Pension Funds & Corporate Government: Lessons from International Experience Fernando Lefort School of Business Administration Catholic University of Chile

Fernando Lefort Escuela de Administración Fondos de Pensiones y Gobierno Corporativo The Impact of Pension Funds on Corporate Government Structure 1.Pension Funds (Institutional Investors) exercise their influence on Company Administration: –Through their decisions to buy and sell stock and other negotiable securities. –Exercising their shareholder rights: Communication Voting Board Members’ election –Exercising their bondholder rights: Covenants

Fernando Lefort Escuela de Administración Fondos de Pensiones y Gobierno Corporativo The Impact of Pension Funds on Corporate Government Structure 2.In emerging economies, pensions systems reform processes have had significant effects on capital market development processes and the accumulation of institutional wealth (the environment has changed for those who issue securities): –Reform of securities markets’ laws. –Credit rating industry development. –Increased transparency. –Professionalization of investment decision making process …

Fernando Lefort Escuela de Administración Fondos de Pensiones y Gobierno Corporativo Growing importance of Institutional Investors: Importance of Institutional Investors as shareholders: –In the USA, more than 50% of shares. –In the UK they hold 76.5%, in France 59.8% and in Germany 39%. Pension Funds in Latin America: –Chile: 7% of shares (11% in 1996), more than 40% in corporate bonds. –Argentina: 5% of shares. –Peru: 9% of shares, more than 40% in corporate bonds.

Fernando Lefort Escuela de Administración Fondos de Pensiones y Gobierno Corporativo Economic context Developed markets: –Vertical agency problem –Reduced incentives to monitoring –Recent statutory changes Emerging markets: –Horizontal agency problem –Presence of business conglomerates –Difficult to monitor –Poor external corporate government mechanisms  Institutional investors are essential.

Fernando Lefort Escuela de Administración Fondos de Pensiones y Gobierno Corporativo Duties of Pension Funds Administrators: Care & Loyalty Trustees have care and loyalty duties to beneficiaries: –Care: Act with due care and diligence in the selection, evaluation and disposal of investments. –Loyalty: Act in the best and exclusive interest of beneficiaries.

Fernando Lefort Escuela de Administración Fondos de Pensiones y Gobierno Corporativo Should Pension Funds Have an Active Role in Corporate Government? Possible interventions: –Entry and exit decisions (portfolio administrator) vs. –Activism in corporate government Considerations: –Liquidity –Legal restrictions –Effectiveness of intervention (benefits vs. costs) –Conflicts of interest

Fernando Lefort Escuela de Administración Fondos de Pensiones y Gobierno Corporativo Statutory Framework for Activism USA: Historically, the law had limited the action of Institutional Investors and prohibited banks from holding shares (Roe 1993). During the 90’s, restrictions are softened and stimulate activism: “Actively monitor and act in circumstances where the action of the Plan, by itself or jointly with other shareholders, may increase the value of Plan investments once the costs of action are discounted.” (ERISA, 404).

Fernando Lefort Escuela de Administración Fondos de Pensiones y Gobierno Corporativo Statutory Framework for Activism UK: Most institutional investors do not exercise their shareholder voting rights. New laws are being threatened if Funds do not take a more active role. Chile: Voting protocols to be followed by Pension Funds Administrators in the election of Board Members. (Article 155, Statutory Decree 3,500). Pension Funds Administrators … may not engage in any activity that implies any participation in the administration of the Company where they have elected one or more Board Members. (Statutory Decree 3,500).

Fernando Lefort Escuela de Administración Fondos de Pensiones y Gobierno Corporativo Rationality of Activism in Corporate Government 1.It is impossible to vote by walking away: Legal restrictions. Lack of liquidity. Core investment policy. Competition. 2.Benefits of activism: Monitoring diminishes agency problems. More information for the market. Better Corporate Government implies better Company performance  increases the value of Funds.

Fernando Lefort Escuela de Administración Fondos de Pensiones y Gobierno Corporativo Dangers in Corporate Government Activism 1.Lack of knowledge. Management of investments vs. Corporate Management. 2.Reduced liquidity. Less float. Access to privileged information. 3.Conflicts of interest. Sensitivity of Administrators to corporate pressures. Administrators’ agency problems. Other interests.

Fernando Lefort Escuela de Administración Fondos de Pensiones y Gobierno Corporativo International Evidence : Information Monitoring and Transmission Evidence in the USA shows better performance when an active shareholder buys a block of shares in order to take on monitoring functions (Bethel et al., 1998). “Shareholder proposals” submitted by Public Pension Funds are useful mostly to alert the market on a Company administration refusal to negotiate with funds. The market reacts with a drop in prices (Prevost and Rao, 2000). The sale of shares by institutional investors increases the chances for CEO dismissal (Parrino et al., 2000).

Fernando Lefort Escuela de Administración Fondos de Pensiones y Gobierno Corporativo International Evidence : Information Monitoring and Transmission Pension Funds in the UK do not add value to the Companies they invest in, and do not contribute to improve their practices (Faccio and Lasfer, 2000). Chile: –The market rewards companies having Pension Funds as shareholders (Lefort and Walker, 2005). –Pension Funds contribute to the election of independent Board Members (Iglesias, 2000; Lefort and Urzúa, 2006). The market rewards companies with a higher number of independent Board Members.

Fernando Lefort Escuela de Administración Fondos de Pensiones y Gobierno Corporativo Differences in monitoring: –More effective monitoring by open Pension Funds because they have no business ties with companies. (Borokhovich et al, 2000; Hartzell and Starks, 2001). –Public Pension Funds have political-social motivations that Private Funds do not. Private Funds add more value than Public Funds. (Woidtke, 2001). International Evidence : Information Monitoring and Transmission

Fernando Lefort Escuela de Administración Fondos de Pensiones y Gobierno Corporativo Empirical evidence is not conclusive in respect of a significant economic effect of “public targeting”: –USA, No abnormal return after targeting announcement, or better performance after conditions are accepted (Wahal, 1996; Smith, 1996). –No evidence of better market performance because of control (Duggal and Millar, 1999). –CalPERS targeting announcements are associated with an abnormal 1% return. Performance increases slightly in the following 6 months (English et al., 2004). –Crutchley et al., 1998, find that only very aggressive activism has effects on performance. –Scanty evidence of the effect of economic activism on Pension Funds in Poland (Gebke et al., 2003). International Evidence : Information Monitoring and Transmission

Fernando Lefort Escuela de Administración Fondos de Pensiones y Gobierno Corporativo Empirical difficulty in evaluating the impact of activism on companies: –It is difficult to measure the economic effect of specific changes in corporate government. –Endogenicity. –Private negotiations between Pension Funds and companies (Carleton et al, 1998). International Evidence : Information Monitoring and Transmission

Fernando Lefort Escuela de Administración Fondos de Pensiones y Gobierno Corporativo Summary Pension Funds are key investors in most countries. Investment monitoring is normally included in their mandate. A proactive attitude may be taken in diverse ways: exit vs. voice. The international evidence is mixed: –In the short run, some monitoring approaches get positive returns. –There is scarce evidence of long-term performance improvements. –It is difficult to establish cause and effect relationships.