Public Pension Fund Management and Corporate Governance

September 24th 2001

Anne Simpson, Program Manager, Global Corporate Governance Forum

www.gcgf.org

Introduction
Corporate governance has become an issue of international concern and many countries
are actively engaged in a reform program to ensure their practices meet international
standards. In this the role of shareholders is considered critical, and much attention has
been focused upon the international investors concerns. What is equally important is the
role that domestic institutions can play in promoting corporate governance reform. In this
session, I want to briefly map out the trends in pension fund asset growth which bring
them to a potentially dominant position in ownership in many markets, consider recent
developments in corporate governance reform relevant to developing countries, and
provide an example of how pension fund reform can promote corporate governance
reform in a mutually reinforcing sets of initiatives the Novo Mercado in Brazil.

Pension funds: growth in assets

First then, let us briefly re-cap the main trends in pension funds investment. Much of this
will be covered in greater detail during other sessions. I simply want to remind us of the
backdrop. The first observation is the rapid growth in pension fund assets over the past 20
years. Figures from OECD members show that the financial assets of institutional
investors have grown from 38% of GDP in 1981, to 128% of GDP by 1998. Pension fund
growth has been a key driver in this asset growth. The second trend to note over this
period is the growing importance of equity investment within the portfolios of pension
fund investors. Just ten years ago, the funds allocated to equity hovered under the 30%
mark. By 1998 they were moving towards 50% of portfolio. The result is that pension
funds are becoming the leading owners of equity in many markets.

It is also important to note that over the same period, the largest pension funds
internationally rapidly increased their exposure to overseas equity. For example, in 1998
the largest 200 US pension funds held almost $300 billion of assets in their international
portfolio. This trend reflects both fund policy for example, at CalPERS a decision was
made to shift overseas allocation from 12% to 20% of their assets in order to diversify
but also to capture the benefits of high potential growth rate in overseas markets. This
shift was facilitated by liberalisation in regulatory rules, for example, in the UK, where
pension funds on average now hold 25% of their equity assets abroad. The net result of
these trends is that financial flows to developing and emerging markets in the past decade
have grown dramatically. This is in contrast to the position with many public and private
pension funds in other markets, where investments in equity may still be capped at low
levels, for a variety of reasons, and overseas investments are limited or banned. The
growth in funded pension funds in emerging and developing markets, coupled with the
liberalisation of pension fund investment in a number of largest developed capital
markets has given rise to an increase in the available pool of capital for investment.

Over the same period, public flows have declined or stagnated. The net result is that
public flows are now a fraction of private flows. It is also notable that when these
dramatically increased private flows are broken down into their main components, we
can see that the main driver has been foreign direct investment, topped up by significant
but relatively volatile debt flows, with portfolio equity coming through in growing
though fluctuating levels. In 1999, for the first year in that decade, portfolio equity
flows outstripped debt.

If these trends in pension fund asset allocation represent the supply side on the capital
markets, equally important has been the growth in demand. Here from public to private
ownership in effect the rapid creation or expansion of the private sector has provided
in many markets a rapid expansion of investment opportunities in equity. This has
provided new vehicles for pension funds to invest in. Total funds raised by privatisation
reached $800 billion in developing countries during the 1990s.

Pension funds as shareholders: exit and voice

The growth in pension fund assets and the increase in equity holdings is significant in
itself. However, there are a number of features relating to the structure of pension funds
which give them a particularly important role in the corporate governance of the
companies whose equity they own. The first is that pension funds are investing assets to
cover relatively long term liabilities. The investment horizon of pension funds is
denominated in decades, not years, or months. This means they have an interest in the
long term performance of their assets, and in equity terms, this means the long term
performance of companies. Equity assets also have the potential to provide returns which
outstrip wage inflation in the long term, which has led to the growing attractiveness of
equity over other asset classes, such as government paper or bonds, which cannot keep
pace with the real rates of returns needed to cover long term liabilities for beneficiaries
seeking benefits linked to earnings. The long term liabilities of pension funds do not
automatically translate into long term investment policies. There is a debate about how
the impact of intermediaries and short term performance benchmarks can distort this, but
the underlying reality is that pension funds can be the providers of patient capital.

The size of pension fund holdings and the transaction costs of trading make it relatively
inefficient for institutional investors to sell. This situation is greatly exacerbated in
illiquid markets, or in the absence of an active market for corporate control or where
regulation confines pension funds to domestic equity holdings. Furthermore, there has
been a marked shift to indexed investment, which provides a low cost means of capturing
market returns. Active managers in developed markets have found it difficult to beat the
market consistently, in an environment where stock selection makes the second tier
contribution to performance relative to asset allocation. Indexed funds have become
among the most active investors in corporate governance, reflecting the maxim if you
cant sell, you must care. In other words, for large pension funds the costs of exit can
be outweighed by the benefits of exercising voice as a strategy for improving
performance in their equity portfolio. Both CalPERS in the US and Hermes in the UK,
both exemplars in shareholder activism, have core indexed portfolios.

An innovative exception is the growth of specialist funds which seek to target

languishing stocks and use shareholder influence to turn around poor performers, through
appointing new directors, and/or challenging company strategy and structure. Examples
include the pioneering Lens Fund, Relationship Investors, Hermes Focus Fund in the UK
and Europe, and hybrid ventures such as the Bradesco Templeton governance fund in
Brazil, Blakeney Investors and Harvest Fund, active in Africa, and shareholder activism
strategy of the Peoples Movement for Participatory Democracy in Korea and Investor
Protection Association in Russia. All have made a virtue of necessity making
shareholder activism an investment strategy in which poor performance is tackled, rather
than avoided.

There are barriers to pension fund activism in corporate governance. Exercising an active
role has its costs, famously, the free rider problem which has bedevilled pension fund
investor activism in many markets. The simple problem here is that the time, effort, risks
and expense of tackling problems at an under performing company sit squarely on the
shoulders of the investor which decides to take on the problem. If there is success, and
performance improves, then the benefits are shared by all investors (plus others
dependent upon the success of the firm, from creditors, to employees and
suppliers/customers). The fact that pension funds are pooled vehicles, representing the
collective savings of thousands, or in some cases hundreds of thousands of beneficiaries,
provides one form of cost sharing. There have also been collective efforts by pension
funds themselves to pool their influence, and share the costs of action, through the
establishment of institutional bodies, such as the Council of Institutional Investors in the
United States and Pensions & Investment Research Consultants in the UK, both of which
were established by consortia of pension funds in an effort to overcome the free-rider
problems an attempt to exercise effective lines of control over the complex agency chains
which feature in diversified portfolios, managed by a range of intermediaries.

The voluntary collective groupings, such as CII and PIRC, also provided another
important benefit to pension funds seeking a more active role in corporate governance,
namely a source of independent research and advice which can mediate the conflicts of

interest which employer sponsored pension schemes face in activism. Such conflicts of
interest may arise through the employers role in appointing the directors or trustees of
the pension fund, its fund managers or advisers, and even the financial contribution
provided.

Another critical feature of pension funds relates to their role investing third party funds.
This has given rise to specific duties attached to the role of those investing other
peoples money.- as it has been dubbed by Mervyn King, who chairs the South African
corporate governance committee. The concept in common law companies which captures
the special responsibilities of those who are not investing on their own behalf, but on
behalf of others, has been designated fiduciary responsibility.

The central concepts are that the fiduciary has a duty of care, (to make sure they are
diligent in the exercise of their role), a duty of prudence, (to ensure they take risks which
are appropriate to the returns which are required), and a duty to loyalty (to act for the sole
benefit of the third party on whose behalf they invest). These underlying principles have
been reflected in a range of legislation and rules at federal, state and scheme level in the
United States and United Kingdom, where pension fund assets dominate capital markets.

Government law and regulation has sought to buttress the independent role of the pension
fund in corporate governance. In part this has been through a concern to ensure that
beneficiaries interests are protected, but it has also led to a growing acceptance of the
role pension fund investors can play in ensuring effective corporate governance. For
example, in the United States, this potential conflict of interest was addressed through an
interpretive note from the Department of Labor in 1998, known as the Avon Letter, after
the company pension fund to whom it was addressed. Here the manager of the Avon
pension scheme asked for guidance from the DoL regarding the exercise of voting shares
held in the parent company. Should these votes be cast in line with the companys own
advice, in recognition of the employers position bearing the balance of cost in a defined
benefit scheme, or should they be cast according to the consideration of pension plan
beneficiaries interests, which may differ over the long term? The clear answer from the

DoL was that the voting rights attached to shares were assets of the pension fund, to the
extent that they affect the value of the investment. This would mean voting decisions
with an economic impact must be taken following independent advice, and exclusively in
favour of beneficiaries interests.

Given the extensive nature of voting opportunities in US companies, be it on takeovers

and mergers, appointment of independent auditors, compensation for executives or the
composition of the board, this judgement opened up a new market. Within months of the
ruling, new business ventures were established offering analysis and voting advice for
shareholders in companies. (For example, Institutional Shareholder Services, set up by
former DoL regulator, Bob Monks and the Investor Responsibility Research Centre
which was founded to provide advice on social and ethical issues these groups have
now been joined in recent years by a wide number of other companies in a range of
markets offering similar research and/or voting services, and expansion of coverage to
international markets by the US and European players.)

It is notable that the DoL Avon letter related largely to the operation of the private
pension funds governed under the Employee Retirement Income and Security Act of
1974, but its ruling in this instance reflected the growing influence and example of the
public pension funds and industry-wide Taft-Hartley funds which had formed the Council
of Institutional Investors two years earlier, in order to pursue a co-ordinated approach on
corporate governance galvanised by the controversies on greenmail where entrenched
management sought to avoid lucrative takeover proposals in what were often
underperforming companies and soaring executive compensation which appeared to have
little relation to the companies real returns to shareholders.

Across the water in the UK, public pension funds were similarly inspired to pool their
efforts on both corporate governance and corporate responsibility concerns, particularly
the public sentiment and NGO activism in favour of disinvestment from South Africa,
during the apartheid regime. In a landmark court case, known as the Megarry judgement,
brought by the trustees of the countrys largest pension fund, for the national coal mining

industry, it was ruled that trustees could consider ethical issues to the extent that these
were considered to have impact upon the financial interests of the beneficiaries. This
prompted widespread interest in the question of to what extent ethical, social and
ultimately, governance questions did affect economic returns to the portfolio, and
growing activism to exploit this new source of hidden value in the portfolio.

A series of corporate collapses in the late 1980s among leading companies which had
published audited accounts that gave no warning of trouble, prompted the formation of
the first corporate governance committee under the Chairmanship of Sir Adrian Cadbury.
Whilst the committee was deliberating upon the recommendations it might make to
strengthen the reliability of financial reporting and controls by the board, the UK was
rocked by a major pension scandal at the Maxwell group of companies. This led the
government to form a committee of enquiry under Professor Goode, to consider how the
assets of the pension fund could be protected from the conflicts of interest, and potential
misuse by the employer.

Cadburys efforts resulted in a Code of Best Practice, and the Goode committee gave rise
to the Pensions Act, which introduced a statutory framework for the governance of
pension funds, and specific protections for beneficiaries, such as strengthening rights to
information, ensuring separation of assets through independent custodians, requiring
trustees to make a statement of investment policy, with reference to risk and
diversification, and recommending that training be provided to assist trustees in the
exercise of their duties.

In response to calls for improving the accountability of trustees to their beneficiaries, the
Act proposed a complicated formula for consultation which could give rise to election of
up to one third of the trustees by scheme members. This has proven difficult to
implement, and though the principle won some support, the mechanism is not popular,
and the voluntary practice in many large funds of allowing trade union candidates to fill
50% of seats alongside management nominees, was considered a better balance. Recently
the Statement of Investment Principles has been expanded to require that trustees also

make disclosure on social, environmental and corporate governance policies where these
exist, which has prompted a further wave of interest and activity in the field.

The outpouring of pension fund activism led largely by public and labor influenced
funds in both the US and UK has led to a vigorous debate on the role and
responsibilities of institutional investors. There is a burgeoning literature on the subject
over several decades which has converged around the notion that long term institutional
investors, can ensure that the congruence of corporate interests, with beneficiaries needs,
and thereby, contribute to the overall economic growth and well being in society. The
notion here is that the character of pension fund investors can provide the role of
guardian in the private sector, where the state is unwilling and unable to provide
effective oversight. Pension fund socialism, Fiduciary Capitalism and An Ownership
Economy are phrases that have sought to capture this appealing notion. The question
now for policy makers establishing or reforming their own pension systems, whether in
developed or developing countries is how to ensure that the governance framework for
pension funds fosters an active role in corporate governance. The old question posed, in a
relatively new context, is who will be guarding the guards?

It is clear that if pension funds are constrained by conflicts of interest, and do not ensure
professional competence in management, investment and administration, and operate
without clear mechanisms of accountability, and transparency, then the governance
problems which undermine the corporation can undermine the effectiveness of the
pension fund. Many of the same governance problems apply. Principal agent problems,
agency costs, asymmetry of information, conflicts of interest can equally apply to the
governance of pension funds. The principal agent problem leads to the management of
companies pursuing courses of action which are not in the interests of the shareholders.
The same can apply to the directors or trustees who are the agents of the pension fund,
where beneficiaries play the role of principal. The costs of this agency problems, the
inefficiencies resulting from asymmetry, and potential conflicts of interest can result in
the pension fund allocating funds inefficiently, tolerating poor management performance,
making inadequate provision for risk management and ultimately contributing to lower

returns and poor reputation with the beneficiaries. These are all problems which have had
to be faced in developed markets, with scandals, poor performance, and loss of
confidence by the public and beneficiaries.

The classic corporate governance problems cited above, have led ultimately to the
formulation of four principles. In their practical application, these are now internationally
recognised as providing a conceptual framework for addressing corporate governance
weaknesses. Before turning to discuss an example of how these might apply to a pension
fund, I want to briefly recap how these came to be agreed, amidst the rapid and at times
breakneck speed of corporate governance activity and reforms internationally.

The rise of corporate governance

Corporate governance was not a recognisable term twenty years ago, although the issues
it addresses are as old as the corporation itself. Adam Smith famously remarked upon the
tendency of managers to misuse the assets of the proprietors, simply because they were
driven by the basic human motives of self-interest.

The global drivers of the debate on corporate governance have come in the wake of
privatisation and liberalisation, which have created both the private sector and mobile
capital which it needs to attract in order to growth. It is important to note that the
international debate is also being affected by local factors. The legal and economic
environment, the pattern of ownership, and exposure to the international market all affect
the extent to which, and the manner in which, the issues are playing out. What is certain
is that the post-privatisation traumas in the transition economies have raised new
concerns with corporate governance, with a focus of concern being the classic agency
problems of self-dealing, coupled with poor enforcement.

The Asia financial crisis exposed corporate governance weaknesses in a region which had
been long admired for its robust economic growth. Central concerns here have focused
upon transparency and protection of minority shareholders. In Latin America, the debate
on corporate governance has been spurred by concerns about shareholder protections

during takeovers and mergers, Africa, issues of sustainable development and anticorruption have been at the head of the corporate governance agenda, whilst in India, the
private (and now public) sector has tackled this agenda vigorously as part of broadening
its access to capital.. The overall impact has been a rapid proliferation of national and
international codes and projects seeking to promote corporate governance reform, which
in itself has led to the need for co-ordination of effort.

The Business Sector Advisory Group to the OECD led by Ira Millstein, of the USA was
the first initiative which sought to identify the common concerns between different
systems of corporate governance. He led a team of senior business leaders from the UK,
France, Germany, USA and Japan through an extensive debate on the trends towards
convergence in corporate governance internationally and the underlying divergence of
governance systems. The conclusion reached was that whilst systems of corporate
governance could, and would, continue to vary reflecting local economic, legal and
cultural history and circumstance, there were underlying principles which were needed in
order to allow companies to compete effectively and efficiently for capital, from both
home and abroad. Hence, the central theme in seeking to identify a common language for
corporate governance centred upon the common demands of investors.

Whether international or domestic, investors have a common interest in protection of

their interests, in transparency, in accountability of the board which is managing their
investments, in fair treatment between classes of investors, and a responsible policy in
relation to the companys role in society, which will ultimately protect long term business
interests. These were formulated in four principles: transparency, accountability, fairness
and responsibility. The Business Sector Advisory Group report was tabled for
consideration by the OECD ministers, who responded by establishing an Ad Hoc
taskforce with the purpose of elaborating practical advice on these underlying principles.

Following a two year period of discussion and consultation, the OECD Principles of
Corporate Governance were published in five chapters addressing

The rights of shareholders

The equitable treatment of shareholders

The role of stakeholders

Disclosure

The role of the board

The principles are not intended to be prescriptive, but to provide a conceptual framework
for discussion and debate by policy makers and their counterpart in the private sector.
They are primarily directed towards listed companies.

The OECD Principles of Corporate Governance have since been adopted by the Financial
Stability Forum as one of the 12 core principles underpinning the international financial
architecture

Pension fund governance

First, though, let us return to our earlier question regarding pension fund governance, and
consider, through a practical example, how the corporate governance principles of
transparency, accountability, fairness and responsibility might apply. The example here is
the California Public Employees Retirement System (CalPERS). This is of interest
because of its long track record of activism in corporate governance. The fund also
provides a useful example of how the fundamental principles of governance for the
corporation can support efficiency and effectiveness in the pension schemes investment
and administration, but also how this enables and encourages the active role that
CalPERS plays in the market as a proponent of good corporate governance.

CalPERS is the worlds largest pension fund. It has assets valued at mid 2000 of
approximately $155 billion. It invests on behalf of over one million public employees of
the state of California. 24% of the portfolio is allocated for international investments
the vast bulk of which is in equities. The fund holds stock in over 1,600 US companies
and 750 companies overseas.

The first tier in the governance structure sets out the responsibilities of the fund through a
framework of law and regulation which sets out the fiduciary duties of those charged with
management, investment and administration of the funds assets.

The governance structure of the fund provides a level of accountability to the

beneficiaries. CalPERS has a 13 member board of trustees, which includes members
elected by constituent beneficiary groups, and members appointed by the employer. The
balance of trustees from beneficiaries and employer can be viewed as mechanism for
promoting fairness, and buttressing the legal requirements on fiduciary duty. It can be
argued that the trustees are more likely to fulfil the duties of care, prudence and loyalty to
the beneficiaries if they have an opportunity to elect their own candidates to the board.

CalPERS has also adopted a policy of full disclosure, which extends beyond the
regulatory requirements for reporting to beneficiaries. The fund has established a website
which provides information on the governance structure, the names and occupations of its
trustees, its investment policies, and crucially, its approach to corporate governance. The
website also has a guest section, where visitors to site can pose questions, or offer
comments.

The governance structure of the fund, its transparency and accountability to beneficiaries
have provided a relatively independent environment within which CalPERS has been
able to pursue an active corporate governance policy. The fund has been active at home
and abroad, with the active support of both its employer and beneficiary appointed
trustees, and with the full knowledge of the beneficiaries on whose behalf they are
investing.

Richard Carlson, a senior elected board member of the scheme explains their thinking, in
a series of speeches on the issue to both domestic and international audiences (which are
also posted on the website).

As a large institutional investorwe have become long term shareowners of major

corporations. High transaction costs associated with equities, larger portfolios and more
money to invest have all created incentives to buy and hold. In a sense, we have become
the patient capital of companies. The idea of simply selling shares in the face of disgust
at a considerable cost to the system has given way to the realisation that being an agent
for change makes economic sense. CalPERS board strongly believes that using a passive
strategy to select stocks does not mean that we have to be a passive owner. We believe
that we have a duty to participants to put just as much effort into being an active owner
as in deciding to become an owner in the first place. To fulfil these duties, we use
corporate governance activism to improve company performance in the United States
and abroad. (The Credence in Corporate Governance to a Global investor: Singapore,
Asia-Pacific Conference on Corporate Governance and Disclosure in Global Markets,
May 24 1999)

CalPERS has published set of corporate governance principles which guide its voting
activity in companies in the US and overseas. This policy for its indexed portfolio is
enhanced by an activist strategy for its under-performing stocks within the portfolio. The
stocks selected each year form a hit list which is publicly announced, and which is
followed by CalPERS encouraging (through informal and formal means) the appointment
of independent directors to the board of directors. There is a three tier selection process
for identifying the candidates for this work. The first is to identify the lowest tier of
market performance, next to assess corporate governance practices and thirdly to carry
out an economic assessment (using the Economic Value Added formula).

CalPERS is confident that the costs of this activism have yielded improvements in
performance. In a study commissioned by Wilshire Associates, published in the Journal
of applied Corporate Finance in 1994, and updated in 1996, it was reported that the stock
market performance of 62 companies targeted between 1987 and 1995 had risen from
significant underperformance relative to the S & P 500 to a 33% out performance.
CalPERS estimates that the costs of their corporate governance activism are less than

$500,000 annually, and that the benefit over the period in the target companies has added
$150 million in value to the portfolio.

CalPERS has taken its activist approach not only to overseas developed markets, such as
the UK, France, Germany, and Japan, but also to developing markets. It formed a
partnership with the Asia Development Bank in 1996 to make long term private equity
investments in the Asia Pacific region, and also made investments in an Asian Recovery
Fund for equity partnerships in workouts. It recently announced that a new policy for
integrating policy on corporate responsibility and corporate governance, and an activist
approach to voting in emerging markets. (links to the CalPERS website and other
corporate governance materials can be at the PSAS Rapid Response Website under the
section on corporate governance policy: rru.worldbank.org.) The CaplPERS strategy is
not without its critics, and the fund is straining at the limits of available influence and
expertise for the implementation of its new strategy. As CalPERS example has been
followed on other issues, so to its attention to corporate governance in emerging markets
may well be followed leading to new incentives for reform.

Conclusions and an example

The question being addressed by policy makers in developing and emerging markets is:
what does the new emphasis upon corporate governance mean for the design of our own
domestic pension funds? The answer being developed in a number of markets is that the
corporate governance role and responsibilities of pension funds needs to be an explicit
component of the pension fund reform agenda. This is to ensure that pension funds which
invest in equity have the benefit of international standards of corporate governance as
set out in the OECD Principles of Corporate Governance. It is also necessary in order to
create the incentives for domestic companies to adopt high standards.

Recent developments in Brazil illustrate some of the options open to policy makers,
working in partnership with regulators and the private sector. Following discussions at
the OECD-IFC-World Bank roundtable on corporate governance in April 2000 in Sao
Paulo, the relative lack of portfolio investment flowing to Brazil was the subject of

discussion. The figures were set out in a study on capital markets recently presented to
the central bank1. Discussions ensued between BOVESPA, the regulators and members
of the international investment community, represented through the World Bank OECDs
Global Corporate Governance Forum Private Sector Advisory Group (see www.gcgf.org
for an account of the activities). A new section of the market has been launched in
response to these discussions the Novo Mercado. Companies listed on this will graduate
through a number of levels requiring corporate governance standards to be adhered to,
including equal treatment for minority shareholders, international audit and accounting
standards, boards which include independent directors. Companies agree to accept
BOVESPA as an arbitrating body in the event of disputes with investors. This innovative
package of measures is designed to meet the requirements of international investors. In
response, the Brazilian pension fund regulator is relaxing the limits on equity investment
for pension funds, should they invest on the Novo Mercado, in recognition that these
higher standards of corporate governance will offer additional protection for pension
funds which currently only allocate very small proportion of their assets to the domestic
stock market. This Brazilian experiment is attempting to create incentives for reform in
the market which both meet the expectations of international investors and foster new
protections for domestic pension funds. The initiative is new, and time will be needed to
see what impact the reforms will have.

Report can be down loaded as a country case study in corporate governance from
rru.worldbank.org