Pension Fund Capitalism or Wall Street Bonanza?

A Critique of the Claim That Pension Funds Can Influence Corporations

by G. William Domhoff

Pension fund socialism in the 1970s. Investor capitalism driven by pension fund activists in the 1990s. Such are the large claims that have been made for the potential importance of public pension funds, working in tandem with union-controlled pension funds, in shaping the decision-making of corporate boards.

This document examines these claims and casts a cold eye on them by tracing the history of the institutional investors’ movement since the 1980s. It suggests that there always has been far less to this movement than the media attention it receives. At the outset, it was an effort by moderate Republicans and centrists, speaking in the name of stockholders in criticizing allegedly self-serving corporate executives, who supposedly do not look out for stockholder interests in a vigorous enough fashion. This emphasis on shareholder value led to common cause with liberal elected officials and union leaders, but the movement as a whole has had no lasting successes, just temporary and symbolic ones, as best seen by the rapacious and often illegal actions of a good number of corporate boards between 1998 and 2008 despite 25 years of effort by those who thought they could use public pension funds as a way to make corporations better for employees.

Not only did the movement fail, but many of the public pension funds themselves became money pots for the biggest risk-takers on Wall Street, who carried out hostile corporate takeovers and corporate buy-outs in the 1980s with their help, then bundled mortgages — including subprime mortgages — into new kinds of securities in the late 1990s and early 2000s, which they sold to naive pension fund managers caught up in the excitement of the housing bubble. Indeed, several public pension funds ended up among the many financial organizations that received government bailouts via the billions of dollars that the Department of Treasury gave to AIG (American International Group, an insurance company) in early 2009.

Meanwhile, an April 2010 study for the New York Times. discussed more fully in the next section, showed that private equity funds (e.g. hedge funds, venture capital funds, real estate investment trusts) made tens of billions of dollars between 2000 and 2010 by (1) charging public pension funds a management fee of 2% on every dollar they managed; and (2) taking 20% of the profits they made through investing the pension funds’ money. The 10 largest public pension funds alone paid $17 billion to private equity firms in that time period (Anderson, 2010).

To top it all off, the biggest financiers on Wall Street tried to make money by working insider deals to invest some of the funds held by the same federal government agency — the Pension Fund Guaranty Corporation — that manages $50 billion in retirement funds for the unlucky souls who worked for corporations that went bankrupt. They grabbed this business by cultivating relationships with Charles E. F. Millard, the former Wall Street investment banker that the Bush Administration had appointed to head the fund. You can read the story, and excerpts from some of the very revealing e-mails, on the New York Times’ Web site. (In July of 2009, under scrutiny from Congress and others, the PFGC revoked the sweetheart deals with Goldman Sachs, BlackRock, and JPMorgan Chase.)

(There are also plenty of scams being uncovered at the state level that are a total embarrassment to those who once claimed that pension funds could have any influence on corporations or be a force for the general good. Instead, they became another source of money for Wall Street to invest in risky deals, and also a way for politicians to help out businesses in exchange for campaign donations. And of course, they lost some of the people’s money in the process, which has been the story of Wall Street for well over 100 years: use other people’s money to pay for the riskiest gambles. This is an unfolding story, so we will add new links to this document from time to time. For example, an article in the New York Times discusses the scandal surrounding the state of New York’s pension fund. where one of the scammers pleaded guilty in March of 2010.)

Then, just at 2010 ended, one of the most respected Wall Street financiers of the past 25 years, Steven Rattner — a one-time New York Times reporter who went to work for a fabled investment firm, Lazard Freres, and then opened his own firm, Quadrangle — sort of and indirectly admitted guilt to bribing a pension fund official via a kickback scheme. He did so by reaching an agreement with the attorney general of New York to pay a $10 million fine and accept a five-year ban on his involvement with any work involving state pension funds. Earlier, he had reached an agreement with the Securities and Exchange Commission to pay a $6.2 million fine and agree to a two-year ban on working in certain Wall Street businesses for the same alleged kickback scheme.

But, since Rattner did not have to admit to any wrongdoing, he can still say his record is without blemish. (He can say he paid the unfair fines and accepted the bans because the government is so powerful.) However, his net worth was down to the $188 to $608 million range, according to a 2009 filing with the Securities and Exchange Commission, and his chances of becoming Secretary of the Treasury, a goal made plausible by his role as a major Democratic fundraiser on Wall Street, have probably ended — at least for the next few years.

Something even bigger popped up in March 2013, when the former chief executive of the California Public Employees Retirement System (CalPERS) was indicted for stealing $14 million from one of the private firms (Apollo Global Management) that invested money for CalPERS. Apollo had been paying one of the CalPERS chief’s buddies to steer at least $48 million in CalPERS business its way, which gave Apollo the opportunity to make hundreds of millions from investing some of the pension fund’s billions. But that was apparently not enough for the chief and his partner in crime, so they perpetrated the $14 million fraud. When the chief exec left CalPERS in 2008, he too became a placement officer for investment firms, but the law finally caught up with him five years later.

The New York Times called the March 2013 indictment the latest in a nationwide pay-to-play scandal that erupted several years ago. Regulators from numerous states, including California and New Mexico, have cracked down on widespread influence peddling in how their state pension funds were invested.

Pension funds and other institutional investors

One of the most persistent claims about corporations in America is that the rich people who benefit from their stock dividends do not control them. The idea is that everybody owns and controls the corporations, even though the corporations seem to dominate the economy to the benefit of a wealthy few. Taking this idea to its extreme, a few analysts have claimed that the accumulations of money owned by everyone through various types of public employee pension funds, union pension funds, mutual funds, and other forms of institutional investors might even come to have a significant role in shaping corporate behavior.

Peter Drucker

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.