Evaluating Pension Fund Investments Through The Lens Of Good Corporate Governance

I understand today’s participants include a number of trustees and asset managers for some of the country’s largest public and private pension funds. Without a doubt, pension funds play an important role in our capital markets and the global economy. This is due, in part, to the fast growth in pension fund assets, both in the public and private sectors.

For example, since 1993, total public pension fund assets have grown from about $1.3 trillion to over $4.3 trillion in 2011. Over that same period, total private pension fund assets more than doubled from roughly $2.3 trillion to over $6.3 trillion by 2011. As of December 2013, total pension assets have reached more than $18 trillion. This growth was fueled by many factors, including the rise in government support of retirement benefits, and the increased use by companies of pension plans as a way to supplement wages.

In conjunction with the growth in pension assets, the total number of individuals participating in pension funds has also grown. For example, in 1993, there were roughly 24 million participants in public pension funds and 84 million in private pension funds. By 2011, those numbers grew to more than 32.7 million and 129 million, respectively. Unsurprisingly, pension fund contributions have followed a similar path, with roughly $119 billion in total public pension fund contributions in 1993 to more than $284 billion in public pension fund contributions in 2011. Similarly, in 1993, total private pension fund contributions totaled more than $154 billion, while this number grew to more than $465 billion by 2011.

The remarkable growth in pension fund assets, however, is accompanied by a number of challenges—including growing concerns that the ultimate beneficiaries of the funds might not get their promised benefits. In particular, pension fund trustees have been dealing with the problem of chronically underfunded pension funds. In fact, just two days ago, Standard & Poor’s released a 2014 survey in which it found that the 50-state average funded ratio for state-sponsored pension funds fell by two percentage points to 70.9% in 2012 from 72.9% in 2011. Another study found that, as of 2012, 30 state-sponsored pension funds were funded at less than 75% of their current and future pension obligations. Indeed, three of these state pension funds were funded at less than 50%. According to another report, at the end of 2013, state and local governments’ unfunded public pension liabilities were estimated to be between $750 billion and $4.4 trillion, depending on the discount rate assumptions used in the calculations. It has also been recently reported that 85% of public pension plans may default over the next 30 years, assuming investment returns of 4%.

Private pension funds are also facing challenges—particularly as was evidenced by the impact on their portfolios by the 2008 financial crisis. Although the situation is improving for some private pension plans, many multiemployer pension plans are still in danger of insolvency. For example, a March 2013 study conducted by the U.S. Government Accountability Office (“GAO”) on private multiemployer pension plans found that 40% of multiemployer pension plans had not emerged from critical or endangered status. That same study found that the Pension Benefit Guaranty Corporation (“PBGC”) expected the number of multiemployer pension plan insolvencies to more than double by 2017, while the financial assistance that PBGC provides to such plans could be exhausted within the next ten to 15 years.

As to public pension plans, a March 2012 study conducted by the GAO on state and local government pension plans indicated that most large plans have assets on hand sufficient to cover benefit payments to retirees for at least a decade or more. However, the same study showed that the gap between asset values and projected liabilities had widened, leading to long-term concerns about sustainability.

That being said, as was recently reported, since the 2008 financial crisis it appears that many states have closed funding gaps and made reforms to public pension funds. Only time will tell if those reforms will solve the long-term problem in the funding of retirement benefits.

Clearly, however, serious challenges remain. For pension fund trustees and asset managers, one aspect of meeting these challenges is to make sound investment decisions and increase investment returns. And, yes, I know that is much easier said than done. Certainly, investment decisions involve many difficult and complex factors, including appropriate asset allocation among equity and fixed-income investments, allocating between domestic and international investments, allocating among different industry sectors, and, of course, selecting the best individual investments possible.

Today, I want to focus on one aspect of the investment decision process that cuts across many of your investments—and that is the assessment of the strength of a company’s corporate governance.

It is often said that good corporate governance helps reduce a company’s investment risk, ensures the effective deployment of shareholder capital, and ultimately contributes to the long-term performance of public companies. In addition, a robust corporate governance infrastructure enables a company to better understand where risks can arise, including emerging risks like cybersecurity. Among other reasons, this is because focusing on strong corporate governance helps companies hire and incentivize good managers, while at the same time promoting accountability. On the other hand, the absence of a robust corporate governance infrastructure can lead to poor decisions resulting in bad outcomes for the company and its shareholders. Ultimately, focusing on the quality of a company’s corporate governance infrastructure often provides answers to the most common questions for investors, such as management effectiveness, corporate transparency, executive accountability, and the ability of shareholders to participate in company decisions.

To that end, I want to focus on a few corporate governance areas that merit particular attention—and that are areas you can favorably impact:

• First, ensuring that the corporate governance infrastructure permits and protects appropriate shareholder engagement;
• Second, the importance of aligning executive compensation with performance;
• Third, the need to ensure high quality financial reporting; and
• Finally, the benefits of promoting diversity in the boardroom.

Pension Fund Engagement with Management

Given the significant role that good corporate governance plays in improving a company’s long-term performance, it makes sense for pension funds to be more involved with their portfolio companies as a way of achieving better returns for their investments. Because of their funds’ long-term investment horizon and the significant size of their investment portfolios, pension funds are well-situated to communicate with their portfolio companies and to demand good corporate governance practices.

Pension funds can engage with their portfolio companies in several ways, for example, through informal discussions with the company’s board and management, or through the formal process of voting your shares and by submitting shareholder proposals for consideration at the company’s annual meetings.

Usually, for pension fund trustees and asset managers, the way you normally communicate with your companies is by exercising the power to vote the shares you own. In fact, voting the shares is one of your fiduciary obligations. As the U.S. Department of Labor has stated, “the fiduciary act of managing [fund] assets [that] are shares of corporate stock … include[s] the voting of proxies [relating] to those shares of stock.”

The importance of voting shares also brings with it the responsibility to monitor company policies to make sure that they are supportive of the voting rights of shareholders and do not seek to limit shareholder rights. For example, it has been suggested that company policies that seek to adjust or restrict share voting rights, such as the issuance of new classes of stock with unequal voting rights called “dual-class voting,” may at times be designed to limit shareholder rights by enhancing certain classes of shares over others. Likewise, proposals for supermajority voting requirements and poison pill plans have been said to be used, at times, to undermine the rights of one set of constituents over other constituents.

It has long been understood that a pension fund trustee’s first interest is to proactively preserve its right as an owner of the company. To that end, pension fund trustees must be vigilant in preserving their ownership right by proactively monitoring and working against restrictions on shareholder rights—and by supporting measures that enhance shareholder rights and their ability to communicate their views.

Moreover, because communications with other shareholders can also bring benefits, pension funds should encourage their portfolio companies to establish forums that allow shareholders to communicate with other shareholders. For example, there are a few progressive companies that have developed online shareholder forums where shareholders can pose questions to the company on a real-time basis, view other shareholders’ questions and the company’s responses, and engage in online discussions with other shareholders. The SEC has tried to encourage these forums, and in January 2008, the Commission adopted rules to facilitate the use of electronic shareholder forums by public companies and their shareholders. Unfortunately, these forums have not yet been widely adopted by U.S. domestic issuers. I believe that good corporate governance starts with communication and transparency, and I encourage you to explore these kinds of forums with your portfolio companies. I also ask that you let the Commission know of any needed improvements to the 2008 rule that could make these forums more common and more useful.

Aligning Executive Compensation with Performance

Another indicator of whether a company has good corporate governance oversight—and whether the board of directors is doing its job—is by determining whether the company’s executive compensation is aligned with the company’s performance.

Clearly, sound compensation policies and practices are fundamental to sustainable, long-term corporate growth and performance. However, there are questions as to whether, over the years, compensation policies have changed to the detriment of shareholders. For example, over the last 30 years, we have witnessed an unprecedented growth in the compensation of corporate executives. A 2012 study showed, for example, that the average annual earnings of the top 1% of wage earners grew 156% from 1979 to 2007, and for the top 0.1% they grew 362%. During this same period, there has also been a dramatic increase in the pay gap between the compensation of company executives and that of rank-and-file workers. For example, in 1980, it was estimated that the average CEO was paid about 42 times the typical worker’s pay; by 2013, however, a study by Bloomberg found that large public company CEOs were paid an average of 204 times the compensation of rank-and-file workers in their industries.

The unprecedented growth of executive pay and the widening pay gap between executives and rank-and-file workers raise important questions about the rational relationship between executive compensation and corporate performance, and whether shareholders have benefitted from these trends. For instance, one study found that an investment strategy that involved buying shares of companies in the lowest 2% of the incentive pay distribution and selling shares of companies in the highest 2% would have earned higher-than-average returns of more than 11% per year during the testing period. Another study debunked the idea that large executive compensation packages are necessary to motivate executives and to align their interests with investors. To the contrary, the study found that executives gave less weight to the value of long-term incentive plans to the point that the amounts offered needed to be enormous to even affect motivation.

Moreover, runaway executive compensation packages may incentivize excessive or inappropriate risk taking to the detriment of investors. In other words, the potential for a pot of gold may lead executive management to take risks they otherwise would not take. Indeed, one recent study found that excessive incentive pay increases a CEO’s motivation to make riskier decisions that open the door to greater increases in the CEO’s overall pay. In this scenario, when the risks do not pay-off, investors get the short end of the stick.

One way for pension funds to ensure that a company maintains sound compensation policies and practices is to weigh-in on the company’s overall approach to compensation. Specifically, under Section 951 of the Dodd-Frank Act, public companies are required to conduct shareholder advisory votes to approve the compensation of executives at least once every three years. Although these so-called “say-on-pay” votes are not directly binding on the corporation, experience demonstrates that corporate boards pay close attention to the voting results and that they will seek to avoid “no” votes greater than 25-30%. Early signs suggest that some companies have reacted positively to the say-on-pay regime, and they have begun to re-evaluate compensation packages when pay outstrips performance.

Because a poorly conceived executive compensation plan can negatively impact shareholder value and because they can create inappropriate incentives for executives to take on excessive risks, shareholders must exercise particular care in evaluating whether compensation policies and practices are aligned with shareholder interests—and how the boards exercise their oversight responsibility.

Ensuring High Quality Financial Reporting

Good corporate governance also extends to financial reporting. A properly functioning financial reporting system is necessary to ensure credible financial information. Both shareholders and boards of directors need transparent, accurate, and reliable financial information both to evaluate and assess a company’s business outlook and, separately, to evaluate management performance.

In fact, a public company’s failure to provide accurate and meaningful disclosure to investors can be devastating. It was not too long ago that investor confidence in the capital markets was eroded in the wake of the accounting scandals at Enron, WorldCom, HealthSouth, Tyco, and others.

In response to these accounting scandals, Congress passed the Sarbanes-Oxley Act of 2002, which, among other things, required company management to implement, test, and monitor internal control systems so as to ensure accurate financial reporting. It also required an outside auditor to attest to management’s assessment of internal controls. Two years ago, however, Congress passed the Jumpstart Our Business Startups Act (“JOBS Act”), which, among other things, largely extinguished the outside auditor attestation requirements for new public companies during the first five years of their existence. This eliminated a critical component to assessing a company’s internal controls. Due to the absence of this oversight mechanism, shareholders now need to be even more vigilant in monitoring the financial reporting and internal control systems of these new issuers.

To that end, pension funds and their managers should focus on whether the boards of directors of their portfolio companies have strong corporate governance processes for overseeing the companies’ financial reporting, and whether the companies’ internal control systems include engaged audit committees, strong company policies, and verification from independent outside auditors.

The strength in our capital markets ultimately requires that shareholders have confidence in the accuracy of companies’ financial information. When all is said and done, in order for shareholders to have confidence in a company’s financial information, however, shareholders first need to have confidence in the board’s corporate governance oversight of the company’s financial reporting process.

Diversity in the Boardroom

In addition, in deciding how to allocate investment assets, you should also consider how the composition of a company’s board of directors affects long-term performance. For example, studies have indicated that diversity in the boardroom—referring to the traditional categories of gender, race, and ethnicity—results in real value for both companies and shareholders. One study that compared the financial performance of S&P 500 companies with differing numbers of women and minority directors concluded that companies with more diversity had better stock returns and less risk of loss for shareholders. Similarly, a 2012 study on the share price performance of companies over a six-year period from 2005 through 2011 found that companies with at least some female board representation outperformed those with no women on their boards.

Unfortunately, notwithstanding these studies, corporate board diversity remains dismal. For example, a 2012 study on Fortune 100 boards of directors found that women and minorities remained substantially underrepresented in corporate boardrooms, and, combined, represented just over 30% of the 1,214 seats. The same study found that women and minorities were also underrepresented in Fortune 500 boardrooms, with white males accounting for more than 73% of the 5,488 available board seats, and women collectively holding only 16.6% of those seats. The composition of the Fortune 500 board seats broken down by race and ethnicity is even more disappointing, with African-Americans holding just 7.4% of the available board seats and Hispanics and Asians holding about 3.3% and 2.6% of those seats, respectively.

Shareholders can have a powerful impact on corporate diversity. Recently, for example, as a result of stinging public criticism because its board of directors only had one female director in a board of all white men, Apple Computer revised its corporate charter to say it is now “committed to actively seeking out highly qualified women and individuals from minority groups to include in the pool from which Board nominees are chosen.” As you exercise your fiduciary duties and obligations as pension fund trustees and asset managers, you should pay close attention to the importance of diversity in the boardroom and how it could impact the company’s bottom line. Your voices can make a difference—and you should not hesitate in making them heard.

Conclusion

As I conclude my remarks, I want to acknowledge again the significant challenges faced by pension funds. You are required to invest prudently, in a diversified manner, at low costs, in a way that ensures reasonable long-term investment returns. You are asked to do so in an environment with ever-increasing obligations, less contributions, volatile markets, and a ballooning retirement wave. This is no doubt a very challenging environment.

Meeting these challenges requires that, among many other factors, you effectively exercise the important ownership rights you have as shareholders. Exercising those rights, and assuring that a company has effective corporate governance, needs to be an integral part of the investment process.

Shareholder involvement does not mean that shareholders need to be involved in the day-to-day management of a company. However, it does require awareness of the company’s overall corporate governance standards and making sure that they are appropriate for the particular company and that these standards are being met.

Only by being proactive, informed, and diligent can shareholders protect and enhance the value of their ownership interest. And, as fiduciaries responsible for other people’s money, that is a particular obligation of pension fund trustees and asset managers. I have no doubt that you are up to the task.