Securities rule curbs ‘pay-to-play’ schemes for public pensions

For at least five years before Alan Hevesi, former New York state comptroller, went to prison in 2011 after pleading guilty to accepting campaign contributions and other gifts from investment advisers eager to invest portions of the state’s massive pension fund, his name had made headlines in connection with the scandal. Indeed, the numbers at the center of the scandal were staggering: the state’s pension fund, for which Hevesi had been the sole trustee, managed nearly $141 billion for public-sector retirees. Hevesi, paroled in 2012, personally made at least $1 million in the scheme. 

But beyond the headlines and a widely distributed mugshot of Hevesi, how unique is his story  really?

Anyone who’s paying attention knows that Hevesi’s take on corruption is far from original — especially in state and local politics. There’s even a term for it, “pay-to-play,” which, in a political context, refers to the bestowal of government work (often lucrative government contracts) in exchange for gifts in one form or another. Still, mystery shrouds the real pervasiveness of pay-to-play practices.  

Even I, a former securities compliance examiner with the U.S. Securities and Exchange Commission (SEC), didn’t have a firm grasp on how rare or how quietly normalized these practices were, especially among trustees of the country’s public pension funds, which collectively manage nearly $4 trillion in assets on behalf of 19 million current and former state and local employees.

Along with Thuong Harvison at the University of Arizona, I conducted research to help clarify the picture on pay-to-play and public pension funds. Our findings suggest that, historically, the practice is hardly rare among those trusted to safeguard the investments of public pension funds.

Specifically, we found that between 2001 and 2016, investment advisory firms whose owners or officers contributed to the campaigns of state government officials obtained a significantly greater fraction of their business from government clients (i.e., public pension plans). 

Could there be an explanation behind this link that has nothing to do with pay-to-play? We tested that question by looking at the data before and after the SEC’s pay-to-play rule for investment advisers went into effect in 2011. The rule made it illegal for an investment adviser to provide services to a government entity for two years after the adviser — or any of its employees — makes a contribution to officials or candidates who hold influence over a pension plan.  

Tellingly, the percentage of investment firms with significant public pension business donating to state candidates dropped by half after the enactment of the SEC rule. Keep in mind that the investment firms and their personnel weren’t prohibited from contributing; they simply couldn’t secure business after contributing. 

To us, this finding makes two things clear: First, pay-to-play activities among public pension fund trustees was pervasive, and second, the 2011 SEC rule appears to have helped cut down on the practice significantly. The rule and its apparent success could serve as inspiration to government agencies overseeing other industries where political corruption is prevalent. 

Could cutting down on corrupt pay-to-play practices around public pension investing prove to be a boon for pension fund performance? We’ll strive to answer that question in the next phase of our research, by comparing the investment performance of firms that make frequent political contributions to those that don’t. Our hypothesis is that performance will be marginally worse among those firms that rely more heavily on contributions, rather than their merits, to secure business. 

We’ll find out. Most of all, we hope that public-sector retirees stand to benefit as pay-to-play practices retreat from public pensions — hopefully, for good.

William Beggs, Ph.D., is an assistant professor of finance at the University of San Diego School of Business, where he teaches an undergraduate course in financial modeling and analytics. Prior to academia, he was a senior analyst with Cutler Investment Group and a securities compliance examiner with the U.S. Securities and Exchange Commission (SEC) in Washington.