Pension Fund Capitalism or Wall Street Bonanza?
A Critique of the Claim That Pension Funds Can
The idea that pension funds could be used to control corporations first gained visibility through the claim by management guru Peter Drucker (1976, 1993) that workers' legal right to their pensions -- whether through a company or a local or state government -- meant they now owned a significant percentage of corporate stock. It followed for Drucker that this was a form of socialism. As the dramatic first sentence of his 1976 manifesto put it: "If 'socialism' is defined as 'ownership of the means of production by the workers' -- and this is both the orthodox and the only rigorous definition -- then the United States is the first truly 'Socialist' country" (Drucker, 1976, p. 1). Now that workers owned the economy, it was just a matter of asserting control.
But as the most detailed analysis of the role of pension funds points out, "The idea of 'pension fund socialism' is an exercise in political rhetoric rather than reality" (Clark, 2000, p. 43). Employees who contribute to pension funds have a legal right to their pensions, but they rarely have any rights when it comes to voting any stock purchased by the pension fund. As for the pension fund trustees themselves, they have a fiduciary responsibility to invest the money they receive from employees as wisely and prudently as possible, but no legal ownership of any stock they purchase. To exert any influence on corporate boards they have to argue that insisting on "good corporate governance" is part of their fiduciary duty because it makes shares more valuable. This line of reasoning is rejected by corporate leaders and most Republicans.
Drucker's flawed idea led nowhere, but the possibility of public pension funds as active participants in corporate governance arose again in the mid-1980s when partners at the Wall Street investment firm of Kohlberg, Kravis, Roberts convinced the director of the pension fund in the state of Oregon to contribute major sums to their takeover projects. Takeover specialists soon drew other public pension funds into the action. For a while, pension managers made some extra money for their funds, but it was clearly the private financiers who were calling the shots and making the big money.
However, the full extent of the private financiers' lucrative use of public pension funds from the 1980s to the present was never fully grasped by anyone until the New York Times commissioned a special study of the ten largest of these funds in early 2010 (Anderson, 2010). Between 2005 and 2008, eight of the 10 handed 45% or more of their total funds to private equity firms to manage, which is why these financiers could make $17 billion investing workers' future pensions between 2000 and the end of 2009. (Recall that the financiers receive a 2% management fee on the amount of money they manage and also receive 20% of any profits they make.)
The author of the study asks why the pension funds agreed to these huge fees and profits for private equity firms. The answer is not hard to find. First of all, the private financiers claimed that their superior talents would lead to higher returns for the pension funds than they would receive if mere public employees invested the money in the ordinary ways. In fact, they often said they would likely make 20% to 30% returns with the pension fund money.
Second, the partners in private equity funds could influence pension fund officials due to a combination of clout -- they give campaign finance donations to the elected officials who appoint the pension fund managers -- and mystique (if you are rich, you must be smarter than everyone else). But it is unlikely, according to two different academic studies cited in the New York Times article, that they delivered on these promises if their management fees and private profits are factored into the equation. For example, one of these studies concluded that between 1980 and 2003, the private equity funds did 3% less well than Standard & Poor's 500-stock index (a generally accepted financial index) after the equity funds' fees and profits are deducted. In other words, the public pension funds could have done a little better by investing in a standard mix of stocks as of 2003.
As for the more recent years, state and local pension funds lost an average of 27.6% of their holdings between 2007 and 2009 because of the collapse of Wall Street's housing bubble and the near meltdown of the entire financial system -- which was not due to subprime mortgages or derivatives, but to wild speculation encouraged by Wall Street. The exotic financial schemes that would supposedly bring big returns through innovation and efficiency, and provide "resiliency" to the financial system besides, led to major problems for public pension funds -- and for the endowments of universities, foundations, and cultural organizations as well, because they had all turned some of their monies over to private equity funds. Although many smaller hedge funds were hurt by the financial collapse, the larget of them were not, and certainly not in terms of the personal finances of their top owners and managers. They were thriving as of early 2010, as reported in an April 1, 2010 report in the New York Times on the still-huge salaries of the managers at the top hedge funds (Schwartz & Story, 2010).
And just how important were public pension funds to the private equity billionaires over the past three decades? Just look at the numbers: the amount of pension fund money that was invested by private equity firms rose from $200 million in 1980 to $200 billion in 2007 -- a thousand-fold increase. As the New York Times succinctly concludes: "Private equity owes its explosive growth largely to America's pension funds" (Anderson, 2010).
So, that's the material reality -- the incredible profit-making background -- that readers should keep in mind as I recount the brief history (and meager results) of the pension fund movement that was supposed to have great influence over corporations by the late 1990s at the latest. While the pension-fund activists were making the headlines that follow, the nation's financial districts, which we can think of collectively as "Wall Street," were making bundles of money.
|Robert A. G. Monks|
The pension funds' direct involvement with Wall Street was followed by a new theory from an unlikely source: pension funds could spark a movement that would bring in other institutional investors to make corporations and their boards more responsible to stockholders. A wealthy Republican maverick from Maine, Robert A. G. Monks, floated the idea while serving as the pensions administrator in Reagan's Department of Labor in 1984-1985. From this perch he decided to make it government policy that institutional shareholders had a fiduciary duty to behave as owners. He said this would improve "corporate governance" through pressures by ordinary stockholders on boards of directors to deliver better "shareholder value." His proclamation did not have the force of law, and could be easily changed by a new appointee or challenged by Congress, and it was ignored thereafter, but it did give the idea some legitimacy.
To further his goals, Monks founded Institutional Investors Services shortly after he left government to provide advice to institutional investors about the quality of the leadership at the corporations in which they invested. He was soon joined in this effort by Nell Minow, the daughter of the chair of the Federal Communications Commission during the Kennedy Administration, Newton Minow, which gave the effort a bi-partisan cast. Although public pension funds only held about 5% of the market value of all corporate stock at the time, they were seen as the key starting point because they were projected to grow in size and importance (see Table 1 for the percentage of market value held by various types of stockholders in 1975, 1985, and 1994.)
|Table 1: Percentage of Market Value Held by Five Major Categories for |
|Households (privately held)||57%||51%||48%|
|Personal Bank Trust Funds||11%||7%||3%|
|Corporate Pension Funds||13%||20%||18%|
|Public Pension Funds||3%||5%||8%|
|Total for These Five Categories||88%||88%||89%|
Source: Margaret M. Blair, Ownership and Control (Washington, D.C.: The Brookings Institution, 1995), p. 46, Table 2.1
Note: The percentages do not add up to 100 because the holdings of commercial banks, savings and loans, insurance companies, closed-end funds, brokers and dealers, and foreign groups are not included.
Monks then encouraged a liberal Democrat, serving as the elected treasurer of California, and the head of the New Jersey Division of Investment to take advantage of his ruling by holding boards of directors accountable for delivering maximum "shareholder value," meaning the highest possible stock prices. In 1985, Monks, the California treasurer, and the New Jersey investment official together urged the leaders of several public employee and union pension funds to form a Council of Institutional Investors that would help them influence corporate governance through their combined voting power with the stocks they held. The leaders of the New York City Employees Retirement System and the State of Wisconsin Investment Board also supported an activist approach. Monks and Minow then provided the Council with advice through their new company, Institutional Investors Services. (They sold the company in 1996, then went on to found The Corporate Library, a web site and consulting service that provides information on corporate governance, including information on the interlocking directors among corporations. Their information is excellent, and they have colorful graphics, but the information is too expensive for academic researchers to purchase.)
Led by the head of CalPERS, another activist public pension fund, the reformers at the Council of Institutional Investors made several efforts to influence corporate behavior by introducing various shareholder resolutions calling for more responsiveness to stockholders concerns. All of the resolutions were overwhelmingly defeated, although a few corporations did alter their policies to allow confidentiality in voting on stockholder resolutions. In 1989, at a secret meeting with members of the Business Roundtable, which is the main leadership group within the corporate community, the pension fund activists were quietly urged to criticize General Motors for its poor profit performance. Shortly after this attack began, the CEO at General Motors was ousted and new policies were put in place, with the Council of Institutional Investors receiving some of the credit for the change. There followed several other pension-fund campaigns against CEO's whose companies were performing poorly, and the movement seemed to be launched (Dobrzynski, 1994).
The small but highly visible successes of these efforts through 1993 suggested the possibility of an "investor capitalism" to one sociologist, Michael Useem, who studies corporate governance at the Wharton School of Business at the University of Pennsylvania. Acknowledging that the largest institutional investors are commercial banks, insurance companies, mutual funds, private investment managers, and corporate pensions that are not prone to challenging corporate boards, he nonetheless claimed that the activists at public pension funds, unions, and church groups affiliated with the Interfaith Center on Corporate Responsibility had come together to "play a role akin to that of political leadership in social movements" (Useem, 1996, p. 54). If they could pull in more cautious institutional investors, the movement might continue to grow.
But other institutional investors never joined the effort. Furthermore, the fledgling challenge to corporate managers all but died after 1993, just as Useem completed his research, because the public pension activists drew criticism from elected officials and some of the people appointed to their boards by the political leaders. The decline of these efforts is mirrored in the career of one of its leaders, Dale Hanson, a long-time state employee in Wisconsin, who was appointed head of CalPERS in California in 1987 to lead the pension fund into shareholder activism. He then took a major role in introducing stockholder resolutions in the late 1980s and was highly visible in the public criticism of the CEO of General Motors mentioned two paragraphs earlier. He was lionized in newspapers and criticized in business magazines.
But public pension fund managers such as Hanson are beholden to a board of directors that is in part appointed by governors and state legislators, so it was not long before Hanson and other activists were facing criticism at home. Since CalPERS was viewed as the leader of the insurgency, business leaders complained directly to the state's newly elected Republican governor in 1990, who reportedly tried to muzzle Hanson (Dobrzynski, 1991). Hanson became especially vulnerable when CalPERS itself did not do well in its investment returns for a year or two. By 1993 he was taking a quieter approach.
In May, 1994, Hanson resigned from CalPERS to become head of American Partners Capital, an investment firm funded by a Republican fundraiser. He also became a member of the board of directors of ICN Pharmaceuticals, a California company with 2,500 employees. Leaders of other public pension funds, faced with similar criticisms from politicians and appointed board members, adopted a slower and quieter approach, simply meeting with individual CEO's or directors to express their concerns, or merely publishing lists of underperforming companies.
The reining in of the public retirement funds was reinforced in 1996 by leadership changes at the Council of Institutional Investors, which by that time included insurance companies, mutual funds, and corporate pension funds as well as public and union pension funds. The majority of members expressed their lack of enthusiasm for activism by electing the director of the pension fund for a large corporation, TRW, as president, despite protests from pension fund activists. (A manufacturing company, TRW was the 125th largest corporation in the country in the mid-1990s.) The vote for the TRW executive was widely interpreted as a rebuff to the leaders of union funds and activists at public employee funds (Dobrzynski, 1996a, 1996b).
The futility of challenges to corporate boards of directors by public pension funds and their allies is also seen in a case in which the New York City Employee Retirement System tried to influence the homophobic employment practices of Cracker Barrel Old Country Stores, a restaurant chain headquartered in Tennessee, after it explicitly stated in policy documents that it would only hire straight people, and then proceeded to fire over a dozen gay employees. The Securities and Exchange Commission rejected the New York City pension fund's proposal for a proxy resolution against the policy each year from 1991 to 1998. At that point it allowed the challenge to be sent out to stockholders, who rejected it by a vote of 26.5 million shares to 5.5 million shares. But even if the challenge had won, the resolution would have been purely advisory. The board could have continued with its anti-gay policies. Ironically, the battle left corporate boards in general with even more control over company employment policies (Davis & Useem, 2002).
Reflecting on their efforts in September 2000, many of the leading pension-fund activists expressed disappointment with the cautious approach adopted by most institutional investors. The head of the Council of Institutional Investors said that they had "won the easy battles," such as being able to have nonbinding shareholder proposals sent out along with company proxies, but that they were in danger of ending up merely writing letters asking executives why they ignore the proposals. She noted, "We are seriously thinking about closing shop because we may be wasting money. We are at a turning point. The more (companies) ignore shareholder proposals, the more they realize they can do that, if they can withstand the embarrassment" (Day, 2000, p. 19).
By 2003 the New York Times was calling the movement a "Revolution That Wasn't" based on interviews with its disheartened leaders (Deutsch, 2003). In 2004 the longtime executive director of the Council of Institutional Investors resigned, having grown weary of the conflicts between representatives from corporate and union pension funds, each of which thwarted reform efforts in their own self-serving ways (Walsh, 2004b).
Matters also went from bad to worse about that time for activists at CalPERS, which had revived its efforts to influence corporate boards when Democrats took control of both the governorship and state legislature in California in 2000, only to see those efforts decline again with the election of a Republican governor, Arnold Schwarzenegger, in 2003. The union leader who had recently been elected chair of the pension fund's board was ousted in 2004 because of pressures he brought to bear on several prominent companies for excessive executive pay and inadequate health care benefits, including the Disney Corporation headquartered in Los Angeles. Prior to his removal, the California Business Roundtable, one of the voices of the corporate community in California, had written an open letter to Schwarzenegger complaining that renewed shareholder activism was the result of organized labor trying to settle contract disputes in the boardroom instead of through collective bargaining. When activists claimed that Schwarzenegger was bringing pressure against the board, one of his public relations assistants called the idea "paranoid musings and conspiracy theories" (Walsh, 2004a, C1). As for the California Business Roundtable, it denied that it had any involvement in the firing except for its general letter of criticism. Taking these denials at face value, the point is that the ascension of a Republican to the governorship, with his power to appoint several new members to the CalPERS board and other state pension boards, had changed the political climate considerably for pension-fund activists.
Any lingering thought that many public pension funds were not much more than happy hunting grounds for Wall Street sharks came crashing down in 2008-2009 as it became clear that public officials, pension fund managers, and political operatives had been for all intents and purposes bribed by rich financiers who wanted the opportunity to take big risks, and make huge profits, with government employees' money. With 40% of all public pension funds investing some of their money in hedge funds in 2008, a cool $78 billion overall, they were a huge source of investment funds for hedge fund managers (Wayne, 2009b),
In addition to large losses for some pension funds due to the risks taken with their money, there were legal problems and scandals for Wall Street bankers and their political go-betweens as it was discovered that criminal activities were part of the picture. For example, in April, 2009, a hedge fund executive pleaded guilty to securities fraud after admitting that he had been paid a stunning $5 million for helping to make it possible for the politically well connected Carlyle Group (an "equity fund" that invests large sums of money for wealthy people) to invest $500 million of New York state pension funds in an energy investment fund managed jointly by Carlyle and another private equity firm (Hakim, 2009; Wayne, 2009a). There are several other such scandals that could be recounted here, and many more that will have surfaced after this document has been completed. It is like a rerun of what happened with "other people's money" in the first ten years of the twentieth century and then again in the 1920s.
As of 2007, institutional investors owned 76.4% of the stock in the 1,000 largest U.S. corporations, an all-time high, up from 46.6% in 1986 when the institutional investor movement began. The list of institutional investors now includes investment companies, mutual funds, hedge funds, insurance companies, banks, and foundations and endowments as well as pension funds. Strikingly, public pension funds only control 10% of these assets, double the percentage they had in 1985, but not much more than the 8% they held in 1994 (Brancato & Rabimov, 2008). Even if public pension funds had the political independence and will power to try to influence corporate boards, they don't have enough assets to make a push without allies. As for their best allies, the union pension funds, they have been decimated for the most part by downsizing, off shoring, and corporate failures in major manufacturing industries.
No one can be 100% sure, but it seems highly unlikely that institutional investors from public employee and union pension funds ever will be able to create a coalition of institutional investors that could do anything more than chide, chastise, or confer with directors and executives from the large corporations in which they invest. They are not a threat to the current power relations in the corporate community. They actually play their largest role when rival private investors vie for their voting support in takeover battles, or when they agree to take part in the profit-making schemes hatched by billionaire financial firms. However, in spite of all their defeats, the Council of Institutional Investors and the Corporate Library still soldier on, hosting meetings concerning "good corporate governance," providing hopeful interviews to newspapers and magazines about the likelihood that things are going to change soon, and selling their advisory services to institutional investors. They are gadflies who do well while doing good.
Looking back at the most vigorous days of the movement, from roughly 1988 to 1993, very little was accomplished. It is now possible for small stockholders to communicate with each other more easily, thanks to a ruling by the Securities and Exchange Commission in 1992, and corporate executives more readily meet with institutional investors. However, no stockholder resolutions relating to corporate governance came close to passing during or after the heyday of the movement. Even the most positive assessments of this activism conclude that it had "negligible" effects on the major issues that ostensibly motivated it, higher earnings and higher share prices (Karpoff, 2006)
By 2002, Useem seemed to agree that the pension fund movement had no power. Writing with a colleague, he noted that shareholder activism is too diffuse to matter (Davis & Useem, 2002). He and his co-author also showed that corporate takeovers have not been a threat to boards since around 1990, and that financial analysts have no clout because they are not objective (they don't dare to criticize the companies their firms are connected with and they rarely suggest that a stock be sold because a company is performing badly). Useem and his colleague are thus left with the possibility that boards and top management can do pretty much what they want to unless they run the company into the ground.
But they save the day by claiming that "share price" is a powerful restraint on corporate governance due to the "efficient market" hypothesis (i.e., the market is always right in its evaluations and can do no wrong, a belief that was totally accepted by many economists and business school professors between 1975 and 2005). Managers and directors are powerful, they conclude, but they are forced to focus on delivering shareholder value by efficient markets that set the price of their companies' stock. It is a theory that has been all but destroyed by the financial collapse of 2008-2009. Thus, contrary to the hopes of the public pension fund activists and those who wrote about them, the largest corporations in the United States are still controlled by a combination of their high-level executives, the for-profit financial institutions that are concerned with the price of their stockholdings in the corporation, and top individual stockholders, all of which are usually represented on the board of directors.
In addition to showing that the pension-fund movement had very little impact when it comes to corporate power, this documents demonstrates that any success for activists in charge of public employee pension funds depends upon the success of the liberal-labor coalition in electing legislators and governors who are supportive of, or at least willing to tolerate, challenges to the governance of private corporations. When the newly elected Republican governor and conservative legislators in California began to question the efforts by Hanson and CalPERS in the early 1990s, it was not long before he gradually began to lower CalPERS's profile. And when the Republican Schwarzenegger replaced the Democratic governor in 2003, pension fund activism by CalPERS began to decline. There are no shortcuts to taming corporate power.
For in-depth commentary on public pension funds, including the big problems they now face, by an experienced analyst, see "Are Pension Funds Drifting Towards Disaster?" at the Pension Pulse blog.
Anderson, J. (2010, April 3). Pension Funds Still Waiting for Big Payoff From Private Equity. New York Times, p. B1.
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Dobrzynski, J. H. (1996a, April 2). Investor group's leadership vote is a rebuff to union members. New York Times, p. C2.
Dobrzynski, J. H. (1996b, April 1). Shareholder-rights group faces a fight over its own leadership. New York Times, p. A1.
Drucker, P. (1976). The unseen revolution: How pension fund socialism came to America. New York: Harper & Row.
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Hakim, D. (2009, April 15). A hedge fund executive is guilty of securities fraud. New York Times, p. B1.
Karpoff, J. (2006). The impact of shareholder activism on target companies: A survey of empirical findings.Unpublished manuscript, Seattle: University of Washington. Available at SSRN: http://ssrn.com/abstract=885365
Schwartz, N. D., & Story, L. (2010, April 1). Pay of Hedge Fund Managers Roared Back Last Year. New York Times, p. B1.
Useem, M. (1996). Investor capitalism: How money managers are changing the face of corporate America. New York: Basic Books.
Walsh, M. W. (2004a, December 1). California pension activist expects to be unseated. New York Times, p. C1.
Walsh, M. W. (2004b, September 22). Leader quits corporate governance group amid clashes. New York Times, p. C8.
Wayne, L. (2009a, June 12). Firm settles in New York pension inquiry. New York Times, p. B3.
Wayne, L. (2009b, April 15). Public pension managers rethink hedge fund ties. New York Times, p. B1.