; (6) guidelines for money managers; (7) guidelines for other investment professionals; (8) legal standards; (9) cost management; and (10) transacting or brokering trades. Subcategories were developed under each of the 10 major categories.

The pension policies were not randomly selected. Instead, GFOA obtained them from pension systems that volunteered to provide their policies. Thus, the conclusions...