Copyright © 1996, LENS Inc. All Rights Reserved
Comments to webmaster@lens-inc.com
If One Cannot Sell, One Must Care
Positioning Pensions for the Year 2000
Thus the large funds are beginning to learn what Georg Siemens, founder of Deutsche Bank and inventor of the hausbank system said a hundred years ago when he was criticized for spending so much of his and the bank's time on a troubled client company: If one can't sell, one must care. 1
Pension Funds in the US
Size Pension Funds make up 48.1 percent of institutional capital in the United States and 29.6 percent of the total outstanding equity.2 The pension system as a whole owns such a large percentage of the total equity capital of the country that "selling" its holdings is no longer a feasible method for dealing with underperforming companies.
As of the end of the third quarter 1994, the pension systems aggregated $4.6 trillion of assets of which $1.18 trillion were public funds, $2.51 trillion were private trusteed funds and the balance were managed as insurance assets. 43.8 percent of the assets of private plans and 48.7 percent of the assets of public ones were invested in equity.3
Institutional Investors owned 51.5 percent of the total outstanding equity and 55.8 percent of the equity of the 1000 largest US corporations at year end 1993.4 By mid 1994 the five largest institutional investors owned 11.2 percent of the largest 25 companies.
Defined Contribution and Defined Benefit
There are two categories of pension plans with regard to benefits. The first, with a rapidly shrinking plurality (45.3 percent of assets) is the "defined benefit" plan. In these plans, the employer is committed to a specific payout, no matter what level of contribution is made by the employee and no matter what the performance of the investments. The employer, whether corporate or government, bears the risks; to an extent, the employer is guarantor of a specific defined benefit. In defined contribution plans (42.4 percent of assets), on the other hand, the employee bears all the risks. 40.1 percent and 32.1 percent of plan assets are respectively invested in equities by defined benefit and defined contribution plans.
In the case of both types of pension plan there is an incentive to achieve superior investment results. The plan sponsor of a defined benefit plan, whether public or private, clearly wants to reduce its obligation to make additional payments into the pension scheme. Defined contribution beneficiaries are entitled to those assets comprising their plan assets so the incentive to maximize values is personal and direct.
Obviously, everybody cannot achieve "superior" results. This has resulted in an increasing percentage of plan assets either advertantly or de facto being invested in "index" funds that match the market's performance.
Public and private plans have many similarities but certain important differences. For purposes of this paper, the one important difference lies in the tendency of plan sponsors to dominate administration of private plans while public plans are more apt to function in a political mode.
The Role of the Government
The commitment of the state (or its subdivisions) to pay a "defined benefit" is in most cases guaranteed by the state constitution. Whether or not there are adequate funds in the pension trusts, the state is obligated to make the promised payments. Funding of pension systems is essentially a matter of inter-generational fairness. In the case of public defined benefit plans, the generation that receives the benefit of services pays the taxes to provide the pensions related to those services. Therefore, decisions about the appropriate investment policy for pension assets are essentially political because in the final analysis the electorate should decide on the levels of risk and reward thought appropriate for one time period or another.
The commitment of corporations to pay defined benefits is ultimately guaranteed by the federal Pension Benefit Guarantee Corporation (PBGC). But, in the first instance, it is promised and collateralized by the assets of the "plan sponsor" employer corporation. A medley of considerations underlie the investment policy of private companies: on the one hand, they can pursue high risk policies (in the manner of the airlines and steel companies in the 1980s) knowing that the PBGC will ultimately "bail" out the beneficiaries, or they can pursue the "conservative" path of assuring that their actuarial returns are achieved and the corporation has the highest assurance that it will not have to divert more than the planned payments into the system. Lawyers and courts can and will argue which alternative more closely achieves the statutory mandate that all trust assets be managed "for the exclusive benefit" of plan participants.
Investment horizons
In general, plan sponsors, both public and private, benefit from maximum long term growth in pension assets. Also, plan participants benefit to the extent that funding of their benefits requires decreased commitments from employers or taxpayers.
Pension funds are not like other institutional investors. They have unique and different characteristics; for example, the need of the plans for liquidity is small and can be determined with great precision. Unlike "mutual funds," pension funds can be considered as "permanent investors." Long-term studies of the rates of return received from investment in different classes of asset conclude that the optimum mode of investment -- when holding period and need for liquidity are not factors -- is in equity securities.5
A common stock-based investment policy for pension funds raises two separate problems. (I) There are drawbacks to public ownership of private enterprise. Pension fund holdings of common stock are viewed as "back door socialism." This is especially problematic when it leads to politically-based initiatives from public pension funds that are unrelated to (or even contradictory to) economic returns. Some examples have included South Africa divestment and bailing out insolvent city governments. (II) Active management -- market timing, industry choice, stock selection -- has not been able, over time, to produce consistently better results than those of the market itself.6 The level and profitability of fees to managers, consultants, trustees, custodians and all manner of service providers to the pension industry is so high that it wipes out any advantage of active management and creates conflicts of interest that make it virtually impossible to receive unbiased advice about investment alternatives. The "indexation" of equity holdings is therefore as a policy and an investment matter compelling for public plans7 and competitive for private ones.
Public funds are entirely funded by the taxpayers and private plans, significantly subsidized through tax incentives, are thus funded by the taxpayer as well. Since it is the taxpayer who is at risk, It is not only appropriate but essential for government to assure that the funds are administered consistent with the public interest. This particularly includes the responsibilities of pension fund trustees as owners of portfolio companies.
Pension Plan Fiduciaries in the US
Public plans are administered subject to the laws of the sponsoring state. Private plans are regulated by the Pension and Welfare Benefit Agency ("PWBA") of the US Department of Labor ("DOL") under the Employees' Retirement Income Security Act of 1974 ("ERISA").
Trustees of public plans are either appointed by a designated political official or they are elected by a particular constituency of plan participants; trustees of private plans under ERISA are appointed by the plan sponsor. In both cases, pension funds are administered by trustees who are subject to the highest standard of care developed by our legal system, the fiduciary standard. The fiduciaries of public and private pension plans have an unenviable role. By law and tradition they cannot personally benefit from favorable consequences through incentive payments and bonuses (with some exceptions), but they can be held liable for unfavorable ones by being fired, if they are in-house, losing the account, if they are outside, and even being prosecuted, if there is an allegation that fiduciary duty has been violated.
ERISA requires fiduciaries to consider only the interests of plan participants in their decision making. And this is their interest as pension plan participants, not their interest as employees or members of the community. But this provision has not been administratively enforced or judicially defined with sufficient conviction to mitigate the crippling conflict of interest problem that hobbles trustee behavior. Fiduciaries under ERISA are subject to strong industry pressures in the performance of their duties. It is clear to individual and institutional trustees that their continued employment is in the discretion of the plan sponsor. To the extent that they exercise their discretion in a manner that is perceived as inimical by plan sponsors, they can be sure of not being reappointed and of being "blacklisted" for new business by other employers.
The trustees of public plans do not need to fear commercial reprisal, but they are subject to political pressures.8 Although, on occasion, public plans such as CalPERS have been willing to oppose the managements of local corporations including Occidental Petroleum and Lockheed, this is a very rare exception.
While the pension system as a whole "owns" almost a third of the total equity in the country, no individual plan has sufficiently large holdings to make information gathering and activity respecting portfolio companies economically rational. For example, TIAA/CREF and CalPERS, the largest pension systems, each hold approximately one percent of the total market equity. For either of them to take the lead as an activist investor means that their beneficiaries bear all the costs of failure and stand only to be rewarded with one percent of the gains. This "collective action" or "free rider" problem challenges the question of trustee prudence. It certainly presents an unattractive alternative to the individual fiduciary who personally cannot benefit from the fruits of his decision, but can adversely affect him, if it is unsuccessful as an investment or as a political matter.
US employee benefit plans have almost no system for informing and being instructed by plan participants. ESOP plans often provide that the trustees will administer "ownership rights (tendering, voting)" in accordance with the instruction of beneficiaries, but there is only anecdotal evidence as to how this process should be conducted. Given the perverse incentives for pension beneficiaries to become actively involved in monitoring corporate management, no matter how great the failure, this leaves us with conflicts of interests with enormous agency costs.
An Ownership-Based Economy
"Ownership" of the commercial sector of the economy by the approximately one hundred million Americans having beneficial interest in the various public and private employee benefit systems provides a stable and "legitimizing" base for the power exercised by the leaders of the vast business aggregations. "Pension Fund Socialism should make it possible for management to regain legitimacy precisely because it re-establishes a genuine, socially anchored ownership."9
The pension system represents a financial foundation for public corporations that is both widespread and long term. Furthermore, those "owners" have interests exactly congruent with those of the overall society; they are the overall society. "The shift to the pension fund as a radically new kind of `owner' is a truly profound change in social and economic power and structure... the shift is far too great a challenge -- equally great as a threat and an opportunity -- to wait for accident or insurgence. How the United States responds will largely decide whether it faces rapid decline as both an economy and a society."10
The Pension System as "Owner"
The owners of large publicly held corporations can not make "ordinary business" decisions. They have no right to do so, and they have no expertise in these areas. Even if they did have the right and the ability to become involved, they would have conflicts of interest with almost any company, as they invariably hold at least some of its competitors, its customers, and its suppliers. Shareholders elect the board, which in turn hires management to perform these functions. Likewise, owners should not interfere with those questions appropriate for boards of directors. If board questions are not being appropriately addressed, the remedy is through replacement of the board.
The fact that their role is limited does not mean it is unimportant. Owners should organize themselves to have the expertise necessary to evaluate portfolio companies and to determine the appropriate level and form of their involvement. Many, indeed most, of the holdings of pension funds may be perceived as performing so well that the only involvement required by shareholders is thoughtful voting of the proxy. In situations where owners determine that change is necessary, owners have to commit the resources (i) to be informed, (ii) to deal directly with management, and (iii), in the very rare cases where discussions are not availing, to determine what kinds of individuals are needed for the board, and (iv) to nominate and elect these new board members. This means, of course, that they must also commit the resources to be able to determine when their involvement is appropriate, or, in other words, "a good investment."
There will be situations where the "emergency" intervention of owners is necessary. These will occur when monitoring is inadequate, but even with the best system of prevention there will inevitably arise circumstances requiring immediate and direct attention. In recent times, the direct involvement of the "blue chip" shareholders of American Express to force out James Robinson in 1992, a comparable imbroglio with Maurice Saatchi in 1994, Morrison Knudson's firing of William Agee, W.R. Grace's discharge of Peter Grace and the phased termination of Kmart, Joseph Antonini in 1995 come to mind.
Owners have to begin to work out a structure of cooperation with other owners. This is of particular importance as a way of mitigating the classic "prisoner's dilemma" collective choice problem, whereby otherwise appropriate shareholder initiatives are not pursued because while doing so would benefit all shareholders only one or a small group have to pay all the costs. One model is that used in the development and operation of huge energy projects and venture capital investment where one party will act as the "managing partner." Over time, this permits a "fair" sharing of the "ownership" burden, all the while assuring that a motivated and highly competent energy is actually doing what needs to be done. Further steps along the lines of the resolution [Attachment 1 ]that I submitted at the EXXON Annual Meeting of 1993 can ensure that no institution has to contemplate the risk of loss of the resources committed to "ownership responsibilities."
The problems of "commercial reprisal" for private fund trustees and "political reprisal" for public fiduciaries can only be solved through a government commitment that pension fund responsibilities transcend all other considerations, despite the strong temptation to use pension money to solve other problems. Without pervasive and even-handed enforcement, however, this message will not be received. A vigorous and visible enforcement effort will remove the burden from those many trustees who want to carry out their statutory responsibility but are inhibited by competitive commercial realities. To the extent that government "draws a line in the sand" and puts all on notice of the priority of fiduciary obligations to beneficiaries, pension fund trustees can begin the process of becoming effective owners.
Value Added Through Shareholder Activism
Similarly, shareholder activism should be evaluated by fiduciaries and law enforcers on strictly economic grounds. Empirical data is beginning to be evaluated by consultants and academics. Wilshire Associates and the Gordon Group are consultants who are retained by clients who are themselves "activist investors." It is, therefore, neither surprising nor convincing that both should assure CalPERS that its activist commitments have been beneficial to plan participants. Academic studies are more equivocal, recognizing that there have in fact been relatively few examples of shareholder activism and no orthodoxy has emerged as to an appropriate way of measuring its impact.
A recent and extensive survey of activism by nine public pension plans over a seven year period (1987-1993) concludes: "Targeting announcements are associated with a small but significant wealth effect for a subset of firms. However, there is no evidence of improvement in the long-term stock price performance of targeted firms. In fact, performance continues to decline even three years after targeting. Moreover, in contrast to other institutions, pension funds do not appear to significantly reduce their holdings in underperforming firms in general, or in firms that they target. Collectively, the results cast doubt on the effectiveness of public pension fund activism as a substitute for an active market for corporate control." 11
Another contemporary study reaches a similar conclusion: "We examine whether institutional investor activism by public pension funds is effective in achieving its stated goal of increasing shareholder value. An investigation of the short-term stock market performance indicates that, during certain periods, there are significantly positive abnormal returns surrounding the targeting of firms for governance reform. In contrast, in any analysis of long-term stock market performance we do not find evidence of statistically significant positive returns. This leads us to question the overall effectiveness of this form of shareholder activism."12
Activism by Public and Private Pension Funds
These studies are particularly useful in making clear what is reasonable to expect from public pension funds and what is unreasonable. Public pension funds, by nature of the mode of appointment of their trustees, are sensitive to political trends (which has disadvantages as well as advantages), to considerations of "fairness" and to concern over "overreaching." Public pension funds, therefore, are well situated to raise issues, as in the area of entrenchment, excessive compensation, and other areas of corporate governance. Beyond this, public pensions are limited. Their political sensitivity can lead to initiatives that are designed more for political gain than for investment returns. They are led most often by people with backgrounds in government, not in business. Only continuing pressure will create change in targeted companies and the adverse risk/return ratio for public trustees' activism makes such constancy improbable. Public funds have been and will continue to be invaluable leaders and allies for activism initiated and maintained by others.
Another way of understanding "reasonable expectations" for public pension plan activism is to consider how much they spend and what they purchase. By and large, the entire expenditure of public plans consists of two items: the time and expense of key personnel and items that can be purchased with "soft dollars." Great discretion is needed in the use of soft dollars, because of the omnipresent fear that the state legislature will decide to exercise control over these public funds. The highly publicized initiatives of CalPERS frequently amounted to the time and travel expense of CEO Dale Hanson, General Counsel Rich Koppes and some home office back up plus a variety of consulting services, limited to those that happen to be eligible for soft dollar payment. For political and budgetary reasons, no money was ever spent for outside proxy solicitors, advertisement or the panoply of professionals needed for a full scale shareholder effort, and victory was declared on the basis of small steps forward. For example, the widely publicized "report cards" issued by CalPERS on the responses they got to their requests for information about companies' corporate governance structure gave "A's" to anyone who was fully responsive, regardless of the substance of the governance provisions themselves.
As for the private pension funds, let's tune back twenty years and consider Peter Drucker's prescient warnings:
The new institutions that we have created -- the pension funds and their "assets managers," who administer and invest the pension moneys -- must have adequate management and be legitimate. Further, they must represent the beneficiaries and bear a clear-cut relationship to them. The pension funds have to be autonomous institutions.... By and large, however, the corporate pension funds have not yet even begun to organize themselves for either accountability or legitimacy. These new institutions must be free from any suspicious of conflict of interest. They must be set up to serve their beneficiaries and no one else.... What matters is that being both commercial banker and pension fund manager puts the bank into an inherent conflict of interest.... Pension funds are much too important to be run as a side line, which is all they can or should be in a commercial bank. Pension fund management requires and deserves an independent institution....13
Twenty years later we are no closer to beginning to answer the question. As a result there is no shareholder activism emanating from the private pension fund system.
"Relationship Investing"
In a sense, all investing is "relationship investing." But the term is most often used to describe the involvement of a significant shareholder. One form, epitomized by the great investor Warren Buffett, has demonstrated massive positive returns from appropriate shareholder involvement in the governance of portfolio companies.
A different form is exemplified by our own LENS fund. Before LENS began, the companies in which we have become active consistently underperformed the market averages. Following our initiatives, LENS, investing in very large companies -- Sears, American Express, Westinghouse, Eastman Kodak, Scott Paper, Stone & Webster and Borden -- achieved annual total returns approximating 23 percent over a period when the S&P has done only half as well. The characteristics that LENS marshals in aid of profit are: (i) our own money; (ii) our business backgrounds (which make it possible for us to select portfolio companies that can be changed and develop the recommendations for change); (iii) our commitment; and (iv) our unwillingness to be distracted. And yet, we could not achieve these results without the support of many of the public funds and private money managers. We had an explicit working arrangement with CalPERS in 1989 in successfully opposing Honeywell's effort to amend its charter to provide for staggered board of directors' elections; CalPERS and several other prominent institutions publicly supported our initiative with Sears Roebuck. In other cases, we were able to get a broad base of support by communicating our concerns to the shareholder community. With the protection of confidential voting for shareholders, we have been able at affordable cost to secure up to 45 percent of the total vote for shareholder resolutions. This has given us credibility and leverage with both the shareholder and management communities.
A number of developments have made it easier to get support for shareholder initiatives. The relaxation of the rules governing shareholder communications have sharply decreased the costs (including the risks) of activism. The increase in the adoption of confidential voting, most often at the urging of shareholders, has limited the real and perceived problems of commercial and political reprisal.
Pension Plan Impact On Corporate Governance
Pension plans in the UK, the Netherlands, Canada and Japan as well as the United States are becoming massive investors in the equity securities of countries outside of their domicile. The liberalization of investment restrictions all over the world has conferred economic and political power on those countries having liquid investable funds. Countries such as France without a funded pension system have belatedly recognized their disadvantage. Carolyn Brancato estimates that US institutional investors increased their foreign equity holdings up to a total of $236 billion in 1993. It is the largest pensions funds (those with assets over $1 billion) that are the major holders of international equities, controlling 88.8 percent of all institutional holdings of foreign stocks in 1993.
In many instances, it is foreign institutional investors who are the most vigorous force for change of the governance of domestic corporations. This was dramatically the case with Harris Associates of Chicago taking the lead late in 1994 in ousting Maurice Saatchi. CalPERS has been prominent in Germany and Fidelity in the UK. Apparently the fear of commercial reprisal is less severe outside of one's home base. This institutional pressure may predictably have a leveling effect on the governance structures of large companies irrespective of the country of their domicile. There is increasing evidence that capital costs are lowest in markets where governance standards are highest and information is most transparent. Thus, Daimler Benz reworked its financial statements and changed its governance provisions so as to be able to list its common shares on the New York Stock Exchange. Pension funds, wherever situated, have much in common with other pension funds. As the quintessential long term investors, they can be a world wide force for governance reform.
Following the repudiation of socialism, the major industrialized countries are struggling to articulate policies to guide their economic systems. The trend to privatization of formerly government-run or sponsored entities in the UK, France and Italy indicates a move away from the traditional centralized "finance capitalism" and towards a more decentralized model. The world-wide pensions systems -- public and private -- with trustees appointed and elected by different constituencies provide the raw material with which a new diversified structure can be created.
Shareholder activism does not necessarily have to be the unique element of a successful governance system. It can co-exist with other disciplines such as hostile takeovers. Even in Japan the informed presence of owners can be harmoniously accommodated with the cultural direction of the economy.
An Action Program For Pension Plans
[The pension funds] are not owners because they want to be owners but because they have no choice. They cannot sell. They also cannot become owner-managers. But they are owners nonetheless. As such, they have more than mere power. They have the responsibility to ensure performance and results in America's largest and most important companies.14
Much of the financial history of the 1980s could be written as the rapid but unacknowledged (even by themselves) acquisition of power by pension plans. Because the pension plans did not understand at first the power conferred by their vast ownership, a vacuum was created that was filled by "takeover entrepreneurs." If the pension plans fail to use their power responsibly in the future, it will result again in a conferral of power on to others. As the volatility of the takeover era showed, this is a significant risk. Pension funds, not only by virtue of their size, but also by virtue of their long-term perspective and their fiduciary obligation to a broad section of society, are better suited for this role than many, including arbitrageurs, takeover entrepreneurs, and the government.
But this can only work if the pension funds recognize their power and organize to become effective. CalPERS has been a leader from the early days of establishing the Council of Institutional Investors to company-specific and broad-based initiatives to the lengthy effort to reform the proxy rules. The amendment of the proxy rules in 1992, in particular, was an enormous step forward. It is much easier for shareholders to communicate with each other. Significant obstacles remain, however. "The extent to which the federal proxy rules frustrate shareholder democracy has been chronicled extensively elsewhere. Many of these issues were brought to the attention of the SEC by the CalPERS letter, but the SEC chose not to address them. In spite of its continued re-examination of the regulatory system and its never-ending series of amendments, the SEC continues to limit shareholder participation in corporate governance both through sins of commission and omission in connection with its proxy rule. Accordingly, the rules remain an unauthorized and misbegotten regulatory endeavor."15 A beginning agenda of what remains to be done in other federally regulated areas was set forth by Professor Alfred F. Conard.16 The Council of Institutional Investors has been very effective in pressing for pension plan legislative and administrative reforms.
One of the most pressing is prompt and unequivocal definition of the "exclusive purpose" rule of ERISA (and something comparable under the laws of most states). The language itself is clear. What is unclear is what that means in real-life application. One of the inevitable comprises in the passage of ERISA was the creation of what has been called "the fundamental contradiction of ERISA."17 Plan settlors were given the right to appoint and control plan trustees. Despite the fact that the legislative history makes it clear that the statute is intended to incorporate the strictest fiduciary standards of the common law, and then add additional strictures to them, from the outset, the position of trustee has been equivocal. Nominally an independent fiduciary, in practice his lucrative position is in the gift of the person from whom he is supposed to be independent. We have earlier considered Peter Drucker's twenty year old perspective that pension fund management is too important to be a secondary activity of a financial institution. "But setting up pension fund management as an autonomous institution would only be the first step. It is equally important that pension funds be organized for legitimacy and accountability."18
There is no need for the pension funds to wait for governmental action. Pension funds can insist on retaining money managers that limit themselves to pension funds as clients. The pension fund industry generates sufficient fee revenue to support such an industry. What this means is that existing fiduciary banks can rationally select either to continue their multifaceted relationships or to limit themselves to serving as employee benefit plan fiduciaries because there is a large enough market under either alternative to support their operations. Further, there would be opportunity for new "special purpose" pension-fund-only trust institutions. Who will start this effort? Once again, the public plans are most likely to lead the way, as they do not run the risk of commercial reprisal in redirecting business. When the public plans have enabled the building of a "pension fiduciary industry" the private plans will find themselves at a competitive disadvantage and may be forced to follow suit. Beneficiary pressures may abet the development of an independent fiduciary system.
Further steps along the lines proscribed by PWBA chief Olena Berg in July 1994 may be necessary. "[T]he Department believes that active monitoring and communication with corporate management is consistent with a fiduciary's obligations under ERISA where the responsible fiduciary concludes that there is a reasonable expectation that such activities by the plan alone, or together with other shareholders, are likely to enhance the value of the plan's investment, after taking into account the costs involved."19
While PWBA here plainly authorizes the expenditure of funds on appropriate shareholder initiatives, there will need to be precedent, publicity and, ultimately, judicial authority before risk-averse trustees become comfortable risking their beneficiaries' money. In the public plan arena, the problem is politics -- state legislatures will not like their pension systems incurring all manner of expenses that have not been legitimated through the appropriations processes. Furthermore, the targets of these initiative are sure to have substantial political clout.
Large fiduciaries are bureaucratic institutions with the same inherent weaknesses as large companies. How can we protect ourselves against simply substituting one bureaucracy for another, increasing costs and having little or even negative impact on efficiency? Fiduciaries have experience in engaging the services of professional advisors on a competitive basis. To the extent that shareholder activism becomes perceived as simply another potentially value-adding service, providers can be competitively selected and evaluated. The market place will be the ultimate judge.