Originally Published: October 31, 2011, Phocion Investments Inc.; August 13, 2015, "NYSSA’s The Finance Professionals’ Post"
Introduction
I was in the process of working on a blog about why fund sponsors were failing the funds and their pension beneficiaries. The blog was going to focus on the role sponsors take in the management of the fund, identify their shortcomings and propose solutions. On Monday the 17th of October, as is my usual custom of staying up late, much to the dismay of my wife, I was watching the The Daily Show with Jon Stewart and his guest that night, Wall Street Journal reporter Ellen Schultz. Ellen was promoting her new book, “Retirement Heist”, which talks about the deliberate mismanagement of pension funds for the benefit of the sponsor and their executives. She had my attention and the next day on my way to buying my slice of pizza, I stopped by the bookstore and picked up her book. Once I began reading, I knew I had to put a hold on my blog and begin reworking it. From focusing solely on the role of a fund sponsor in the management of pension funds, this blog will also look at the sponsor’s place in society and the long term consequences of their short term focus.
The History of Pension Funds
To better understand the impact that fund sponsors are creating we need to look at the history of pensions. After centuries of existence, pension funds became the norm in the 20th century. Beginning with the public sector in the early part of the period, private sector pensions proliferated only after the Second World War. This chronological order is very important in understanding one of the main drivers in the increased demand for private sector pensions. With two World Wars and the Great Depression behind them, humanity had experienced a large amount of suffering over a very short period of time. The sacrifices society had made for almost a half of century was still fresh in the collective memory and people’s demand for security increased exponentially. Private sector employees began to demand the same benefits that the public sector had already began enjoying. Moreover, the growth experienced by many firms resulted in an increased demand in talent and using incentives such as pension funds became increasingly popular. Not only did this meet the needs of society, but it also met the needs of corporations who did not need to compete solely on salaries to attract the best talent. This period can be characterized as the time where people began and ended their careers with the same employer. It can also be said, that this was also the height of loyalty for employees who took pride in the firms they worked for and proudly spoke of “our firm” when talking to friends and family. Both employers and employees benefitted during this period; employers were able to attract the people they needed to fuel their growth without breaking the bank and employees were able to find the security that they desired.
Fast forward to today, these same firms view the pension funds as a drag to growth and employees have lost that sense of security their parents and grandparents had enjoyed. In “Retirement Heist”, Ellen goes on to describe the change when firms succumbed to the temptation of their overfunded pensions and the decision to take a short-term earnings focus to the direct benefit of executive compensation. I liken the rapid acceleration of excessive compensation to the long-running game show “The Price is Right.” In the 70s, contestants would become ecstatic over the opportunity to win a brand new living room or china set, whereas today, only a brand new car can bring out the same kind of reaction. Within this environment, fund sponsors short-term focus has brought about long term consequences and although the solutions are simple, they are significant and would require a complete change in sponsors’ beliefs.
Long-Term Consequences
Fund sponsors’ have developed a misguided understanding of pension funds and their own role in the management of these funds. As pension funds brought a sense of security to employees and in turn helped contribute to the increase in consumer spending, the unintended consequences of the current actions of many sponsors may be the opposite. It is essential that fund sponsors understand that their firms do not exist in a bubble and that their actions reverberate throughout society. Ultimately, it returns back to the sponsors’ firms themselves where they will feel the effects of consumer uncertainty and the resulting decrease in spending. The tapping of pension funds for the sole purpose of contributing to the P&L has a finite lifespan. As funds become more and more depleted and other funds change from DB to DC plans, this resource will have reached its end. Executive compensation will become unsustainable and a significant drag on earnings and growth. Until sponsors fully comprehend these effects, many companies would have lost out in years of growth and fallen behind to worldwide competitors who have been more diligent and have had greater foresight.
Furthermore, a workforce obligated to save more and perhaps work in their retirement years, limits the younger generation of some very important resources: firstly, the financial resource many of their parents provide them in their undergraduate and graduate studies; secondly, employment opportunity. Many of their parents will be working longer than they expected, thus limiting the number of available jobs. The short-term benefits that many sponsors enjoyed by plugging into the pension funds will have created a sub-optimal environment for corporate profits and a workforce with limited, if any, attachment to their employers. In addition to the long-term drag on earnings that the tapping of pension funds will have contributed too, there will also be a drag on innovative ideas as employees will be less willing to provide their best ideas to their employers. Employees who do not feel appreciated by their employers work hard enough to keep their jobs but not enough to make any significant contribution to the company. A corporation’s health and future is dependent on the society it exists in and an ill society will not translate to profitability and growth.
The Quick Guide to a Passing Grade
The solutions to these issues are not complicated nor are they long. First and foremost, fund sponsors need to reevaluate the objective of a pension fund and who it serves. The black and white answer of a corporation’s sole responsibility to shareholders does not fit well in the grey world we live in. Sponsors’ duties are to shareholders, clients, and employees, who without them, the firm does not operate and remains just an idea on paper. Depending on the situation, each stakeholder will receive greater weight. Employees should receive the greatest weight when it comes to pension funds and any decision that will affect their financial security.
Secondly, Fund Sponsors need to abandon the short-term perspective of meeting the next quarters’ estimates. It may be almost impossible to do so when the executive compensation is tied to such short-term objectives. Realigning the time horizon with the performance based compensation to focus on the long-term would provide more thoughtful decisions that will ensure the firm continues to operate profitably without relying on pension fund money as a contributor to the P&L.
Lastly, sponsors lack the fundamental knowledge of the investment industry to properly oversee the pension funds they sponsor. Too often sponsors decide to outsource the management of their fund without properly evaluating the in-house management they had in place before. Many talented managers who consistently produced the returns to meet the obligations of the funds were let go on poor evaluation processes. Ultimately, many of these firms return to in-house management when the external managers have under-performed and have cost the company a significant amount in fees. With a strong understanding of the workings of a pension fund and the investment industry, sponsors’ will be able to ensure the best evaluation processes and the proper oversight has been put in place. This is not to say sponsors need to become experts in the field of investments, but rather to have enough knowledge to understand the reports they receive and to be able to ask questions requiring informative answers. For example, constantly blaming the results of a fund on the events in Europe would not constitute an informative answer and the sponsor would be able to identify this.
The Rubik’s Cube Lesson
I usually conclude my blogs with a resume and a small amount of wisdom to go along, but with this blog I will offer the lesson of the Rubik’s Cube as my last words. In the early 80s, the Rubik’s Cube made its appearance in my house when my brother succumbed to the rage of the cube and went out and purchased it. As an overconfident 7 year old with an extensive educational background consisting of Pre-K, kindergarten, and the first grade, I decided that this cube would not be of any challenge to my abilities. After diligently working on solving it for an eternity (eternity = 1 week for a 7 year old), the results did not meet my expectations. Although there was no performance based compensation awaiting me once I completed the cube, I did strongly envision being greeted as the family genius and acknowledged as the most intelligent sibling.
Two choices stood in front of me to proceed to solving the cube: the first was to continue working on it and learn with every mistake I made; the second was to unglue the coloured stickers and realign them appropriately. Either choice would end up with the same result, except that, the first method would require more work, more time, and more thought. The second method would be instant with little thought and work involved. I chose the second option as my eagerness to prove my intelligence outweighed my earnestness to do it properly and the one consequence I never took into consideration occurred. My temporary glory ended quickly when everyone realized I had rendered the Rubik’s Cube non-functional for the rest of my family. The essence of the cube lesson: Short-term focus for short-term gain has far more reaching consequences than we may have envisioned.