October 17th, 2015
Institutional investors are the majority owners of most publicly traded companies but allow activist hedge funds with smaller positions to push through corporate changes. The author offers various reasons why institutional investors may be reluctant to actively participate in proxy fights but then suggests several practical forms of investor engagement that support long-term value creation. So, in future campaigns by hedge funds, institutional investors should actively participate to ensure that the outcome promotes long-term growth instead of temporary price spurts.
Across the world, a clamor is rising against corporate short-termism—the undue attention to quarterly earnings at the expense of long-term sustainable growth. In one survey of chief financial officers, the majority of respondents reported that they would forgo current spending on profitable long-term projects to avoid missing earnings estimates for the upcoming quarter.1
Critics of short-termism have singled out a set of culprits—activist hedge funds that acquire 1% or 2% of a company’s stock and then push hard for measures designed to boost the stock price quickly but unsustainably. 2 The typical activist program involves raising dividends, increasing stock buybacks, or spinning off corporate divisions—usually accompanied by a request for board seats.
Majority Owners Defer to Hedge Funds with Much Smaller Holdings
A substantial majority of the stock of most public companies in the United States is owned by a concentrated group of mutual funds, pension plans, and other institutional investors. 3 Many of the largest institutions, such as Vanguard and CalPERS, say they are focused on building long-term shareholder value rather than short-term profits.
So, an activist with 1% or 2% of a company’s stock has no power to get its reform program adopted unless it can win the support of the institutional investors that own a majority of the company’s stock. And if those institutions vigorously advocate a long-term approach to shareholder value, they should be able to block any program that does not meet that objective.
In fact, institutional investors usually do not take an outspoken position for or against proposals by activist hedge funds—with the notable exception of Laurence Fink, the CEO of BlackRock. In a recent letter, he warned US companies that they may be harming long-term value creation by capitulating to pressure from activist hedge funds to increase dividends and stock buybacks. 4
In many cases, however, company executives have given in to activist pressure by adopting new strategies or adding board members without holding a shareholder vote. For example, an activist named Harry Wilson with a relatively small position in General Motors pressed the company to deploy $5 billion of its cash to buy back its stock. 5 This move probably does not make sense in the long term since General Motors needs a large cash cushion to deal with possible downturns. Yet General Motors agreed to Wilson’s proposal without putting it to a shareholder vote.
Institutional Reluctance to Push for Corporate Reform
Perhaps institutional investors are merely talking publicly about long-term value as they privately root for the hedge funds to boost the short-term stock price. Nevertheless, there are systemic reasons why institutions are generally reluctant to be proactive in pushing for long-term reforms in corporate strategy or leadership.
- Over 30% of US stock assets under management are now held in index mutual funds or exchange-traded funds that are based on indexes. Although large and diversified managers, such as State Street Global Advisors, may follow most of the stocks in the S&P 500 Index, many managers of index funds have no analysts with in-depth knowledge of most stocks in the particular index. Hence, such index funds are not in a good position to analyze an activist’s program for a specific company.
- Actively managed funds tend not to publicly assert a strong position on either side of a proxy fight unless doing so meets a cost–benefit test. 6 The cost of participation is high because it includes management time and potential litigation. On the benefit side, even a holding of $400 million in one stock may be less than half of 1% of the fund’s overall assets.
- If either type of fund expends significant resources in supporting or opposing an activist’s program, it faces a serious free-rider problem. Although the fund incurs all the costs of the campaign, most of the benefits go to other shareholders who have not contributed to the costs.
- Given these cost–benefit challenges, a number of asset managers have effectively outsourced their voting decisions to such proxy advisory firms as Institutional Shareholder Services (ISS) and Glass Lewis—which may or may not have a long-term perspective. According to Stanford University researchers, four sizable asset managers have disclosed that they uniformly follow the voting recommendations of one proxy adviser.7
- In contrast, activist hedge funds frequently concentrate a large portion of their assets in the stocks of a few target companies. Managers of these funds receive an incentive fee equal to 20% of realized gains. Thus, the cost-to-benefit ratio in proxy fights is much better for concentrated activist funds than for diversified mutual or pension funds.
- Moreover, activist hedge funds can control a much higher percentage of proxy votes than their economic exposure to a target company’s shares through a practice called empty voting. For example, asset managers can lend their shares to a hedge fund and then not recall them for a contested proxy vote; 8 alternatively, hedge funds can cast a significant portion of the votes in a target company’s election while maintaining an economically neutral position by shorting the target’s stock.9
Encouraging Institutional Investors to Engage
So, what can be done to encourage institutional investors to take more vigorous positions on activists’ proposals? To begin with, securities regulators, CFA Institute, and other relevant groups should publicly stress that when institutional investors are the largest shareholders in a company, they should play a decisive role in determining the outcome of an activist campaign against that company. In other words, big owners should act like big owners.
In that role, institutions should carefully study any proposal’s impact on a company over many years, depending on the type of company and its history of delivering long-term results. The long term is much longer for electric utilities and drug companies than for software developers. The market has been supportive of mature companies that seem successful at long-term investments, such as Google and Shell. 10 Other companies, however, waste corporate capital in research projects or in huge acquisitions that are poorly conceived and/or executed.
In a 2014 bulletin,11 the US Securities and Exchange Commission (SEC) helpfully emphasized the duty of investment managers to diligently implement their proxy-voting policies. However, the bulletin expressly allows investment managers, with the consent of their clients, to adopt policies of voting consistently with the directors of a target company or certain types of activists—or of not voting proxies at all. Thus, the SEC guidance may inadvertently lead to less independent evaluation of activist proposals by small equity managers or to no proxy voting by index fund managers trying to minimize costs.
In a 2010 release, the SEC announced a major initiative to rethink the “plumbing” of the proxy process, including the subject of empty voting, but this project seems to have been delayed.12 Now is the time for regulators across the globe to examine the complexities of empty voting and adopt a well-designed rule against acquiring votes without comparable ownership. Even without any government action on empty voting, institutional investors can include in their stock loans a provision retaining the right to vote the stock in the event of a proxy fight.
But long before any proxy fight is in the offing, institutional investors should push for their vision of sustainable long-term growth through engagement with the companies they own. In the United Kingdom, for example, the Investor Forum was recently established to promote a long-term approach through shareholder engagement with British companies.13 At the request of either investors or companies, the Investor Forum will facilitate engagement on specific issues of value creation. More generally, it is promulgating guidelines on how investors can collectively discuss issues without running afoul of such legal rules as those that require filings by substantial shareholders acting in concert.
On the legal front, some US institutions have been especially concerned about the barrier imposed by SEC Regulation FD (Fair Disclosure) to in-depth investor engagement with publicly traded companies. A corporate target would be reluctant to provide material nonpublic information to selected shareholders, because Regulation FD requires it to promptly post that information on its website. However, this barrier can be overcome by an exemption in Regulation FD that allows a company to release nonpublic information to a select group, such as long-term institutional holders, if they sign an agreement to keep the information confidential—and not trade on the information until it becomes public.14
Another form of investor engagement is the participation of institutional shareholders in the process of nominating directors with a long-term approach to corporate growth. In Sweden and Norway, a public company must invite its five largest shareholders to join a meeting of its nominating committee to discuss the selection of directors. 15 Germany and other EU countries allow shareholders with at least 5% of a company’s voting stock to nominate a director to its board. Even in the United States, where a federal appellate court rejected the SEC’s proxy access rule on procedural grounds,16 several corporate giants (e.g., General Electric) now allow director nominations by shareholders owning at least 3% of their stock for at least three years.17
Perhaps most important, institutional investors can promote a long-term orientation by rejecting a company’s compensation plan if it puts too much emphasis on short-term results. In almost every country, shareholders can now vote on binding or advisory resolutions about corporate compensation reports.18 Most companies base their cash bonuses on only the prior year’s performance, although stock awards usually encourage a longer time horizon through vesting requirements. If institutional investors want companies to take a long-term approach to corporate growth, they should push for a three-year performance period for determining cash bonuses.
Conclusion
If institutional investors are dissatisfied with a company’s performance, they no longer have only two choices—sell the stock or oppose management. If institutional investors are serious about supporting long-term value creation, they can pursue this goal through various forms of investor engagement with the company. Then, if a hedge fund launches a proxy fight, they should vigorously participate to make sure the outcome promotes corporate growth over the next several years rather than the next few months.
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February 6th, 2015
By Robert Pozen.
While the president’s plan could return millions worth of U.S. foreign profits home, the tax rates he has proposed are politically unrealistic.
In President Obama’s new budget released earlier this week, he proposed four major changes in the way the U.S. taxes foreign profits of U.S. multinational corporations. The document contains several useful ideas for much needed corporate tax reform. And while the rates proposed are quite unrealistic, perhaps these are the President’s opening bids in what could become a lengthy negotiation with Republicans in Congress.
Under today’s rules, the U.S. taxes foreign profits at 35% — but only if and when these profits are brought back to the US. As a result, U.S. multinationals have chosen to defer indefinitely the payment of US taxes on $2 trillion in foreign profits by keeping them abroad.For instance, General Electric GE 1.41% holds $110 billion in foreign profits abroad; Microsoft MSFT 1.46% $76 billion and Pfizer PFE 2.87% $69 billion, according to Audit Analytics.
In response, Obama’s proposed repealing the right to defer US corporate taxes on foreign profits. Under the current deferral system, US multinationals have a powerful tax incentive to construct facilities and buy companies located outside the US. If deferral were ended, these companies would make locational decisions based on business factors, rather than tax rates. Thus, a substantial portion of foreign profits of US multinationals would likely be brought back to the US to build plants, buy technologies and pay dividends.
Second, the budget would reduce the corporate tax rate from 35% to 28%. This is another sound idea because the U.S. currently has one of the highest corporate tax rates in the world, making it uncompetitive in a global economy.It’s true that reducing the tax rate to 28% would lower tax revenues by $840 billion over the next 10 years ( the standard period for revenue estimates), but the budget suggests that this revenue loss can be offset by closing “loopholes” in the corporate tax code.
In fact, most large corporate tax preferences are aimed at promoting economic growth so they have strong bipartisan support. The tax preferences generating the largest revenue losses include the research and development tax credit, the special deduction for US manufacturing, and accelerated depreciation for capital investments. Of course, there has been a lot of clamor about the favorable tax treatment of corporate jets, incentive fees for hedge fund managers, and generous allowances for drilling costs. But these much criticized “loopholes” amount to less than $100 billion in revenue losses over ten years.
Thus, in order to help make up for losses in tax revenue, Congress would need to dedicate to rate reduction the revenues raised by the third and fourth proposals in the budget.
The budget would establish a global minimum tax of 19% on all foreign profits of U.S. corporations, which could generate $206 billion over 10 years. Once that tax is paid, US corporations could freely bring back their foreign profits to the U.S. To help meet this minimum, U.S. multinationals would receive tax credits for most of the corporate taxes paid to foreign countries. So for instance, if a company paid more than 23% in any foreign country, it would satisfy the global minimum tax without any additional tax payments to the US. On the other hand, if a company were taxed elsewhere at only 12%, it would have to pay the U.S. at least a 7% tax in order to meet the global minimum of 19%.
The global tax has several advantages — most importantly, it would discourage U.S. multinationals from shifting their foreign profits to tax havens with rates near zero. However, most corporate executives would view 19% as too high relative to other proposals. Last year, Republican U.S.Congressman Dave Camp, formerly chairman of the House Ways and Means Committee, used 15% as a baseline rate in his draft bill.
The new budget also proposes to levy a transition tax, a one-time tax of 14% on previously untaxed foreign earnings, regardless of whether the earnings are repatriated. Then these profits could freely be brought back to the US for any legitimate purpose. Although this proposal would raise $268 billion over 10 years, the budget would dedicate most of this new tax revenue to infrastructure investments.
In any event, 14% is not politically feasible as a transitional rate. US companies held these foreign profits abroad in reasonable reliance on long standing US tax laws. For this reason, a tax on prior foreign profits should be below 10%. The Camp bill, for instance, put forward a 8.75% tax rate on prior foreign profits held abroad.
In short, although the tax rates in the budget may be too high, Republicans should be attracted by some of its ideas – allowing foreign profits to be repatriated to the US at a relatively low rate and bringing the US corporate tax rate closer to the global norm. Let the negotiations begin!
Robert Pozen is a sen
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October 22nd, 2014
By Robert Pozen and Theresa Hamacher.
After years of heated debate, the Securities and Exchange Commission, the US regulator, recently adopted stricter rules for US money market funds. The new rules are intended to limit the potential systemic risks of money market funds by reducing the likelihood of runs on these vehicles.
The rules will have the biggest impact on money market funds serving institutional investors, which will have to move from a constant to a floating net asset value. The rules will also put pressure on most institutional and retail money market funds to impose liquidity fees and suspend redemptions during financial crises. But neither set of rules will apply to money market funds holding 99.5 per cent or more of government securities.
Thus, the two critical questions are what constitutes a government security, and what differentiates an institutional from a retail money market fund?
The rules narrowly define governmental securities to include cash, US Treasuries and securities issued by US federal agencies. Notably, for this purpose, government securities do not include securities issued by state or city governments – the assets held by most tax-exempt money market funds.
All non-governmental money market funds must abide by the SEC’s new requirements for fees and gates. If such a fund’s weekly liquidity assets falls below 30 per cent of its total assets, its board would be authorised to impose a liquidity fee of up to 2 per cent on all redemptions. The board would have to determine that a liquidity fee would be in the best interests of the fund.
If the weekly liquidity assets dropped below 10 per cent of its total assets, the fund would be required to impose a liquidity fee of 1 per cent on all redemptions.
Similarly, if the weekly liquidity assets of a non-government money market fund dropped below 30 per cent of its total assets, its board could in its discretion suspend redemptions temporarily. To impose an exit gate (lasting no more than 10 business days), the board would have to find that such a gate is in the best interest of the fund.
In contrast to the rules on liquidity fees, if the weekly liquidity assets of a non-government money market fund dropped below 10 per cent of its total assets, there would be no requirement to impose a redemption gate. The decision on the gate would still be left to the discretion of the fund’s board.
This difference in regulatory treatment reflects the SEC’s concerns that mandatory redemption gates might encourage runs on money market funds. The SEC prefers liquidity fees because they provide investors with a choice: they can remain in the fund or leave by paying a modest exit fee.
The other significant distinction is between retail and institutional money market funds.
Retail non-government money market funds will continue to report a constant net asset value of $1. Under the final rule, a retail fund must be designed to provide reasonable assurances that it will attract only natural persons, as opposed to institutions such as corporations or pension funds.
However, institutional non-governmental money market funds will soon have a floating net asset value on a daily basis. This requirement is a sensible way to discourage institutional investors from redeeming fund shares at a constant $1 value, even if the fund is experiencing significant losses. During the 2008 crisis, many institutional investors made large redemptions from money market funds to get out before the funds could no longer maintain a constant $1 value.
One concern is that investors will realise a small gain or loss every time they redeem shares of a money market fund with a fluctuating net asset value.
In short, the new rules are likely to reduce the chances of runs on money market funds in times of financial crisis. But it remains to be seen whether these tougher requirements will diminish the appeal of the funds relative to bank deposits for short-term investors.
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March 4th, 2014
Interview conducted by Gretchen Gavett.
Robert Pozen knows a little something about thriving at the top — he’s the former chairman of MFS Investment Management, a senior lecturer at Harvard Business School, and the author of the bookExtreme Productivity. I recently asked him about how demands on executives — and CEOs in particular — have changed over the years, and how today’s leaders can best navigate their busy days. An edited version of our conversation is below.
What are the most pressing productivity issues executives are facing today, and how can they tackle them?
For executives who aren’t part of the C-suite, I think the two most pressing issues are meetings and email. They consume a ridiculous amount of people’s time, and a lot of it isn’t well spent. But they’re both solvable problems.
On email, my suggestions are pretty simple. First, don’t look at it every minute; look at it every hour or two. Second, try to discipline yourself to read only the subject matter in order to discard 50% to 80% of your emails right away. We all get so much spam. Third, practice what I call “OHIO” — Only Handle It Once, immediately deciding what to do with each email. Concentrate on the emails that are important and answer them right away. And don’t put them into some sort of storage system, because by the time you’re ready to finally tackle them, you’ll spend another half an hour trying to find them.
As to meetings, I’ve really been clear in my book about what makes a good meeting. First, you ought to have the materials and agenda sent out in advance. Second, the person who’s presenting the issues should speak for a short amount of time, 10 or 15 minutes, and not consume the whole meeting. Third, you need to have a real discussion and debate. Fourth, you should end the meeting with clear to-do’s — what are the next steps, who’s going to follow through on them, what are the time frames? And fifth, you should end the meeting at the very latest in 90 minutes, and try for 60 minutes.
But there are slightly different issues CEOs and the C-suite are facing, right?
A lot of the critical issues that I see from advising CEOs, and being one myself, stem from how to allocate your time.
There are two classic errors CEOs make. One, they often schedule their whole day up, every hour and every day. I believe you need to leave time — an hour in the morning and an hour in the afternoon — for thinking, and for things that come up, for emergencies.
And the other error, which is much more fundamental, is that many CEOs are asking themselves the wrong question: since four main functions need to be done, who’s the best at doing them? Many top executives often come up with the same answer in all four areas: Me, me, me, and me. Which leaves them with a lot to do.
But the better question is, what can I and only I as a CEO do? That’s a very different question.
For instance, CEOs might have come from the advertising or marketing side of the company, so they may be very well the best person to put together a new ad campaign, in terms of skill set. But that’s not a good use of their time, because it’s a very delegable task. On the other hand, if a company executive has to meet with a top regulator, the CEO may be the only person that has the clout to get the meeting. Or if someone needs to deal with the board, the CEO may be the only one who can do this effectively.
It is imperative that CEOs make the best use of their time — their scarcest resource. But many CEOs wind up spending huge amounts of time doing things that are really delegable and not enough time on the things that are really critical to being the CEO.
You’ve been analyzing this topic for a long time, both as an academic and as an executive. What big changes have you seen over time?
A lot of the same issues continue to be there; the crucial difference is technology. And technology is both a big positive and a big negative. It’s a big positive in the sense that now you can, as a CEO, use your time very efficiently. That is, you can speak to people by phone from almost anywhere. You can get information instantaneously — CEOs can accomplish a huge amount from the back of the car.
On the other hand, because it’s so easy for people to reach you, it’s hard to have thinking time. And if you let yourself be a person who is giving detailed directions all the time, your reports are going to ask you for directions all the time.
So it’s about setting up boundaries.
Yes. Before a lot of this technology, you could be a little sheltered. Now there aren’t any constraints on the amount of information you can be sent or the number of people who contact you, or where you can go quickly. That’s the negative part of technology. The potential is there for you to go everywhere, try to read everything, and be totally overwhelmed.
What are other coming challenges you see, aside from technology?
Almost all companies have gone global. In the large companies, many derive 50% of the revenues from abroad. And even in smaller companies, they have to export. Doing business globally requires a very different skill set than distributing domestically.
But there are many executives who are very U.S.-centric. They really haven’t spent much time overseas. Being a leader today requires that you have lived overseas, or have spent a lot of time overseas.
So how do you handle the demands of international business travel?
You as the CEO actually have to show up at your high value-added offices around the world. And that takes a lot of time and effort. When I was running Fidelity’s investment arm, we had offices in London, Tokyo, and Hong Kong. We also had distribution offices all over the place.
I tried to visit, at least once a quarter, those investment offices because they housed our prized contributors: portfolio managers and analysts. They needed to meet me regularly and have a chance to talk through issues. When you run a global operation, it’s hard to maintain a global esprit and an integrated approach. And the CEO has an important role in leading those.
And what about the relationship with their board?
The nature of corporate boards has changed significantly over the last 20 years. When I joined my first board over a decade ago, a friend called me up and said, “We need an American on our board, would you consider it?”
I said “sure.” He sent me some material on the company and told me that the CEO was coming to town in a few weeks and asked if I would have dinner with them. So this director and the CEO and I had dinner. At the end of the dinner, the CEO asked, “OK, are you ready to join the board?”
By contrast, when I joined the Medtronic board, the lead independent director came to my office and interviewed me first. Next I had to meet with a number of the independent directors on the governance committee, and then, at the end, I saw the CEO. It is probably true that if the CEO really hated me, the board might not have gone forward, but I was 90% on board before seeing the CEO.
Now CEOs have shorter tenures than they used to, and the notion of the imperial CEO is no longer accepted by most directors. They want a much higher level of accountability and a much higher level of transparency. And the CEO who doesn’t realize that has probably made a bad career decision.
With these shorter tenures, how can CEOs deal with the inherent pressures that go along with them?
I believe that being a CEO is a lonely existence, so I think CEOs need personal coaches — preferably somebody who’s been a CEO — to help with overall strategic thinking and also somebody just to talk with about company matters. A CEO really can’t talk openly to anybody else in the company.
If being a CEO is increasingly lonely, how should CEOs sort of seek and maintain connections with family and friends, especially when they’re so busy?
Families are very important, so CEOs should carefully protect their family time. It’s easy to say, “Oh, I cannot possibly get home on most business days until 10 p.m.” The demands on the time of most CEOs are so great that they easily do that. But I insisted on getting home to eat dinner with my wife and children at 7:00 p.m. and to share two or three hours of quality time.
Family time is critical. If 10 years later your kids are grown up and you haven’t really spent much time with them, there is no way to recapture those years. Moreover, family dinners were healthy mental breaks for me. There were many times when I was struggling with a difficult problem, stopped thinking about it for three hours at dinner, and then suddenly the answer would hit me.
So what should — and shouldn’t — executives do when they get home?
You don’t want to come in the door, and then immediately receive phone calls or answer your email. Before I walk in the door, I will literally sit in my car and finish all my emails and all my phone calls; I won’t walk in the door until I’m out of work mode.
If you come home for dinner, and immediately get a phone call or start checking your email, then you really undermine the notion of “quality family time.” In the end, you will retire from your business, but your family is forever.
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February 25th, 2014
By Robert C. Pozen.
President Obama’s proposal is well-intentioned but may not get workers to save more. A better plan: Automatically enroll workers to an IRA.
FORTUNE — President Obama recently proposed to help more workers save for retirement through an executive order creating the myRA. The plan is being billed as the Roth IRA for every man or woman with neither access to a 401(k) plan at their workplace nor the lump-sum deposit to open an IRA on their own.
Though well-intentioned, this isn’t the best way to encourage workers to save more — it’s just a politically easier route. A better way is to automatically enroll workers with a retirement plan through payroll deductions and give them the option to opt out. Congress has considered such a plan for years, but it has never gone anywhere, and it’s tough to see how things could turn around given the partisan bickering we’ve seen in Washington.
Nonetheless, an automatic Individual Retirement Account (IRA) is worth reevaluating as the president makes his pitch for myRA. Half of America’s full-time employees, about 75 million, arenot offered any type of retirement plan at work (except for Social Security). Although many work at small firms with fewer than 10 employees, some work at larger firms. Over 20% of American employers with 100 or more employees — mainly in agricultural, construction, and retail sectors — do not offer any type of retirement plan at work.
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In theory, these 75 million employees are legally entitled to open an IRA, which offer contributors substantial tax benefits. However, less than 5% of these 75 million employees actually open a tax-advantaged IRA. Why? Inertia. It takes time and energy to go to a financial institution, fill out an application and make a few choices.
Countless studies have shown that participation rates are much higher if employees are automatically enrolled in a retirement plan, but then given the opportunity to opt out.
Here’s what a bill to establish the automatic IRA could look like:
1. All employers above a certain size (e.g., over 10 or 20 full-time employees) would be required to link their payrolls electronically to a qualified financial institution offering an IRA meeting certain criteria. But this requirement would not apply to any employer already offering a retirement plan.
2. Participating employers would presumptively deduct a specific percentage (e.g., 2%) of the monthly salaries of full-time employees as contributions to an IRA. However, these employees would have several months to decide to opt out, or choose a lower level, of these presumptive contributions to an IRA.
3. To constrain administrative costs, all contributions to an Automatic IRA would be at least $25 per pay period. To defray the startup costs for the new program, each participating employer would receive a modest one-time tax credit (e.g., $300).
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All three of these features would need Congress’s blessings, but due to the ongoing partisan bickering, lawmakers seems incapable of passing non-essential bills. The president’s myRA proposal is a pale shadow of an automatic IRA. Here are a few critical differences:
1. Under myRA, employers would be encouraged to connect their payroll systems to their retirement accounts maintained by the U.S. Treasury. However, myRA is an entirely voluntary, not mandatory program so it’s uncertain how many would enroll.
2. Even if employers chose to participate in myRA, their employees would need to affirmatively authorize payroll deductions going to this program. This would be an opt-in, not an opt-out process.
3. The minimum contribution to a myRA doesn’t boost very much savings; it would be $10 per payroll period, after an initial $25 contribution. And participating employers would not receive a tax credit to defray the startup costs of joining the myRA program.
To substantially increase retirement savings in America, Congress should adopt the Automatic IRA with its more effective features.
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December 19th, 2013
Have you heard of the two terms “risk retention” and “qualified residential mortgages”? Federal regulators are reportedly close to adopting rules defining these two terms, which will largely determine the future shape of the home mortgage market.
Here is the background. The Dodd-Frank Act tried to stop mortgage lenders from issuing mortgages and then immediately selling them to a large financial institution. That institution would put together a pool of home mortgages and sell securities based on the cash flows from the pool. Before the Dodd-Frank Act, because the issuers of many home mortgages immediately sold them, the issuers had little incentive to do a good job of checking carefully whether the borrowers would be able to pay off these mortgages. In other words, these issuers had “no skin in the game.”
In response, the Dodd-Frank Act generally required mortgage lenders to retain some risk in the mortgages they sold. In specific, these lenders were required to retain 5% of the economic risk if they sold mortgages that later defaulted. At the same time, Congress was concerned that such a requirement would lower the volume of new home mortgages. So, Dodd-Frank established several broad exemptions to the risk retention requirement for mortgages that Congress believed were relatively safe.
In the future, the home mortgage market will be dominated by mortgages covered by these exemptions. Almost every firm will prefer to originate and sell these exempt mortgages, rather than retain some of the risk that non-exempt mortgages will later default.
A look at risk
Let’s review the three main types of home mortgages exempt from the risk retention requirement and whether they seem justified. In this regard, studies show that low down payments are by far the best predictor of mortgage defaults.
First, Congress exempted from the risk retention requirement all mortgages insured by the Federal Housing Administration (FHA), which currently accounts for over 40% of the new mortgages in the US. These mortgages are issued by private lenders and then insured by the FHA if they meet certain criteria. But the FHA insures mortgages where the borrower makes a down payment of only 3.5% of the home’s value. So the FHA is insuring 100% of a mortgage where the lender retains no risk and the borrower has a very low down payment. For these and other reasons, the default rate on FHA-insured mortgages has been rising and the FHA is now in serious financial trouble.
Second, Congress exempted from the risk retention requirement all home mortgages sold by private lenders to Fannie Mae or Freddie Mac. These two large institutions went bankrupt during the financial crisis and were effectively taken over by the federal government. Yet both institutions currently buy over 40% of new home mortgages from private lenders and then effectively guarantee such mortgages against default. Although Fannie Mae and Freddie Mac have stricter standards than the FHA, they both will buy home mortgages where the borrower makes a down payment of only 10% of a home’s value. Again, the federal government is not protected from loss by either risk retention by the lender or substantial down payments by the borrowers.
Third, Congress gave the regulators express authority to exempt from the risk retention requirement “qualified residential mortgages” or QRMs. In my view, the criteria for QRMs will be followed by most private lenders for most homes mortgages not insured or backed by the federal government. If a lender follows these criteria and quickly sells the mortgage, the lender will not have to retain any risk of the mortgage defaulting. Most importantly, federal regulators proposed in 2011 that QRMs have a down payment of at least 20% of a home’s value. But this proposal was met by a barrage of criticisms that a 20% down payment would unduly slow down the mortgage market and undermine the goal of home ownership, so the regulators are reportedly ready to adopt a down payment standard of 10% or even 5% for a QRM.
In fact, most private lenders in Canada insist on a 20% down payment for home mortgages. And the Canadian housing market is booming–without a tax deduction for interest on home mortgages. Indeed, the rate of home ownership in Canada is higher than that rate in the US.
Down payments are key
In short, Congress was right to require mortgage lenders to retain 5% of the default risk in the mortgages they sell. This requirement creates the incentive for these lenders to check carefully on the ability of borrowers to pay off their mortgages. If we are going to waive this risk retention requirement for a broad array of home mortgages, we should make sure that the borrowers make a relatively large down payment. A large down payment by the borrower is the best way to reduce mortgage defaults without a risk retention requirement for the lender
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November 24th, 2013
By Robert Pozen and Theresa Hamacher.
While shareholders of public companies in the UK and US have been voting on advisory (non-binding) resolutions about executive compensation, those in the Netherlands, Norway and Sweden have been voting on binding resolutions.
This might change. The UK government has proposed moving from advisory to compulsory resolutions on executive pay and, recently, the Swiss approved a referendum directing its parliament to require public companies to hold binding shareholder resolutions over pay.
Based on the available data, however, we do not support a general requirement for all public companies to hold a binding shareholder vote on executive compensation. But if less than a majority of the shares voted at one annual meeting favour a company’s executive compensation plan, then at the next annual meeting, the shareholder vote on that company’s executive compensation plan should be binding.
Let us begin by reviewing the data on advisory resolutions in the US and UK. In the first half of 2012, only 53 US public companies received less than a majority vote on their executive compensation plan. Of these 53, however, 45 gained majority support for their say on pay resolutions in 2013, according to Institutional Shareholder Services.
This rebound seems to mean that these 45 companies responded adequately to shareholder concerns in 2012.
In the UK, 75 public companies received dissenting votes of 20 per cent or more on their say on pay resolutions in 2003. According to a recent analysis by Professors Fabrizio Ferri and David Maber, institutional shareholders were most concerned that these“high dissent” companies had severance contracts promising to pay their terminating executives more than one year’s compensation.
Yet before the next advisory vote in 2004, 80 per cent of companies with these objectionable severance contracts revised them to provide executives with only one year’s compensation.
Moreover, in both the US and the UK, public companies have revised compensation arrangements before advisory votes in response to shareholder criticisms.
Negotiations between companies and their shareholders before advisory votes seem to have happened frequently, but it is impossible to get an accurate count.
Despite the usual responsiveness of companies before and after advisory votes, there are recidivists. For example, the say-on pay resolution of Oracle did not receive majority approval in 2012 – probably because the software company reported total compensation for Larry Ellison, the chief executive, of more than $78m (mostly from the “fair value” of the options he received).
Nevertheless, before the next advisory vote, Oracle did not make the compensation changes sought by its shareholders, including heavyweights such as the Vanguard and BlackRock funds.
Such repeated stonewalling of shareholders could not happen with binding resolutions on executive compensation, although these are hardly a panacea. In 2004, the Netherlands adopted a requirement for a binding vote on executive compensation, but Dutch shareholders did not veto any company’s executive compensation plan until 2008.
Since 2008, Dutch shareholders have rarely cast a binding vote against a company’s executive compensation plan. However, many more Dutch companies have withdrawn compensation proposals when a negative shareholder vote appeared likely, according to the deputy director of VEB, the Dutch shareholder association.
In Sweden, after the adoption of a binding shareholder vote on executive compensation in 2006, shareholders in general did not become more actively engaged with their public companies, according to a 2011 OECD study. Votes against Swedish companies for their executive compensation are rare, with one notable exception.
Home World Companies Markets Global Economy Lex Comment Management Life & Arts fast FT Alphaville FT fm Markets Data Trading Room Equities Currencies Capital Mkts Commodities Emerging Markets Tools 11/19/13 The (advisory) ties that bind executive pay – FT.com
In 2010, the Swedish government voted its 37 per cent block against TeliaSonera’s variable pay guidelines.
Led by the Swedish government, 52 per cent of its shareholders voted against these guidelines, so the Nordic telecommunications group had to renegotiate all its executive employment contracts.
In short, with binding or non-binding votes, shareholders rarely disapprove of an executive compensation plan. Rather, they exert considerable influence to curb what they perceive as glaring compensation abuses through informal negotiations before either type of vote.
Since most companies are quite responsive to shareholder concerns expressed through advisory votes, we do not support binding resolutions as a general rule.
However, we recommend a binding vote the year after a say-on-pay resolution does not garner a majority of the votes cast. This two step process would strongly encourage the small current group of recidivist companies to be more responsive to the concerns of their shareholders.
Robert Pozen is a senior lecturer at Harvard Business School. This article was co-authored by Theresa Hamacher, president of Nicsa.
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November 19th, 2013
By Robert Pozen.
While many commentators have expressed concerns about the large deficits of public pension plans, few have rung the alarm about the large deficits of retiree healthcare plans (RHPs) of local governments. In fact, the funding gaps for RHPs are usually at least 20% higher than those for public pensions. For example, the Mass Taxpayers Foundation has recently reported that Massachusetts local governments – cities and towns ( not the State ) – are saddled with $15 billion in pension deficits as compared to $30 billion in RHP deficits.
RHP deficits are larger than pension deficits of local governments for two main reasons. First, until 2004, no local government was required to include RHP deficits on their balance sheets. Even now, local governments are generally allowed to calculate these deficits on the basis of whatever they believe is the expected return on assets – as opposed to the actual return. Second, local governments have never been required to pre-fund RHP liabilities, in contrast to the pre-funding requirements for most pension plans that have been in place for two or three decades. In Massachusetts for instance, the funded ratio of assets to liabilities is 57% for local government pensions, but less than 1% for their RHPs.
On the other hand, RHPs may be amended in most states without running up against the constitutional protections for pension plans in many states. Thus, we should have a serious political debate about what should be the ground rules for RHPs offered to current and new public employees – but not for those already retired whose benefits should remain the same for fairness and political reasons.
The legitimate objective of RHPs is to help ensure that long-term public employees receive healthcare if they retire a few years before they become eligible for Medicare at age 65. However, most local government employees can retire at age 55 after a relatively short stint of public work. For instance, most municipal employees in Massachusetts are eligible for healthcare benefits after only 10 years of public service. Indeed, some public employees in Boston are eligible for healthcare benefits after 10 years of part-time work for the city.
So what can be done to constrain the financial threat of RHPs to local governments? First, local governments should require at least 20 years of full-time public service before retired public employees become eligible for RHPs. Second, healthcare benefits for retired public employees should not start until after they reach age 55 and they do not have another source of healthcare benefits (such as a private sector employer after they leave public service ).
This last condition raises a third question – why should local governments continue to offer RHPs to anyone eligible for Medicare? Although many public jurisdictions move their retirees entirely to Medicare at age 65, some continue to pay 50% to 80% of Medicare Part B premiums for their retired employees; and nearly all pay at least 50% for supplemental medical plans like Medigap. This seems unnecessary since Congress has kept Medicare premiums fairly low for most recipients, and raised such premiums only for those in higher income brackets who can afford to pay more.
Fourth, local governments should take advantage of Obamacare to offer relatively inexpensive and quality policies to their retirees between the ages of 55 and 65. Such policies at three different levels (Bronze, Silver and Gold) must be offered by every state through exchanges (run by the state or the federal government). Moreover, for policies bought through such exchanges, public retirees would be eligible for federal premium subsidies, which extend to families of four until their incomes exceed $90,000 per year.
Finally, local governments should use realistic assumptions in calculating the RHP liabilities they now report to taxpayers. Between 2009 and 2011, for example, Boston lowered its RHP liabilities by $1billion simply by increasing its “assumed” returns on most of its long-term investments from 5.25% to 7.25%. By these unsubstantiated enhancements in actuarial assumptions, cities like Boson are effectively distorting honest debate that all cities and towns should be having about the funding of these RHPs.
In short, while not ignoring the deficits of public pensions, we should also focus on the deficits of RHPs in most local governments. Although the deficits in RHPs are substantially larger than those in public pensions, RHPs are easier to revise from a legal perspective. Nevertheless, any benefit revision for public employees will be politically controversial. So local governments should accurately calculate the unfunded liabilities of their RHPs, and seriously consider several reforms — most importantly, tightening eligibility requirements and integrating RHPs more closely with Medicare and Obamacare.
Pozen is the former chairman of MFS Investment Management, a senior lecturer at the Harvard Business School, a Nonresident Senior Fellow in Economic Studies at the Brookings Institution, and author of the book The Fund Industry: How Your Money Is Managed.
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