Pension Funds as Owners and Investors

Editor’s Note: Luis A. Aguilar is a commissioner at the U.S. Securities and Exchange Commission. This post is based on a Commissioner Aguilar’s keynote address before the NAPPA 2012 Legal Education Conference; the full address, including footnotes, is available here. The views expressed in the post are those of Commissioner Aguilar and do not necessarily reflect those of the Securities and Exchange Commission, the other Commissioners, or the Staff.

As an SEC Commissioner focused on investor protection, I’d like to talk to you today about some issues important to investors in the current capital market environment, and how public pension funds, in their capacity as shareowners and investors, can be a more effective voice for America’s working families.

Investors are the Capital Providers — The Economic Impact of Public Pension Funds

First, I want to quickly highlight the critical role public pension plans have in our economy. As they often do, the statistics tell the story: State and local pension plans serve about 14.4 million active employees, and pay benefits to about 7.5 million current beneficiaries. In 2010, public pensions paid an average benefit of just under $26,000 per year. That regular income provides security, stability and peace of mind that individual savings and defined contribution plans alone cannot ensure for most workers.

Pension plans may also help reduce the disparity in retirement incomes between men and women, as well as the wide income gulf between white and non-white households in retirement. A 2009 report by the National Institute on Retirement Security found that, while older households headed by women, and those headed by people of color, were significantly more likely to be classified as poor than their male and/or white counterparts, that disparity is substantially reduced among households receiving pension income.

State and local government employee retirement funds had total financial assets of $2.8 trillion at the end of 2011. This immense pool of capital is funded by employee contributions, employer contributions, and investment earnings. A majority of such funds is invested in the stocks and bonds of U.S. corporate issuers, with substantial investments also made in venture capital and private equity funds and other asset classes. These investments make public pension funds a significant source of capital for American business. Importantly, another benefit of pension fund capital is that pension funds typically invest with a long-term perspective. This “patient capital” is essential for true capital formation and an important contribution to stability in a capital markets environment that is often all too focused on quarterly returns.

The benefits paid by pension plans are also a strong driver of economic activity. Retirement income security is not only essential for seniors; there is also evidence that it may enhance the economic health of our communities as well. Seniors with pension income are significantly less likely to receive public assistance. Pension plans also support the economy by providing a stable source of income that retirees can rely on to meet day-to-day needs. Thus, when beneficiaries spend their paychecks, they support local business owners and other segments of the economy, providing, in effect, a stimulus to business revenues and helping to generate economic demand and employment. This powerful economic impact has a “multiplier effect,” as the business revenues supported by retiree spending can, in turn, be invested by the recipient to purchase inventory, hire workers, or fund growth. A recent study calculates that multiplier as 2.37 to 1, or $2.37 in total economic output supported by each dollar paid out in pension benefits. Accordingly, through America’s public pension plans, teachers, first responders, and other government workers are a significant source of capital to American businesses.

Challenges Facing Public Pension Funds

That being said, public pension funds face significant challenges in the current economic and political environment.

A series of burst bubbles, culminating in the most severe financial crisis since the Great Depression, has reduced investment returns over the past dozen years for pension funds as well as other investors, while at the same time putting increased fiscal pressure on the state and local governments that fund employer contributions for public workers. Although annualized investment returns for public pension funds remain strong over the long-term, averaging 8.3% for the 25-year period ending December 31, 2011, 10-year returns were below forecast at 5.7%. In addition, over the years, some governmental bodies have failed to make adequate plan contributions or granted unfunded benefit increases. As a result, although most large state and local government pension plans have assets on hand sufficient to cover benefit payments to retirees for a decade or more, the gap between asset values and projected liabilities has widened, leading to long-term concerns about sustainability. At the same time, near-record low interest rates and inflation projections have led some plan administrators to prudently reduce long-term investment return assumptions; which has the effect of increasing actuarially-required contribution rates. To address these challenges, state and local governments have responded with legislation to reduce pension fund costs by increasing employee contributions, raising retirement age and years of service requirements, and changing formulas for calculating benefits, including the elimination or modification of cost-of-living adjustments.

I know that many of these challenges are beyond your control and I know that these are issues that pension funds are working hard to manage. From my interactions with many pension funds, I know how important it is to you to keep our promises to America’s fire fighters, police, educators, and other public workers who rely on their pensions for a safe and secure retirement.

Dodd-Frank Executive Compensation Provisions

I also know that pension funds take seriously their role in our capital markets and the corresponding obligation to act responsibly in exercising their rights as shareowners.

To that end, I want to discuss certain corporate governance provisions of the Dodd-Frank Act concerning executive compensation and related matters. These requirements are intended to help empower shareholders to exercise their rights as investors and business owners, and to make sure that a company’s directors and officers are living up to their responsibility to act as prudent stewards of the assets entrusted to them.

Section 951 of the Dodd-Frank Act requires corporate issuers to hold non-binding shareholder votes on executive compensation at least once every three years and requires a separate shareholder vote to determine the frequency of such “say on pay” votes. The SEC adopted rules to implement these requirements on January 25, 2011. Although smaller reporting companies are not required to comply with say-on-pay until after January 21, 2013, larger companies have just completed the second proxy season of mandated say-on-pay voting.

Although relatively new, say-on-pay voting has already had several high profile outcomes. For example, last year, the executive compensation package of Hewlett-Packard was rejected by a majority of the shareholders voting. In response, HP’s compensation committee restructured incentive programs to limit discretion, eliminate tax gross-ups for some officers, and tighten pay and performance links, among other changes. Following these changes, the company received a 77% approval percentage in this year’s say-on-pay vote. Similar stories can be told about other issuers.

More recently, in April of this year, the shareholders of Citigroup rejected a board-approved compensation package for its senior executives. To date, Citigroup has been the largest company by market value to suffer a no-vote on executive pay.

“Say-on-pay” is an opportunity for pension funds and other investors to have their voices heard and to make an important contribution to the good governance of the companies they own. It is my expectation that boards and compensation committees will take the results of say-on-pay voting seriously, as appears to have been the case at HP. Importantly, our rules require annual disclosure in the issuer’s proxy statement of whether, and if so how, the company has considered the results of its most recent say-on-pay vote.

In contrast to the Commission’s swift action in adopting rules to implement public company say-on-pay provisions, there are a number of other Dodd-Frank provisions regarding executive compensation and corporate governance where the rules have still not been proposed. These provisions mandate the SEC to require disclosure showing:

  • the relationship between executive compensation and financial performance of the issuer;
  • the ratio between CEO compensation and median total compensation for all other employees; and
  • whether directors and employees are permitted to hedge any decrease in market value of the company’s stock.

Like many others, I am disappointed that the Commission has not made more progress on these important provisions.

Moreover, beyond the Dodd-Frank requirements, it is simply good corporate governance to shed some light on the dramatic growth in CEO compensation that has taken place in recent decades. It has been estimated that CEO pay at the largest companies grew from 42 times the average worker’s pay in 1980 to 531 times the average worker’s pay in 2000. Reports state that, even after the market crash of 2008, in 2010, large company CEOs received average compensation that was 343 times worker pay. And just this month, The New York Times reported that the median pay of the nation’s 200 highest-paid CEOs increased five percent in 2011 from the prior year. This appears to be one additional reason that investors have told us that the disclosure required by the Dodd-Frank executive provisions is important to them.

A Challenge for Investor Protection — Promoting Audit Quality

Another significant corporate governance challenge is the unacceptably large number of audit deficiencies identified by the Public Company Accounting Oversight Board (“PCAOB”), in routine inspections of outside auditors. This is a disturbing trend, which raises serious concerns about the proper functioning of the securities market.

As this group knows well, the PCAOB was established by Congress in the wake of Enron, WorldCom and other accounting scandals of the “dot-com bubble” era. The PCAOB is charged with overseeing the audits of public companies to protect the interests of investors and to further the public interest in the preparation of informative, accurate, and independent audit reports. We are heading into the Board’s ninth annual inspection cycle, and the largest accounting firms — that is, those that issue audit reports for 100 or more public companies — are audited annually, so there is a wealth of information about audit quality that can be analyzed.

Unfortunately, the available data raise serious issues about the quality of the audits. For the 2010 inspection cycle, the Board issued inspection reports for eight accounting firms in the “annual inspections” category. In the aggregate, these firms are responsible for auditing the financial statements of the great bulk, by market capitalization, of public issuers. In each case, the Board identified multiple audits with deficiencies in the performance of audit work reviewed; and in each case, the Board’s inspection team identified multiple weaknesses that rose to the level of audit failures. In these cases, the Board’s inspection team determined that the deficiencies were of such significance as to appear that the auditors had “failed to obtain sufficient appropriate audit evidence” to support their audit opinion on the financial statements. This is a criticism that goes to the very heart of what an independent audit is all about.

Moreover, the evidence suggests that this year’s results were not an aberration. Many common deficiencies cited in those recent inspection reports were also identified as frequent weaknesses in the PCAOB’s 2010 report on audit risk areas affected by the economic crisis, which focused on the 2007, 2008 and 2009 audit cycles.

This is simply not acceptable. Investors need reliable and useful information to make good investment decisions. They must have confidence that an issuer’s financial statements fairly reflect its true financial condition and results of operations, and properly disclose its contingencies and other risks. It is of particular concern that, in the wake of the financial crisis, audit quality appears to be deteriorating.

A Public Discussion on Promoting Better Audit Quality

In reaction to its findings, last year the PCAOB issued a concept release that explored some potential ways to promote better audit quality. The Board noted that its inspections “frequently find audit deficiencies that may be attributable to a failure to exercise the … professional skepticism and objectivity” required of auditors. The release requested advice and comment on potential approaches the Board could take to help auditors maintain that required mindset more consistently.

Professional skepticism is a key element of the professional conduct required of all auditors. It requires “an attitude that includes a questioning mind and a critical assessment of audit evidence.” Exercising such objectivity means that an auditor must be, in fact as well as in theory, truly independent of management. As the PCAOB’s chairman has put it: “Skepticism is what makes the auditor’s work relevant to investors…. [It] is the foundation for investor confidence in financial reporting.”

Following that concept release, the Board received hundreds of comment letters; convened a two-day public meeting with dozens of panelists; and sought the views of its Standing Advisory Group and its Investor Advisory Group. This public discussion has generated a truly extraordinary amount of valuable information about auditors, audit committees, management, and investors and the way they prepare, review, audit, and/or use financial statements, including a broad range of issues that need to be considered in terms of improving auditor independence and objectivity and, ultimately, audit quality.

The Board is currently considering a wide range of potential options for improving audit quality, including possible measures regarding periodic auditor rotation, enhanced disclosure in the audit opinion, an “Auditor’s Discussion and Analysis” in the issuer’s Annual Report, improvements to auditing standards, and the continued importance of effective root cause analysis when audit failures do occur, as well as ideas for strengthening the role of the audit committee and improving audit committee performance.

Whatever the outcome of the PCAOB’s project, the discussion should certainly be useful to anyone committed to improving audit quality.

As shareowners and investors, public pension funds can make an important contribution to the current dialogue on improving audit quality. I encourage you to provide comments to the PCAOB and the SEC, and I urge you to ask the companies you invest in, and their audit committees, to promote independence, objectivity, and professional skepticism on the part of their auditors. I know that many of you are already doing so.

Shareholder Oversight — A Right of Ownership

In addition to the PCAOB, some shareholders have also expressed concerns about audit quality by submitting shareholder proposals relating to the audit engagement process. For example, a proposal submitted to companies such as Walt Disney, Deere, Alcoa, GE, and AT&T requested that the company establish an auditor rotation policy that would have imposed a seven-year term limit on the engagement.

Another proposal, submitted by a shareowner to companies such as CA, Dell, and McKesson, called for the issuer’s audit committee to provide an annual “audit firm independence report,” disclosing the length of tenure of the company’s current audit firm, the aggregate fees paid to the firm, and other information regarding auditor independence and objectivity.

The companies that received these proposals generally sought to exclude them from their proxy statements on the ground that the proposal related to a matter of ordinary business that should be left to management and the board. The SEC’s Division of Corporation Finance received at least 24 requests to exclude the above proposals on such grounds, and in each case the staff sided with the issuer by issuing a “no-action letter.” However, such letters by the staff do not require Commission input, and do not represent a determination by the Commission or any of the Commissioners.

The staff action was predicated on current SEC rules that permit a company to exclude a shareholder proposal if the proposal deals with a matter relating to the company’s ordinary business operations. However, there is an important exception to that rule: In those cases in which a proposal’s underlying subject matter transcends the day-to-day business matters of the company and raises significant policy issues, the proposal is generally not excludable on such grounds. This is particularly the case when an issue has emerged as a topic of “widespread public debate,” as this issue has been. Given the extensive public discussion occasioned by the PCAOB’s concept release, and the long history of debate on this issue, a strong case can be made that shareholder proposals relating to auditor independence and objectivity and audit quality raise significant policy issues and should not be excluded on ordinary business grounds.

More broadly, I am not convinced that the engagement of the independent auditor should necessarily be considered a matter relating to “ordinary business operations” within the meaning of the Federal proxy rules. For example, shareholders of public companies have routinely been given the right to ratify the company’s selection of an independent auditor since the 1930s. According to reports, in 2010, 92% of the companies in the S&P 500 held a shareholder vote on auditor ratification.

We know that the quality of audit services is of paramount importance to investors. It is also a matter of great public importance. In the words of Chief Justice Warren E. Burger of the United States Supreme Court, the role of the independent auditor is “a public responsibility transcending any employment relationship with the client.” As the Chief Justice said:

The independent public accountant performing this special function owes ultimate allegiance to the corporation’s creditors and stockholders, as well as to the investing public. This “public watchdog” function demands that the accountant maintain total independence from the client at all times and requires complete fidelity to the public trust.

Clearly, this public function “transcends” a company’s ordinary business operations as well.

As the Court of Appeals for the Third Circuit has held, “Surely, the audit of a corporation’s books may not be considered to be peculiarly within the discretion of the directors. A corporation is run for the benefit of its stockholders and not for that of its managers.” Accordingly, as that court stated, the selection of the corporation’s auditors is “beyond any question … a proper subject for action by the stockholders.”

In other words, issues relating to auditor independence and audit quality are matters of corporate governance, not merely ordinary business operations. It is only prudent that shareholders, as the owners of their companies, should have a voice on these issues.

In light of the wide prevalence of audit failures so clearly documented by the PCAOB, I respect that shareholders are trying to protect their interests. As a Commissioner of an agency that proclaims itself the “Investor’s Advocate,” I am on their side.


As I conclude my remarks, I want to end where I started, by acknowledging the important role of public pension funds.

As significant investors, public pension funds are a needed voice in the ongoing public dialogue involving the issues facing investors today, including corporate governance and audit quality. As fiduciaries, public pension plans can be a powerful voice on behalf of their beneficiaries, working men and women whose voices are often drowned out. You and your beneficiaries have a direct stake in the results. You should speak out on behalf of investors, and you should hold the SEC accountable to act on behalf of investors. You have a lot to contribute, and I look forward to hearing what you have to say.

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