The Politics of Public Pension Funds
Romano, Roberta, The Public Interest
In most large U.S. corporations, the owners are passive investors who do not run the business. This creates an agency problem, allowing the managers to operate the business for their own ends, not the shareholders'. In the 1980s, corporate takeovers tended to mitigate the agency problem. Poorly performing managers were threatened with replacement by new owners who were willing to pay the shareholders a premium to take control of the firm in the expectation of increasing profits. With the lull in takeover activity in the 1990s, commentators concerned about corporate performance have sought alternative mechanisms to discipline management; the most prominent strategy is to encourage institutional investors to be more active in corporate governance.
Institutional investors are the principal target of corporate-governance strategies because they hold larger blocks of stock than individual investors. By being able to spread the cost of active monitoring of managers over a larger number of shares, corporate governance becomes more cost effective. Moreover, one group of institutional investors has been the focus of attention: public pension funds (state and local government employees' pension funds).
Public pension funds are typically considered the best candidates for corporate-governance activity because other financial institutions, particularly banks and insurance companies, are thought to have conflicts of interest. The conflict comes in monitoring managers of corporations whose stock they hold as a result of other business relationships they have with corporations, relationships which might be jeopardized if they opposed management on a matter of corporate governance. Corporate pension funds are suspect because they are run by corporate managers themselves.
When it comes to conflicting incentives to monitor corporate managers, however, there is no such clear-cut distinction between the public and private sector. Public pension funds are also confronted with conflicts of interest, though of a distinctive type. Namely, public fund managers are subject to political pressure to accommodate investment and voting policies to local considerations, such as increasing in-state employment. Just as certain private fund managers can be threatened with loss of business if they vote their shares against incumbent management, public funds can face economic losses if firms propose to close plants in states whose funds have not voted cooperatively or to not locate facilities in states whose funds are pro-management voters. Although these conflicts are geographically delimited compared to those involving private financial institutions, it is an open question whether one sector's decision making is more constrained than the other by its type of conflict.
While I have not attempted to measure the relative degree of conflict of interest in corporate-governance matters across private and public investors, I have investigated whether there are conflicts of interest in the public sector affecting fund decision making. There is ample anecdotal and statistical evidence to conclude that there is a significant problem and that it will increase if public funds intensify their monitoring activities. This severely limits the benefits from a strategy of encouraging public pension funds' activism in corporate governance. Moreover, the best method of mitigating the conflict of interest that public pension funds face is to privatize the funds by shifting their organization from defined benefit plans to defined contribution plans, but such a transformation will eliminate their ability to engage in corporate governance. More about this later.
A tempting target
The percentage of corporate equity held by institutional investors generally, and by pension funds in particular, has increased exponentially over the past few decades. From holding less than 1 percent in 1950, pension funds held 26 percent of corporate equity by 1989. …