Restoring Trust: Proposals for Shareowner Stewardship

By Stephen M. Davis, senior fellow, Millstein Center

"Capitalism without owners will fail," Robert A.G. Monks has famously written. Today, as we sort through the wreckage of the financial crisis, it is time to re-frame this insight for policymakers charged with crafting a new architecture for global financial markets. Think of it this way: Owners that fail to exercise stewardship responsibilities must be understood as constituting a systemic risk, right up there with lax regulation and substandard board oversight. That is the essence of findings from an international roundtable the Millstein Center conducted on February 13 in New York City.

In the run-up to the collapse, a select cadre of funds demonstrated vigilance and sought to overhaul governance at companies such as AIG. But too many others did not. Instead, uncritically, they poured the collective savings of tens of millions of employees into banks, corporations and Wall Street ventures that over-compensated CEOs, engineered artificial short-term gains and gambled fatally with risk. It was not just a US blunder. In a March 12 speech, City Minister Lord Paul Myners scolded UK pension funds that "disengaged investors lead to ownerless corporations and the risk of unaccountable executives and boards running amok." But the US has harbored a unique public policy challenge. The federal Department of Labor, charged with overseeing pensions covered by the Employee Retirement Income Security Act of 1974 (ERISA), was loath to exercise oversight powers to ensure that retirement fund behavior was aligned with long-term member interests. In particular, participants in the Center roundtable on shareowner stewardship concluded that: 

•  Short term thinking among investors has been pervasive, expressed specifically in the way funds compensate portfolio managers. The consequences are clear: nearly 80% of corporate managers have reported that they would sacrifice future economic value to manage short term earnings so as to meet investor expectations.[1] 
• Too many retirement arrangements lack transparency or accountability features that could prompt better oversight from members. 
• Too many administrators of funds follow a culture which rejects the concept that shareowners have a fiduciary duty to monitor portfolio companies. 
• Fund investments are often highly fragmented, with fractional holdings across thousands of stocks, making it less advantageous for any one fund to perform careful monitoring or mount intervention/engagement. And 
•  Funds allocate limited and often insufficient resources for engagement, particularly on environmental, social and governance (ESG) risks.

A bedrock structural feature may be affecting the ability of many U.S. retirement plans to serve as optimal stewards of employee savings. Almost no plan sponsored by corporations gives members a voice in how it operates. By contrast, in Britain, Australia and other countries pension schemes are overseen by trustee boards selected from the sponsoring company as well as retirees and workers. This is important because the way a retirement system is governed appears to affect the performance of pension savings. Studies by the Rotman International Centre for Pension Management show that over time, when an employee pension plan is transparent and accountable, it generates at least one to two percent of additional return per year.[2] Over a 20 year savings period, that amounts to a big boost for the average worker. But if a retirement plan is opaque and unaccountable to members, the drain can be equally large.

Despite its mandate to protect retirement savings, serial US administrations have allowed the Department of Labor's watchdog role as a check on retirement fund governance to wane. Enforcement has been episodic at best, particularly when it comes to overseeing how regulated funds undertake their duties as stewards. A scathing 2004 General Accountability Office probe into DOL practices detailed just how safeguards had disappeared.[3]

The Center's roundtable found consensus on a recovery agenda for fund governance; we will soon release this as part of an omnibus white paper on reforms to the capital market. In the meantime, consider the following four public sector steps to restoring robust ownership to capitalism.

• Either through new law or regulation, the Labor Department could mandate that each retirement plan covered by ERISA (particularly the single-employer plans) have a real governing body of trustees--including beneficiaries--led by an independent chairman. Plus, it could ensure that each board meets top professional standards of skills, independence and accountability, and discloses fully and regularly how it operates to the people whose money it safeguards. Thus outfitted, plans could have a better chance of providing credible, independent and conflict-free leadership on benefit choices facing sponsors and employees.
• Each plan could have to show publicly how money managers tie their own pay to long-term performance instead of short-term stock churning. In cases of 401(k)-style defined contribution arrangements, trustees could be required to explain whether asset managers they've selected for member choices are ones who operate as owners--by voting shares, steering clear of companies that harbor high risks, working to oust directors when companies are heading wrong, and raising their voices when boardrooms neglect extra-financial risks such as climate change and human capital. 
• The DOL could obligate each ERISA plan to disclose annually how its investment approach (or the approach of any selected 401(k) investment choice) identifies, evaluates and manages extra-financial ESG risks such as climate change, human capital and reputation, and how it monitors agents and portfolio managers on how they treat these factors. If a plan does not address these real, under-appreciated assets and risks, it should have to explain why. 
• A 21st century Labor Department could require each plan it supervises to mount an interactive website enabling employees and retirees to review and comment on savings arrangements. Web 2.0 now enables collective user ratings of services from medical practices to restaurants. It would be possible to do the same with pension plans to spur a race to the top, and help regulators police.

Critics will charge that such an agenda, imposed in economic crisis, will add financial burdens and red tape when what companies really need is relief to survive. But with savvy tax changes and smart oversight, the switch to accountable savings could reduce value leakage while preserving the ability of retirees to purchase products our corporations sell. That's a win-win we desperately need.

[1] Research conducted by Graham, Harvey and Rajgopal ("Value Destruction and Financial Reporting Decisions"). See similar conclusions in The CFA Centre for Financial Market Integrity and the Business Roundtable Institute for Corporate Ethics (Breaking the Short-Term Cycle, July 2006).
[2] Steward, F. and J. Yermo (2008), "Pension Fund Governance: Challenges and Potential Solutions," OECD Working Papers on Insurance and Private Pensions, No. 18.
[3] Available at www.gao.gov/new.items/d04749.pdf.