The Pension System and the Rise of Shareholder PrimacyMartin Gelter in The Harvard Law School Fourm on Corporate Governance and Financial Regulation (blog), July 20, 2012
Post written by Professor Martin Gelter.
In the paper, The Pension System and the Rise of Shareholder Primacy, which was recently made publicly available on SSRN, I explore the influence of the pension system on corporate governance, particularly shareholder primacy and the relationship between corporations and their employees. Today it is widely accepted among business managers, scholars of corporate law and financial economists that the objective of corporate law and corporate governance should be to promote shareholders wealth (as opposed to a wider community of interests, including employees, creditors, suppliers, customers and local communities). Shareholder capitalism is, however, a relatively recent development. Large, publicly-traded corporations in the middle of the 20th century were characterized by managerial capitalism: managers had taken over the role of entrepreneurs within the firm, and compared to their predecessors they were hardly accountable to owners. Economists sometimes saw this as an advance over previous periods characterized by dominant founders, given that the system seemed more rational and stable. Around 1980, managerial capitalism began to give way to investor capitalism. Hostile takeovers, and later equity-based executive compensation, began to emerge as the new forces creating incentives for managers to focus on share value.
This article explores the reasons for this highly consequential change. It is often thought that shareholder primacy prevailed because it is more efficient, and managerialism therefore could no longer be maintained in a competitive economy. I argue that changes in the pension system have been a major force pushing corporate governance toward shareholder primacy. Up to the 1970s, workers typically relied on payouts from a defined benefit (DB) plan for retirement. Employers bore the investment risk, and plans were designed to create incentives to stay with a particular employer. Workers’ human capital and pension wealth were tied to the firm, thus creating a strong dependence on its continued ability to fund the plan. Since the 1970s, DB plans have been losing ground to defined contribution (DC) plans, including 401(k)s. These plans have the advantage of being more portable in the case of a job change, but employees bear the investment risk. Hence, a large part of the populace, became dependent on capital markets for retirement savings, and thus became, in the words of Chancellor Leo Strine, “Forced Capitalists”. While there were several reasons for the shift, most were exogenous to the corporate governance system, namely ERISA and changes in tax law.
My paper makes two main points. First, I argue that the optimality of shareholder primacy is contingent on specific conditions: A more shareholder-oriented system is more desirable if pensions directly depend on investment success in the capital market rather than on a specific employer’s or the government’s ability and willingness to keep paying them. Second, the change had important consequences for the political economy of corporate governance and likely contributed to the popularity of the shareholder primacy model in the public discourse. While few would argue that shareholder primacy is perfectly implemented at the moment, pro-investor corporate law has become more important for the middle class. In traditional pension plans, workers depended primarily on their employer’s ability to fund pensions, while in today’s system retirement benefits strongly depend on capital markets. Shareholder wealth thus became more important for larger segments of society, and pro-shareholder policies became more important relative to pro-labor policies strengthening employees’ position vis-à-vis their employer. This helped shareholder primacy to become the dominant factor in corporate governance debates. While it is not always clear whether shareholders truly benefit from reforms strengthening shareholder influence on firms, protecting investors has become an agenda of the center-left, while the significance of policies protecting jobs with specific employers seems to have decreased.
Pro-shareholder policies have even had the support of unions during the past two decades, which would previously have been hard to conceive. Admittedly, the strongest advocates of shareholder activism have in fact often been institutions managing DB plans such as unions and state public pension systems. But the increased dependence of retirees on equity investment strengthened the role of institutional investors across the board and made pro-shareholder policies more attractive. Moreover, I discuss possible implications for how human capital is created in the US economy. Since pension wealth is now less often tied to the firm (but to the capital market), workers may be less inclined to invest in firm-specific human capital in the past and more inclined to develop generally applicable or industry-specific skills. My argument complements other explanations that have focused on the growth of the financial industry and the availability of external debt finance, particularly for takeovers.
I also suggest that international comparison confirm the thesis: In most Continental European countries and in Japan, workers rely to a smaller degree on private pensions than in the United States, but primarily on public “pay-as-you-go” systems (roughly equivalent to, but much more extensive than Social Security). To the extent that private pensions exist, they typically take the form of DB plans. The much smaller dependence of workers on the capital markets in these countries may help to explain the smaller popularity of shareholder primacy that comparatists have typically observed. Before some changes since the 1990s, in sharp contrast to the US, capital markets were largely irrelevant for workers planning for their retirement.