The Next Catastrophe

Think Fannie Mae and Freddie Mac were a politicized financial disaster? Just wait until pension funds implode.

(Page 2 of 4)

Many of these funds prospered in the 1990s, when the basic material stocks that they frowned upon swooned, while the favored sectors—mostly technology and financial stocks, which were considered “clean investments”—did great. But the technology and communications bust of 2000–02 knocked out one of SRI’s pillars, and now the crash in financial stocks has destroyed the other. Despite much hype to the contrary, socially responsible stocks, as measured by major broad-based SRI stock funds, have significantly underperformed the market this decade, and some of the most aggressive pension funds that use “responsible” screens—such as the California Public Employees’ Retirement System—have taken some of the largest hits.

“Investing in socially responsible stocks just because they are socially responsible is not—underline not—a valid investment thesis,” says Steven Pines, a senior investment consultant for Northern Trust. Many of the largest socially responsible mutual funds, including a leading benchmark, the Domini Social Index, have been laggards for years. The Sierra Club’s high-profile social fund, which had regularly trailed the benchmark S&P 500 index by about 6 percent a year, liquidated in December, a victim of its poor performance record. As recently as last November, 76 out of the 91 socially responsible stock funds were underperforming the Dow, according to the investment research company Morningstar.

“This crisis highlights the limitations of social research methods,” says Dirk Matten, who holds the Hewlett-Packard chair in corporate social responsibility at York University’s Schulich School of Business. Although some socially responsible research models are more sophisticated than others, particularly ones that eschew simplistic screens, social investors have downplayed the actual business of a business, including whether it can create jobs and spread wealth, while overweighting what Matten believes are more symbolic concerns, such as announced programs to combat climate change.

Sometimes corporate social responsibility can mask or come at the expense of responsibility to shareholders. Fannie Mae, for instance, was named the No. 1 corporate citizen in America from 2000–04, based on datacompiled by the top U.S. social research firm, KLD Research and Analytics in Boston. Well, it does have a great diversity program.

As recently as mid-2008, three of the top eight holdings by the leading social investing organizations in the country were financial stocks: AIG, Bank of America, and Citigroup. AIG was praised for its retirement benefits and sexual diversity policies; Bank of America strove to reduce greenhouse gas emissions and promote diversity; and Citigroup donated money to schools and tied some of its loans to environmental guidelines. The stock prices of all three companies tanked in 2008.

From South Africa to the Shop Room Floor

The catalyzing event that changed pension funds from boring retirement pools to political operators was the international boycott of apartheid South Africa in the 1980s and the campaign to limit investments in companies that did business with Johannesburg. The success of the campaign energized baby boomers, now entering their prime earning years, who were committed to “making a difference” with their dollars. Taking a cue from these social investors, pension funds began dabbling in what came to be known as economically targeted investments—injecting money into communities or projects that addressed social ills, with healthy returns becoming a secondary concern.

The earliest pension fund social investing initiatives were often cobbled together during crises, with little appreciation for unintended consequences. In the 1980s, for example, the Alaska public employee and teacher retirement funds loaned $165 million—35 percent of their total assets—for the purpose of making mortgages in Alaska. When oil prices fell in 1987, so did home prices in the nation’s most oil-dependent state. Forty percent of the pension loans became delinquent or resulted in foreclosures.

While unions and social investors often work together, their investment strategies are not always in sync. In 1989, under union pressure, the State of Connecticut Trust Funds invested $25 million in Colt’s Manufacturing Co. after the beleaguered gun maker—hardly a favorite of the SRI crowd—lobbied the state legislature to save jobs. Colt’s filed for bankruptcy just three years later, endangering the trust funds’ 47 percent stake.

In the late 1980s, the Kansas Public Employees Retirement System, then considered a model of activist social investing, placed $65 million in the Home Savings Association, after its lobbyists told top officials that this would help struggling segments of the state economy. That investment evaporated when federal regulators seized the thrift. All told, the Kansans wrote off upward of $200 million in economically targeted investments.

Olivia Mitchell, executive director of the Pension Research Council at the Wharton School, has reviewed the performance of 200 state and local pension plans from 1968 to 1986 . She found that “public pension plans earn[ed] rates of return substantially below those of other pooled funds and often below leading market indexes.” In a study of 50 state pension plans during the period 1985–89, the Yale legal scholar and economist Roberta Romano concluded that “public pension funds are subject to political pressures to tailor their investments to local needs, such as increasing state employment, and to engage in other socially desirable investing.” She noted that investment dollars were directed not just toward “social investing” but also toward companies with lobbying clout.

Because of poor returns, these early experiments in economically targeted investments lost their allure. Most states and municipalities steered clear of social investing for a time. That hesitancy eroded during the 1990s, partly as a result of a new strategy employed by organized labor.

With their membership falling, union leaders found it harder to influence companies or politics from the factory floor. The new approach was to ally with social investors and adopt one of their key tactics: lobbying through shareholder resolutions intended to pressure corporations. “The strengthening of shareholder democracy promises to further empower investors to address governance issues such as out-of-control executive pay as well as environmental and social issues such as climate change,” Jay Falk—president of SRI World Group, which advises pension funds on social investing—said in 2007, as the tactic was gaining traction.

Union-led pension funds are also trying to rattle political cages, but they’re running closer to empty every day. Even before the sell-off, in the summer of 2008, while nearly 90 percent of nonunion funds met minimum safe funding thresholds—meaning they had adequate cash on hand to pay their benefits—40 percent of union funds were at risk. “These are high risk numbers even in a steady economy,” writes Diana Furchtgott-Roth, a pension fund specialist with the conservative Hudson Institute, in a recent study. Furchtgott-Roth notes that union fund management practices are opaque, costs are higher than at nonunion funds, and the plans have promised more than they can ever hope to deliver. “When workers entrust their retirement assets to an outside party, it is important that this party’s only interest be achieving the best returns possible,” she argues. “Unions clearly do not do this.”

California Screamin’

Editor's Note: We invite comments and request that they be civil and on-topic. We do not moderate or assume any responsibility for comments, which are owned by the readers who post them. Comments do not represent the views of or Reason Foundation. We reserve the right to delete any comment for any reason at any time. Report abuses.

  • joesixpack||

    What does Joe the Plumber think about this?

  • ||

    No surprise. Houston TX pensions will now be paid for with PENSION BONDS. Just like San Diego our kleptocrats screwed the pooch and the fool taxpayers are on the hook again. Unfortunately none of our crooks went, or will go, to jail.

  • LurkerBold||

    More evidence of your collapsing Capitalist system. When Obama begins converting the US to Progressivism then things will change for the better.

  • Reinmoose||

    One of the problems with funds that only invest in what they see as socially responsible firms is that these investments will atificially support a stock's price. Of course there are ways to be socially responsible without necessariliy hurting the bottom line (a dedication to promoting women to executive positions, for example), but deliberatly picking stocks based on the fact that you think they won't seek as much profit is a really stupid way to invest money that you need.
    Sure - if you have some extra money laying around, throw it at firms that incur extra costs to be environmentally friendly or be uberphilanthropic and all that - but don't do that with money you expect to grow at a certain rate and ultimately lead to your ability to retire with a house on the beach.

  • xyz||

    I supose if we all had invested with Nazi Germany in 1930 we will all be VERY RICH Nazis. The free world will not exist and Germany's Arian race will be ruling Washington and the rest of the world. Where will you the author find a place on the internet to voice your oppinion and not get your face broken afterwards in a prison cell?

  • Reinmoose||

    impressive - godwinned in the 5th comment.

  • ||

    Actually, lurkertroll, I would say that it's more evidence that "progressivism" is a pie-in-the-sky, dreamy vision that doesn't work. This has zero to do with capitalism and everything to do with social engineering. Had the investors stuck with the Make Money system of investing, rather than their warm-fuzzy dream of "making a difference", things probably would have worked out better for them.

    I know...don't bait the troll...I just couldn't resist.

  • ||

    Of course there are ways to be socially responsible without necessariliy hurting the bottom line (a dedication to promoting women to executive positions, for example)

    Promoting people with ovaries to executive positions over people with greater merit, can not help but have a detrimental effect on the bottom line.

  • Reinmoose||

    Warren -
    Fail yoself
    I didn't make any distinction over qualification. My statement was made assuming equal qualification between candidates.

  • ||

    So if a man and a woman have equal qualifications, the woman should automatically be the one chosen? Fail there too. That's discrimination.

  • Reinmoose||

    Ok, maybe someone should try reading what I wrote.

  • ||

    Don't worry about a thing- our retirement funds are safe as houses, mate!

  • ||

    Cool. Barack Obama will just help bankrupt the country like he helped bankrupt Illinois' pension systems. Obama voted to increase pension obligations and benefits for government union employees while also voting to decrease payments to fund those pension systems. As a result of Barack Obama's fiscal policy votes in Illinois, they now have this.

    "In the time it takes you to read this sentence, Illinois taxpayers will be $200 deeper in debt. The state's pension debt will exceed $44 billion this summer(08), increasing at a rate of about $120 per second, according to Gov. Rod Blagojevich's administration.

    The debt already tops $42 billion - enough to give every one of Illinois' 12.8 million residents a check for $3,300 or buy 937,000 Cadillacs at $45,000 a pop." - Springfield State Journal-Register 5/25/08

  • ||

    Reinmoose | January 12, 2009, 1:26pm | #
    Ok, maybe someone should try reading what I wrote.

    I read what you wrote. If what you wrote doesn't mean favoring women over men for promotion, then it doesn't mean anything.

  • Reinmoose||

    It didn't suggest favoring women over men. It brought it up as an example of one thing that could be described as "socially responsible" that would not necessarily have a detrimental effect on the bottom line of the company, leaving all other variables alone.
    Just because I admit that such a thing exists does not mean I'm in support of it. Although frankly, a company can do whatever they like - if they want to favor women, go ahead and do so. I imagine some companies that do this will end up more profitable than companies that don't, but not by virtue necessarily of the sex of their employees.

  • ||

    Excellent article. The point about SRI favoring companies who make symbolic gestures is an excellent one too.

  • LurkerBold||

    Companies should employ more women as part of social good. Women should be bosses for great justice.

  • Sam Grove||

    We've had progressive government in the U.S. for over a century.

    This is where it has brought us.

  • LurkerBold||

    HA! You call this corrupt Corporatist system Progressive? HA! FAIL

  • ||

    One thing that goes unacknowledged in assessing the Federal Government's balance sheet is the fact their pension scheme is completely empty. Congress robs it every year and stuffs it with IOU's of a similar legal structure to the "special securities" they ply into the Social Security system every year when they skim it.

    I don't know the exact numbers, but it is an onerous debt that the government perversely owes itself. Talk about an Enron scheme for hiding debt, they just do it right in front of our faces. At least the other public pension schemes actually invest the proceeds of the worker's payments (albeit poorly, it seems).

  • ||

    Progressivism as ideological vanity is not a sound investment for the future of anything .

    You see this stupid bullshit social awareness crap!?!?! This is why whatever horrible bullshit conservative rhetoric is out there, liberals will always be able to piss me off more.

  • Damn it all||

    "When Obama begins converting the US to Progressivism then things will change for the better."-
    But of course, Jesus dressed as a half Kenyan- half white American man has come to save us all.
    Sure if you like cradle to grave socialism.

    Progressivism is the back handed way of saying…baby sit.

  • ||

    I'm 50, never been in a union, or worked for the government, and have no pension at all. Please tax me more. Thankyou.

  • spike||

    Hey, I've got a great idea. Let's privatize Social Security!

  • Dan||

    I don't think the author really makes his case.

    The story is filled with specific anecdotes about investments that turned out badly, and decisions that cost potential gains, but the article does not tie these to overall performance of the funds, except by insinuation. To be convincing, I think the article would have to show that social investments were a major part of the overall investments, and that these specific investments performed significantly worse over a period of time.

    The story does not disentangle public pension fund underfunding from investment problems. Politicians have a well-known bias for believing extravagant promises of investment returns, because it allows them to promise great pension benefits to public employees while leaving plenty of money left over for other purposes. As I understand it, at least until recently, public pension funds were not subject to the same federal requirements as private plans. Even without investment problems, I believe that public pension plans in the United States are underfunded by trillions of dollars. To be more convincing, the story would have to distinguish poor investment performance from underfunding. For example, a 20% loss by Calpers is less than the average decline in the stock market.

    The story mixes different kinds of investment influences. Investing to promote specific causes, activist investing, and investing to provide jobs all have different effects. Investing to promote specific causes clearly reduces investment performance for social causes, which is potentially a problem. Activist investing (as famously practised by Calpers) is a way to increase returns. On average, I understand that management at large companies manages to squander about half of profits on ill-conceived expansion and excessive pay, with ill-conceived investments by far the larger of the two. Simply forcing a rubber-stamp Board of Directors to actually function can greatly increase returns, and this is what Calpers attempted. Investing to provide local jobs and housing is clearly counterproductive, because the investment will show losses precisely when the pension fund recipients most need the money. Regardless of the reasons this kind of investing is done, it is a mistake.

    Suspiciously absent is any discussion of pension fund management fees, which are an obvious source of problems.

    I think the article would be more convincing if it stated a hypothesis, such as that social investing is a problem, and showed the total effect as a lower long-term investment return compared to other types of investments. I think the article is less convincing when it mixes different issues, lists specific anecdotes without relating this to overall performance, and does not separate out other problems such as underfunding and excessive fees.

  • ||

    Eventually the taxpayers will rebel and refuse to vote for tax increases to cover these plans. The local governments will file for the chapter 9 and that will be that. The plans will be reduced from the impossible to the barely possible and that is as good as it will get. The states that have the highest burden are losing population, specifically from the productive segment. Eventually when the goose can't be plucked any further is when the proverbial spaghetti will hit the fan. Already there are rumblings in Congress about the bailouts, and this is occurring at the best possible moment for the statist. When the public pension bomb goes off, the fight between the states will be rather ugly, but in the end the more lefty states will take the hit as the rest of the country will be in no mood to subsidize them.

  • ||

    In NY, both the State and Municipal employees' pensions are guaranteed by the State Constitution. If the penion funds went bust, the taxpayer would have to come-up with additional funding. Even if the state filed bankruptcy, pensions would be paid first. In order for NYC to keep it's head above water, a new pension tier would have to be created. It is a difficult task to lure future employees, expecting them to do the same job for less moneys and a lesser of a pension. Middle class prospective employees will eventually leave (when a robust economy returns) for warmer weather and, hopefully, better opportunities. This is when a City starts to really decay... as did Detroit, et al.

  • ||

    States Lose 867 Billion in Pension Funds-

    Please give us a bailout because of our stupid social investments!

    I think we should give Citi Bank and Citi Group Credit card hijackers even more-

  • ||

    spike | January 12, 2009, 11:12pm | #
    Hey, I've got a great idea. Let's privatize Social Security!

    Great Idea!

    Then the FEDS can say- We so sorry! Our Bad! We lost all your retirement monies in a scam hedge fund.

    Hey! Don't laugh-
    It could save trillions in paper work.

  • Brian Cartmell||

    The United States hasn't ever really been a capitalist state, so blaming capitalism like some of the commenters on here is fairly naive, it's never been much of a free market either.

    Right now the biggest threat is the divide between the politicians and the rest of us, those states who funds should reign in the federal government which is out of control with power and spending.

    Also this just popped up on Bloomberg.

    (State Pensions' $865 Billion Loss Affects New Hires)

  • Keith Brainard||

    The author attributes the bankruptcy of the City of Vallejo "largely to unmanageable pension obligations." This is not true; Mr. Entine should correct this misrepresentation. Vallejo's bankruptcy was caused by declining tax receipts (mostly due to lower property tax collections) and exacerbated by high employee salaries. Vallejo city workers do not participate in Social Security, meaning that the employer (taxpayers) do not pay the 6.2 percent to Social Security most private sector workers pay. Vallejo's employer (taxpayer) pension contributions are consistent with most other public employers in California.

    Moreover, Mr. Entine does not put into proper context the value of the socially-responsible investments of public pension funds. Public pension funds hold assets of more than $2 trillion. Some funds have engaged in socially-responsible investing initiatives, but as a percentage of total assets, the sums are quite small and SRI cannot be held responsible for pension fund investment returns. In fact, for the 10-year period ended June 30, 2008, public pension fund investment returns outperformed their corporate pension fund counterparts as well as the universe of endowments and foundations. The idea that these funds are substandard performers is not supported by the facts.

    The author's contention that the Alaska public pension funds loaned one-third of the value of their assets to mortgages, is simply false. These funds had several billion in assets at that time; $165 million was nowhere near one-third of their value.

    Numerous studies by academics and professional economists recently have documented the positive economic benefits that emanate from public pension funds. Read some of those studies here:

    Do public pensions face problems? Yes. However, compared to any other facet of this nation's retirement benefit structure, including 401k plans, Social Security, pension benefits for federal employees, etc., pension benefits for employees of state and local government are in better condition and far more cost-effective.

    This is not the first attack by Reason on public pensions that relies on misrepresentations and distortions; read my response to a similar Reason attack several years ago, here:

    Keith Brainard

  • ||

    LurkerBold you meant to say socialism not progressivism ...

    'Obama begins converting the US to socialism then things will change for the better'

    And of course because you are a socialist, you support using private tax payer's money to replenish government pension funds because the managers of these funds blew it. Isn't socialism great? We all get to pay for somebody elses mistakes and problems. That seems to be a major tenant of socialism.

    We will see about socialism changing things for the better. Socialism hasn't worked anywhere else and it will not work here. Calling it progressivism won't change that.

    If you want socialism, move to Europe and have 50% of your income stolen from you by the government in exchange for a nanny state and sub par services you probably don't even want.

    And remember lurker, progressivism is socialism. don't try to dress it up with a fancy word. Call it what it is. You are not fooling anyone. Troll.

  • ||

    "The plans will be reduced from the impossible to the barely possible and that is as good as it will get."

    I wish that was true. Unfortunately I think the federal government will make this its next big bailout and cover it with more federal debt. The old coots will get their SSI and their pensions, enjoy 30-year retirements, and the younger generations will work until they die in the traces, trying to pay for it all. Unless they move to another country.

  • ||

    "Unless they move to another country."

    It's not just a safe bet, it's already happening.

    America's Berlin Wall

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