“We’re not in the 90’s any more, Toto”

1. ADDRESSING THE FIDUCIARY RESPONSIBILITIES OF PUBLIC PENSION BOARD MEMBERS THROUGH IMPROVED GOVERNANCE POLICIESPresentation by Christopher W. WaddellSenior Attorney, Olson Hagel & Fishburn, Sacramento, CATacoma Employees’ Retirement SystemJanuary 14, 2011

2. “We’re not in the 90’s any more, Toto” • Ten years of essentially flat equity returns • Unfunded liabilities require much higher plan sponsor contributions when plan sponsors already facing fiscal crises. • Private sector DB plans much rarer, 401k plans decimated. • Electorate with “pension envy” angered by impact on government services and potential tax increases. • A few choice scandals aren’t helping any

3. Hard Times for Most Pension Plans • Pressure on government plan sponsors from increased pension contributions (service cuts, layoffs, etc.). • Pressure to reduce benefits • For new hires? • For existing members? • For retirees? • Pressure on actuarial assumptions. • Pressure to find investments that will yield that return • Pressure to abandon “equity risk premium” (liability driven investing

4. Providing a Fiduciary and Governance Framework • Identify the parameters of applicable fiduciary duties • Discuss pension governance “best practice” principles. • How should TERS get started?

5. Loyalty, Impartiality and Care • Loyalty: • “…A trustee is held to something stricter than the morals of the market place. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior. As to this there has developed a tradition that is unbending and inveterate.” • Chief Judge (Later Supreme Court Justice) Benjamin Cardozo • “Punctilio” = A minute detail of conduct in observance of a code.

6. Loyalty—Plain English Version • A fiduciary must not harm the interests of system members and beneficiaries by doing any of the following: • Self-dealing • Acting in the interests of a third party (includes employer/plan sponsor) • Favoring one group of members/beneficiaries over another (Duty of impartiality).

7. Duty of Impartiality • Derives from the duty of loyalty. • Duty of loyalty owed to all members and beneficiaries—fiduciary must be impartial among differing interests. • Retirees and actives; • Younger and older members; • Long-term and short-term members

8. Duty of Impartiality—Cont’d • Doesn’t require absolute equality • Decision to favor one group over another must be made carefully after weighing different interests. • Risk of being second-guessed mitigates towards avoiding decisions favoring one group over another if otherwise prudent to do so. • Don’t always have to make the tough decision.

9. Duty of Care • Act with the care, skill, prudence and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with those matters would use in the conduct of an enterprise of a like character and with like aims.

10. Duty of Care—Cont’d • Emphasizes process over outcome; • Not “one size fits all” • Evaluate in terms of the actions of prudent fiduciaries for other systems facing similar circumstances. • Independent of the question of good faith (“good heart, empty head” not good enough).

11. When Loyalty and Care Collide • Giving credit where credit is due: • Arthur B. Laby, “Resolving Conflicts of Duty in Fiduciary Relationships,” 54 American Law Review at 75. • “Path walked by a well-meaning fiduciary is fraught with peril.” • True in 2004; even more true now.

12. Duty vs. Loyalty--Thesis • Duty of Loyalty is a negative duty not to harm the principal. • Think in terms of the Hippocratic oath: • “Primum non nocere” • “First, do no harm.” • Philosophy perspective: Immanuel Kant • All duties are either perfect or imperfect. • A “perfect duty” “permits no exception in the interest of inclination.” • Perfect duties are unambiguous

13. Duty vs. Loyalty—Cont’d • Laby concludes that duty of loyalty can be explained as a perfect duty. • Conversely, duty of care is: • A positive duty to take steps to act for members/beneficiaries benefit. • “Open-ended and uncertain.” • “Judgment-based” • Therefore, an “imperfect” duty under Kant’s approach.

14. Duty vs. Loyalty—Laby’s Conclusions • Duty of Loyalty is absolute/ Duty of care is incremental. • Where there is conflict, Duty of Loyalty would not permit exceptions to provide “incremental benefits” obtained from following Duty of Care. • Duty of Loyalty prevails over Duty of Care because fiduciary first must “do no harm.”

15. Where are We? • Identify the parameters of applicable fiduciary duties • Discuss pension governance “best practice” principles. • How should TERS get started?

16. Why Adopt Governance Policies? • Provide a framework for decision-making that fulfills fiduciary requirement of “procedural prudence.” • Clarify roles and responsibilities of board members and staff to system, members, employer, and stakeholders. • Define expectations • Deterrence against future bad decisions or conduct

17. A Suggested Framework • Stanford Fund Governance Initiative (SFGI) • Identify principles of best practice that promote better governance of pension funds. • Develop tools that assist pension fund leaders to implement those principles. • In May, 2007, SFGI released the “Clapman Report,” which set forth best practice principles in five key areas. • www.law.stanford.edu/program/.../Clapman_Report-070316v6-Color.pdf

18. Clapman Report • Transparency of a fund’s rules and governance structure • Fund leadership • Trustee attributes and core competencies • Addressing conflicts of interest and related disclosure issues • Delegation of duties and allocation of responsibilities

19. Transparency of a Fund’s Rules and Governance Structure • A fund should clearly define and make publicly available its governance rules • Gathered in one location that is clearly accessible to persons involved in the governance process and the public • Ideally posted on the System’s website • Annual affirmation of understanding and compliance by board members

20. Fund Leadership • Identify and disclose its leadership structure • Governing body should consist of qualified, experienced individuals dedicated to fulfilling their fiduciary duties to fund beneficiaries • Doesn’t mean that board members have to come in as experts, but that they must take reasonable steps to acquire the skills to serve appropriately as a fiduciary.

21. Fund Leadership-Continued • Board should promote policies that strengthen fiduciary principles in the selection and monitoring of trustees • System should establish clear lines of authority between its governing body and staff • Board should have authority to select or dismiss key staff and have access to unconflicted, qualified external counsel and consultants

22. Trustee Attributes and Core Competencies • Board members should have a thorough understanding of the fund’s obligations to its beneficiaries, the fund’s economic position and strategy, and its relevant governing principles. • The board should include individuals with relevant investment and financial market expertise and experience

23. Trustee Attributes and Core Competencies--Continued • Board members should obtain education that provides and improves core competencies • Board members should be able to obtain intelligible explanations of recommended actions from staff, advisors or colleagues • No such thing as a “dumb” question • Annual evaluation of trustee skills

24. What are the “Core Competencies” • Loyalty to best interests of fund’s beneficiaries • Ability to disassociate personal viewpoints from objective requirements of fiduciary obligations • Willingness and ability to dedicate the necessary time and attention to system business • Understanding of the system’s operating environment and underlying economic and structural relationships

25. Core Competencies--Continued • Understanding of the obligations of a fiduciary relationship • An inquisitive nature • Ability to consider and debate issues in a civil and constructive manner • Effective communication and interpersonal skills • A substantive base of knowledge

26. Addressing Conflicts of Interest and Related Disclosure Issues • Establish and publicly disclose its policy for dealing effectively with situations that raise either: • An actual conflict of interest; or • The potential for the appearance of a conflict of interest • Regular reporting and disclosure of actual or potential conflicts

27. Addressing Conflicts of Interest--Continued • Periodic verification of compliance • No undue influence on any person to engage in a transaction that creates an actual conflict or appearance of impropriety • Public disclosure of information sufficient to ensure that trustees and staff are fulfilling their fiduciary duties

28. Delegation of Duties and Allocation of Responsibilities • Board should be permitted to rely on the expertise and advice of appropriately selected and unconflicted consultants and staff • Consultants should be required to comply with fund’s conflict of interest and ethics policies. • Fund should evaluate cost/benefit evaluation of expenditures • Effective monitoring of all service contracts

29. Where are We? • Identify the parameters of applicable fiduciary duties • Discuss pension governance “best practice” principles. • How should TERS get started?

30. Getting Started: Observations • Any set of best practices must be flexible and adaptable to the unique circumstances of each fund—not “one size fits all.” • View recommendations as a conceptual framework to measure adequacy of existing policies and/or need for new policies

31. Observations-Continued • Policy development is a hard, grueling process. Given other demands on pension funds in era of scarce resources, most systems are not going to be able to make significant progress without assistance.

32. Help is Available/More is On the Way • AFSCME Public Pension Fund Best Governance Practices Report • Model policies in these areas • Board Member Responsibilities and Core Competencies; • Board Member Education; • Ethical and Fiduciary Conduct • http://www.afscme.org/docs/AFSCME-report-pension-best-practices.pdf • Clapman 2.0 Project • Develop model policies in all five best practice areas • Report Targeted for Release in Summer, 2011

33. First Things First • Small bites • Written delegation of authority from Board to Retirement Director • Look at need for policy development/refresh regarding roles and responsibilities of Board members, Board Chair, and staff • Board member education • Conflicts of interest policies

34. QUESTIONS? • Christopher W. Waddell • Senior Attorney, Olson Hagel & Fishburn LLP • (916) 442-2952 • chris@olsonhagel.com • www.olsonhagel.com