By Stephen Davis – Associate Director and Senior Fellow at the Harvard Law School Program on Corporate Governance
It is no small irony that the biggest source of capital in the world – tens of millions of savers who entrust financial nest eggs to investing institutions – has been missing in action in determining how asset owners and asset managers behave in their roles as agents when they own corporate equity.
But thanks to a series of unexpected, if long-overdue reforms, that cohort of grassroots savers is about to show up in force for the first time. Implications for corporate boardrooms and the global fund industry are vast, especially when it comes to environmental, social and governance factors (ESG).
To appreciate the revolution now getting under way, let’s first look at how that universe of beneficiaries got excluded in the first place – and what has changed.
It was 44 years ago when the US passed the Employee Retirement Income Security Act of 1974 (ERISA), its mother statute covering pensions. Back then, the Dow Jones closed the year at 616 (it’s now just under 25,000) and nearly all worker savings were gathered in defined benefit (DB) plans. These vehicles guaranteed a specified income to members. Sponsor companies, not plan members, shouldered everyday investment risk. Moreover, the funds had comparatively little to worry about in meeting their obligations. The ratio of workers to retirees hovered at about 16 to one, and retirees didn’t, in general, live that long after work ended. Most plan sponsors could and did run their funds on virtual autopilot, acting as passive holders of equity and bonds in the knowledge that cash piles would be sufficient to cut cheques monthly to those eligible. Similar perspectives and demographics held sway in Britain, the Netherlands, Australia, and other markets with invested pension arrangements. Grassroots savers had little or no consciousness of their indirect involvement in the capital market.
Fast forward to today. DB plans are an endangered species in the US and UK; employees lucky enough to have retirement benefits have been herded over time, and en masse, into defined contribution (DC) plans. These place investment risk squarely on the individual saver and funnel capital into mutual funds that did not even exist when ERISA was born. Corporate matching contributions are down, or have disappeared entirely, so employees by necessity have had to become aware of how markets affect their savings. Moreover, the demographics are radically different. We are fast closing in on a ratio of two workers for every one retiree, meaning that collective investment vehicles can no longer be indifferent owners of equity and count on cash piles being adequate. Investment chiefs have to pull every lever available to achieve satisfactory returns. Passivity is no longer an option. On top of all that, retirees are living a lot longer, requiring invested assets to deliver payouts for longer periods.
For all the wholesale shift of risk onto plan members and retirees, the governance architecture for safeguarding long-term nest eggs has remained stuck in 1974, especially in the US. Plan members have no more say over plan decision-making than they had when they were passive recipients of defined benefits. The paralysis is even more striking when compared to the steady improvements in governance of public company boards, which have transformed from clubs to professional bodies. But neither US legislation nor regulation has provided for member participation in bodies governing retirement plans. So, while members can select investment choices from a 401(k) menu, they cannot make judgements about what is on the menu to begin with. In fact, in too many cases, plans are run by a single executive at the sponsoring company. It is no wonder that too many Americans are woefully underinvested, or paying too much in fees, to meet their retirement goals.
Elsewhere, though, change is in the air. There is, increasingly, recognition that while all the helpful governance and stewardship codes proliferating worldwide have offered meticulous guidance to corporate managers, corporate boards and institutional investor agents, they have largely ignored grassroots citizen savers who supply capital.
The International Corporate Governance Network (ICGN) was first to reform. Its Global Stewardship Principles explicitly called on institutional investors to feature their own independent governance structures that ensure behaviour aligned with the interests of beneficiaries. Then UK policy bodies – mainly the Pensions Regulator and the Financial Conduct Authority (FCA) – took important steps to ensure that boards overseeing retirement plans are at least partly representative, skilled up, transparent, and provided with appropriate powers to protect member savings. The FCA, in particular, issued a brutally frank report identifying secrecy in fund manager fees that crippled the capacity of citizen investors to hold agents to account. So new transparency standards are in place. At the same time, UK legislation provided for new Independent Governance Committees at DC plans that has begun to equip beneficiaries with fresh information. Plan members and NGOs, such as ShareAction (disclosure: I am a trustee) have seized on the new flow of data to advocate for more fund accountability to savers. The job is not complete. But similar measures are in place in the Netherlands and Australia.
All this was prelude, though, to the most far-reaching recent development. In January 2018 the European Commission’s High-Level Expert Group on Sustainable Finance (HLEG) released its long-awaited final report, which points the way for near-term EU action. In it, the group spelled out its aim: “A sustainable future is one in which citizens are able to engage fully with the financial system as a whole and ensure that their money is being invested responsibly and sustainably.” To do that, HLEG went further than any recommendations before to invite citizen investors into the capital market tent. Pension funds, it asserted, ‘should ensure that they have a sound understanding of the broad range of interests and preferences of their members and beneficiaries, including ESG factors’. Further, the report declared that every investment agent has an obligation to ‘proactively’ seek out and incorporate ‘the preferences of clients, members and beneficiaries’ on key issues in ‘investment decision-making’, whether such issues are ‘financially material or not’. A handful of EU funds, such as APG and PGGM, already have mechanisms in place to regularly test member opinion. Most do not – yet.
As revolutionary as HLEG was in mapping a new role for savers in Europe, it may already be a lagging indicator. In the US, despite formal barriers against beneficiary participation in decision-making, researchers – and especially mutual funds sales forces – are detecting a marked new culture of savings expectations among millennials. Younger savers, especially women, increasingly want their investment agents to incorporate progressive social and environmental values into stewardship behaviour. That’s why we have seen unprecedented steps by the likes of BlackRock, State Street Global Advisors, and Vanguard, the three biggest fund families, to demonstrate their bona fides in ESG. They voted against ExxonMobil management last year on climate change; they have proven vocal in calling for gender diversity in corporate boards; and in February 2018 they went public in ways never seen before, urging US gun manufacturers to embrace safety and control standards. The big three now see their ability to compete for custom hinging on their ability to align with citizen investor interests on environmental, social, and governance criteria. That’s new, and it should help performance, if research is to be believed that better governance is associated with better returns.
As savers enter the ESG ecosystem, corporate boardrooms will have to learn to accommodate investing agents that are more vocal and engaged. Such institutions will be looking to earn their own ‘licence to operate’ among their clients. So, in turn, they will be pressing for more responsibility among portfolio companies. Consequences are only just beginning to be felt, to be sure. But one thing seems certain: the days of the AWOL citizen investor are over for good.
About the Author:
Stephen Davis is an associate director and senior fellow at the Harvard Law School Program on Corporate Governance and co-author of What They Do With Your Money: How the Financial System Fails Us, and How to Fix It (Yale University Press, 2016)