Growing Value and Activism Bring New Scrutiny to Public Pension FundsPublished: June 11, 2008 in Knowledge@Wharton
After decades in obscurity, public pension funds are drawing attention as civic organizations raise concerns about the programs' costs, and as some funds take activist investment stands, such as demanding divestment from firms that do business in Sudan or Iran.
The public face of government pension funds was explored at a Wharton Impact Conference titled "The Future of Public Employee Retirement Systems," sponsored by Wharton's Pension Research Council and the Boettner Center for Pensions and Retirement Research. Researchers at the conference presented two papers about the nature of opposition to traditional defined-benefit plans for public employees and the true costs of activist pension investment policies.
"Everybody is paying more attention to pensions than they were 30 years ago partly because of the aging population -- and the civil servant population is aging more quickly than the population as a whole," said Olivia Mitchell, Wharton professor of insurance and risk management. Mitchell is also executive director of the Pension Research Council and director of the Boettner Center, which co-sponsored the conference. "The costs of their retiree benefits are burgeoning and as those costs increase, everybody has to pay more attention to them."
Even though public pension funds have done a relatively good job of providing for members' retirement, ideologically driven organizations, such as Americans for Prosperity, a Washington, D.C. non-profit that promotes limited government and free markets on the local, state and federal levels, are rising up to roll back benefits, according to Beth Almeida, Executive Director of the National Institute on Retirement Security.
Almeida presented a paper at the conference titled, "The New Intersection on the Road to Retirement: Public Pensions, Economics, Perceptions, Politics, and Interest Groups." She wrote the paper with Kelly Kenneally, a communications consultant, and David Madland, director of the American Worker Project at the Center for American Progress.
Too Big to Ignore
"Public pension plans were for decades sleepy things that nobody paid attention to," said Almeida in an interview. But in recent years they have begun to aggressively pre-fund their liabilities, increasing the level of investment dramatically. At the same time, public pension funds began to invest in assets, including equities, with additional risk compared to the "plain vanilla" investments they had made since the 1950s.
As a result, the funds have grown to about $3 trillion in value. "Obviously, with an investment that large, it becomes a focus and people are interested in taking a look at it," said Almeida.
Almeida and her coauthors examined survey data related to public pensions and examined case studies from four states that recently had been under pressure to cut back on traditional plans and move toward the type of defined-contribution plan common in the private sector.
The survey data revealed most citizens are uninformed about public pensions and have little interest in changing the system. According to the paper, "There does not appear to be a real groundswell of discontent on the issue of public pensions and no demand rising up from ordinary citizens for wholesale changes. It appears that efforts to dismantle public pensions are tied to partisan politics and organized ideological interest groups."
While the survey research showed individual Republicans had little concern about public plans, there was a correlation between Republican-controlled legislatures and movements to dismantle traditional government pension plans.
To understand that connection the authors examined four states -- Alaska, Colorado, California and Utah, which have experienced movements to change their government plans. The authors discovered that the most important element driving change was the presence of an ideologically motivated group urging a move toward more individual responsibility in public pension finance.
However, Almeida noted that Alaska and West Virginia, which had moved toward defined contribution plans, now have "buyer's remorse" and are taking steps back toward traditional defined-benefit plans for public employees.
Almeida said the research indicates the ideological bent of activists pushing toward defined-contribution programs "talks past" the voters, which may ultimately lead to failed policy. "What these cases show is that when these policies aren't enacted on a fully fleshed-out analysis of policy but a more ideological approach, there's a bigger risk that policy will be enacted that folks will come to regret later," said Almeida.
During the conference Mitchell raised the issue of "pension envy" which she described as antagonism toward public defined-benefit plans that seem lavish compared to what most private sector employees can expect.
"Ultimately, the question will be how much more taxes will taxpayers be willing to kick in to fund these benefits, particularly if they themselves don't feel they are in a comparable situation," said Mitchell in an interview. She said pension envy is particularly strong when it comes to public employees who "double-dip" or continue to work in another job after retiring at a full pension from another employer.
Mitchell said in most cases the pension benefit comes in return for deferred compensation throughout the worker's career and represents a promise that was made. However, she added, many pension plans have formulas that make it easy for public employees to enrich themselves by spiking their final salary to increase their level of benefits in retirement.
She recalled incidents of public transit drivers getting into accidents in the last months of their career because they were exhausted from working excessive overtime to boost their final salary. "I don't have a big problem with people taking a pension according to the rules and then going on to work if they need the money, but I do think some of these rules are easy to manipulate and that's where there needs to be more public oversight."
Pension funds that take on activist social causes were examined by Brad Barber, professor of finance at the graduate school of management at the Davis campus of the University of California. He presented a paper titled, "Pension Fund Activism: The Double-Edged Sword."He described two types of pension fund activism: "shareholder activism" and "social activism."
Funds act as shareholder activists when they use their clout as investors to pressure companies into practicing good governance, for example, dropping poison pill takeover defenses.
Barber researched the question of whether shareholder activism enhances investment portfolios. He tracked the California Public Employees' Retirement System (CalPERS) which has been investing in corporate equities since 1984. In 1987 CalPERS launched its governance program aimed at improving corporate performance. In addition to its public crusades, CalPERS does extensive behind-the-scenes negations at companies to influence governance.
Barber tracked the performance of the CalPERS focus list over the past 15 years and found indications shareholder activism enhances the value of its portfolio. However, he said the evidence was not scientifically sound. Nonetheless, he added that substantial theoretical work underpins the notion that shareholder activism does improve results for investors.
He is less certain about social activism. Again he turned to CalPERS, which has been ordered by legislation to use its influence to demand corporations divest from businesses in South Africa, Sudan and Iran. The CalPERS board has also taken stands against corporations on social grounds. In Oct. 2000, overriding the recommendation of its staff, the board ordered the fund to divest from tobacco companies.
Limits of Activism
The board also called for the resignation of Safeway Stores CEO Steven Burd in 2004 while the grocery chain was in the midst of a labor dispute. Sean Harrigan, a food workers' union official was president of CalPERS at the time, and was ousted from his position later that year. Harrigan said he was removed under pressure from business and Republican Governor Arnold Schwarzenegger.
Barber said the Safeway actions diminished CalPERS' credibility. "My concern is that these institutions do engage in a lot of sensible actions. We really need them as watchdogs of corporations. But if you also get them engaged in questionable activities with a political motivation or social motivation they think is noble... those interventions could be questioned."
At a minimum the decision to divest from any company, for any reason, constrains investment options and limits a fund's ability to benefit from a diverse portfolio, Barber pointed out.
In an interview after the conference, Barber cited a 1971 article by Milton Friedman that appeared in The New York Times in which the Nobel-winning economist argues that corporate executives who take on 'social' responsibilities for the firm are, in effect, acting as civil servants. "If they are to be civil servants, then they must be elected through a political process," Friedman wrote. "If they are to impose taxes and make expenditures to foster 'social' objectives, then political machinery must be set up to make the assessment of taxes and to determine through a political process the objectives to be served."
Barber said the discussion boils down to how to allocate resources. Social activism might be appropriate if it can generate a profit or return on investment.
For example, for funds interested in environmental sustainability, he pointed to project financing that could be used to retrofit buildings to conserve energy. Many small building owners are reluctant to lay out the capital necessary to retrofit their properties. Large pension fund investors, however, could finance the renovations and earn back a return by having the building owners pay them back with their energy savings. In some cases, insulation can create savings of 30% on energy bills, Barber noted.
"A lot of companies in the private equity and venture capital arena can think cleverly about how to use finance to solve some of these problems," said Barber. "Large investors should be focusing on what venture capital and private equity investments are out there."
Measuring Carbon Footprints
Another environmental initiative that is gaining attention is disclosure of a firm's carbon footprint to guide investment. Barber said that might be justified because research on disclosure policies indicates firms can lower their cost of capital if they have high-quality disclosure policies.
Barber noted that firms need to take social issues into consideration as they conduct their business. The classic example is Wal-Mart, which suffered a backlash when it focused solely on low costs without regard to the impact of its business on local communities. "I think some of the bad publicity they've gotten has materially hurt shareholders," said Barber. "That's an example of how taking their eye off those issues might have destroyed shareholder value."
Mitchell pointed out that interpretations of the Employee Retirement Security Act of 1974 (ERISA) prohibit private-sector pension funds from taking any actions that are not solely in the best financial interests of plan members. As a result, most pension activism has been focused on the public sector.
She cited the example of CalPERS' decision to divest from tobacco firms, which Barber ,noted in his paper ,limited investment returns. "Who bears the cost is unclear," said Mitchell. "In the case of a defined-benefit plan, what it means is somebody down the road will have to pay more in, or benefits may be lower than expected."
Another problem is reaching agreement on what causes to support, or ignore. "There are a lot of flavors of activism," Mitchell remarked. In addition to tobacco, alcohol and other 'sin' products, she said social activism has also extended to military procurement and weapons firms. She also noted there is a movement to create Islamic funds in which no interest is incurred in keeping with interpretations of the Koran.
"The point is what's up for you may be down for someone else. It gets difficult to get people to agree on which flavor of activism they like," said Mitchell.
"I see the role for activism in pension investment more clearly when it's a defined-contribution plan and individual investors can read and review the evidence and put their money where their hearts are," she continued. "In the case of a defined-benefit plan what I worry about is that the money managers may be exerting funds for some sort of political or social judgment which might not be consistent with either the risk the pension plan should bear, or with the views of the participants who may have to kick in more money or have their benefits cut if the performance is not satisfactory."