How pension funds can destroy companies

A Hostile World

The world of industrial investment is full of sharks. Hedge funds, arbitrageurs and fund managers who gamble on short-term share price movements are all acting to maximise the value of their holdings in the short-term. None of these stock market players could care a hoot about the longer term health of the companies whose shares they are using as gambling chips.

Faced with huge pressures, many company managers have responded by seeking to please short-term investors, whilst tailoring their remuneration packages to benefit from 'creating shareholder value'.

So, as a result, the tenure of top managers has rapidly declined to something like 3 years in post for CEO's, and a whole raft of remuneration practises has been developed that reward short-term fixes and deal-making behaviours, both of which have been shown to damage the essential fabric of companies.

Companies face a huge range of challenges - investors who want the maximum returns quickly, managers who can benefit whether the company survives or not, in addition to the normal pressures of competition, regulation and the like. Truly the contemporary business environment is extremely hostile to companies that set out their stalls to survive and thrive for the long term.

Do they have any real supporters? Well, there is one class of investor that is best represented by Warren Buffet's Hathaway Corporation.
Buffett and his partner, Charlie Munger, invest for the long term in a relatively small number of companies which they get to know a lot about, whose managers they get to know, and in which they take a close nurturing interest. Result? Their companies and their shares have outperformed the US S&P 500 index for decades.

Pension Funds' Best Interests.

Pension funds, Like Berkshire Hathaway, should also be playing a long-term game - pensions accumulate over whole careers. So those running funds and taking care of members' interests should think and act with the long term very much in mind.

Do they? Not by any means enough, and the effects are not just the underperformance of the funds themselves - many pension funds are the source of wider industrial underperformance and company failure.

In some part, this is the result of the legal framework governing the duties of trustees.
Ian Hamilton, an experienced pensions manager and trustee, explains it as follows,

"....I think there is a real difficulty for trustees within the current framework of their legal duties.

Firstly, the trustee's duty is towards all of the beneficiaries of the trust (not just scheme members). One of the beneficiaries is (potentially) the sponsoring company, particularly in the sense that improved investment performance equals lower company contributions.

Under the legislation as it stands, only one third of the trustees must be elected by the members. The other two thirds are company appointments and generally members of the company's management, often with a bias towards appointees from the finance function. The company will also have the power to 'dis-appoint' trustees.
Thus there are considerable pressures on trustee boards (both in terms of their legal duties and from the company's management) towards achieving results that are at least in line with the median and there is, therefore some comfort to be had in 'following the herd'. It would be a brave trustee board (keeping in mind their typical structure) which would hold to a position of 'investing for the long term' in the face of continuing underperformance against the median"

So, before we even start, we encounter several 'wheels within wheels':

1. The duties of trustees are not solely towards the members of the fund, but also to take care of the interests of the sponsoring company
2. But, companies do not have an unequivocal duty to provide good pensions to their employees, or even secure their pensions.
3. A majority of trustees in many, if not most, company funds are management - who in turn, are likely to feel the pressures, directly or indirectly, from fund managers for their companies to boost share prices.
4. This in turn, causes them to put great pressures on fund managers to produce an above average performance. Thus a cycle of pressures on companies is started.

Here is what happens.

The Destructive Game.

• Pension fund trustees, who are elected or appointed to take care of the interests of members of pension funds.
• Investment Fund Managers, who are charged with investing the fund's monies in order to meet the trustees' objectives.
• Pension fund actuaries, who give advice on the amounts needed to secure current and future pension liabilities.
• Financial advisers to funds, whose main role is to advise on the best investment strategies and Investors.
• Companies, which provide the bulk of the financial contributions to final salary pension funds - if it is a defined contribution fund, it is usual for benefits to be much lower, and companies' contributions (and risks) to be commensurately less.
• Company Managers, whose main duties are to secure the interests of 'shareholders' (In effect, Institutional Fund Managers, who are supposed to represent the interests of those whose money they are investing.)

• Trustees, who naturally want to maximise the returns of their funds, set high and competitive targets for those who invest their money.
• They will frequently review the performance of the fund managers who typically report to them on a quarterly basis.
• If performance is sub-standard over as little as one to two years, (actuaries take a much longer view when valuing the assets and liabilities of funds), they begin to agitate for performance improvements, and if they are not forthcoming, will change the fund manager.
• Fund Managers, who are part of the wider financial services industry, have devised a large range of indices and benchmarks, to help trustees rate, judge and choose between them.
• Pension Fund Financial advisers will help trustees to rate fund manager's performance, and, if they are not happy with a particular one, choose another from a 'hot list'.
• Thus, the heat is really on for fund managers, who know that their heads are on the line if they do not at least perform in line with a competitive index - even two quarters' underperformance may cause the ground to shake. Note, fund managers' remuneration is heavily geared to two things; performance against an index, and the size of Funds Under Management. Beating the competition will result in larger funds and huge performance bonuses, trailing means the sack.
• Many fund managers, therefore aim to outperform quarter by quarter by buying and selling shares, and speculating on short-term share movements.
• In turn, many fund managers hold a large share portfolio (to reduce risk), and will apply huge pressure on the companies in which they invest to get their share prices as high as possible, as quickly as possible. Companies who appear to be unresponsive to these pressures are either severely downgraded, and their share prices fall, making them vulnerable, or have great pressures put on them to change management, putting in someone who is more responsive to 'shareholders' interests'. The net effect of all this is that most fund managers know little, and care less about the deeper potentials and prospects of companies - the only issue is whether they think the share price will rise or fall over the next short period.
• Good outcomes for fund managers are that companies outperform reliably and perpetually, or, if they slip, even for a short while, that they take drastic action to raise the share price, or that they are sold or broken up at a premium price.

None of this is good for Companies that wish to build a secure and durable business. Continual out-performance in perpetuity is almost impossible, drastic action foments more crises than it cures, and many companies have been needlessly destroyed or sold to foreign competitors, who often exist in a more supportive environment and therefore play to different rules.

The Outcomes.

The underlying truth about good companies is they are much more that bundles of assets that can be conveniently bought and sold to suit the short-term interests of investors.

Good companies are created and sustained by the consistent efforts and commitment of thousands of people with a wide range of special talents. They require sustained investment in innovation, product and service development, and in capital to replace and improve facilities and equipment.
But the absolute bedrock upon which exceptional performance is built is the skills and commitment of their leaders and staff. If these people do not respect each other and feel common interest and commitment to the success of the enterprise, it will under-perform and ultimately fail.

It does not take very much imagination to see that the pressures that often originate from pension funds are unlikely to support sustained high performance.

• Pressures for short-term performance results in a cycle of underinvestment in projects and processes that have projected long-term payoff, for example R&D investment, which is markedly lower than in other developed countries.
• The pressures for exceptional and rapidly delivered performance has caused the growth of a breed of 'superstar' industrial and investment managers, who can rapidly be fired if they do not meet exaggerated expectations. Thus, the tenure of top managers has declined and the new breed has a strong tendency to be deal-oriented, to get quick visible results.
• The financial markets want quick 'delivery' and believe that transactions and corporate deals are the best ways to get them. All the research shows that deal-based management actually destroys value in the long run, unless it is an adjunct to long-term business and organisation building - which few feel they have time for.

• High rates of company failure.
• Disproportionate rates of failure and eventual disappearance of companies in sophisticated knowledge-based industries that require consistent investment.
• A growing tendency for managers to concentrate on the short term, to fixate on outcomes that will please the financial markets and to be overwhelmingly biased towards financial skills.
• Long-term and declining company performance

And, underlying it all, low productivity, low rates of innovation and relatively low rates of Pay and GDP per head.

Are any of these factors true of British quoted companies and Britain in general? Yes, all of them.

The only people who seem to benefit from the destructive cycle are Investment managers, investment bankers, stockbrokers and those managers who are astute enough to be in the right place at the right time and get out before their houses of cards collapse.

Pension fund trustees please take note - you could be an important part of a cycle of industrial destruction - your company could be next!!