In response to demographic trends and aging populations, many countries have enacted pension reforms from pay-as-you-go to fully-funded pension systems. The transition to a fully-funded pension system relies on the introduction of pension funds investing individual savings in financial assets, including domestic equity. Pension funds acquiring large stakes in listed companies have an incentive to monitor managers and controlling shareholders, to engage in negotiations with management, to make proxy proposals, and to get involved in the choice of board members. This could have an effect on corporate policies, may limit controlling shareholders’ ability to extract private benefits of control, and could lead to a more dispersed ownership structure. For these reasons, there is a widespread belief among policy-makers that pension reforms instigate mechanisms leading to improved corporate governance and increased shareholder discipline, especially in countries (such as much of continental Europe) where conflicts of interest arise between controlling owners and minority shareholders. Are these beliefs true?
The existing literature on shareholder activism and institutional ownership has mostly focused on pension funds in the US and the UK, where conflicts of interest between controlling and minority shareholders are less likely to arise because ownership structure is diffuse and large owners are less likely to be involved in management. This literature has failed to identify systematic effects of institutional ownership on firm value and corporate governance because these studies attempt to capture institutional investors’ monitoring using specific episodes of activism, making it difficult to go beyond clinical studies of specific institutional investors, and because exogenous changes in institutional ownership are generally not observed, making it difficult to draw conclusions about causality. We proxy for changes in the expected monitoring activity by using changes in institutional ownership, allowing us to assess the effects of institutional ownership in a large scale experiment instead of evaluating specific episodes of shareholder activism, and we exploit the substantial exogenous shock to institutional ownership caused by the Swedish pension reform. By employing this exogenous variation in ownership, we are better able to assess causality. During the implementation of the Swedish pension reform, one of the public pension funds that had traditionally been active in corporate governance was forced to sell most of its equity participations and to reallocate funds to the government and some newly created public pension funds. The reallocation of assets of this pension fund and the subsequent inflow of funds in public and private pension funds serve as an ideal natural experiment for how substantial changes in institutional ownership structure affect firm performance.
We find that an increase in the holdings of public pension funds as well as of large independent private pension funds is associated with an increase in shareholder value. In contrast, equity stakes by private pension funds affiliated with industrial groups or financial institutions if anything decrease firm value. The empirical evidence suggests that the effects on firm performance are due to differences in pension funds’ monitoring activity and propensity to contrast controlling shareholders, as affiliated pension funds are subject to conflicts of interest and only large pension funds that acquire large illiquid stakes have an incentive to monitor. Strikingly, controlling shareholders appear to resist active pension fund interference by accumulating votes directly or through pension funds whose votes they control. The price of acquiring a vote to cast in shareholder meetings increases if public pension funds - the ones that have the higher likelihood to influence the choice of board members through their representation in nominating committees - acquire shares.
Overall, our results suggest that the effects of institutional investors on firm performance depend on the industry structure of pension funds. While many of these pension funds become activist shareholders, their participation need not necessarily lead to more dispersed ownership and market oriented financial systems. The overall impact of an increase in institutionalized savings on ownership concentration, firm performance, and corporate governance depends on pension fund incentives and the private benefits of control for controlling shareholders. These effects are probably more pronounced in countries where ownership tends to be concentrated. In these contexts, controlling shareholders not only appear reluctant to relinquish control, but their ability of controlling votes through their related pension funds may even increase the entrenchment of control.
Our findings have important policy implications. Pension reforms, by creating a new class of potential activist shareholders in the form of pension funds, could in principle improve corporate governance and increased shareholder discipline. However, the net effect on corporate governance and shareholder discipline very much depends on the incentives of the pension funds and controlling shareholders. In countries where private pension funds are created and managed by other financial institutions (such as banks) and these financial institutions in turn are controlled by families and other dominant shareholders, an increase in institutionalised saving could lead to a further concentration of ownership and a deterioration in shareholder discipline. In such environments with concentrated ownership, there may be a role for professionally-managed public pension funds that become activist shareholders and defend the interests of minority shareholders.
This column is based on “Pension Reform, Ownership Structure, and Corporate Governance: Evidence from Sweden” by the same authors available as CEPR Discussion Paper No. 6489 at http://www.cepr.org/pubs/dps/DP6489.asp