They’re everywhere in New York City. On foot, horseback, bicycle, car and three-wheel motor scooter: they’re New York’s finest, the police. Then there’s firemen, who, when not fighting fires or riding around in big red trucks, can be found shopping for gourmand fixings at the local market. And let’s not forget the city employees who keep the bureaucracy and machinery of the five boroughs going. Or the army of teachers charged with developing the minds of legions of little New Yorkers.
Anyone with an inkling of the breadth and depth of the ‘Big Apple’ can begin to envision these crowds. Altogether they’d probably fill Yankee Stadium a few times over. Ever wonder where their pensions will come from? Or where the pensions of all those who policed, protected and taught before – numbering half a million – are coming from? For the answer, take a trip to New York’s Greco-Roman municipal building in lower Manhattan. Dodge marriage parties, run the metal detector gauntlet, ride up a creaky elevator and stride down the cavernous marble corridor. There, behind a 1940s frosted glass door, meet Jon Lukomnik, deputy comptroller for pensions for the City of New York.
It’s a far cry from the sleekly appointed suites of most fund managers. Yet this is the nerve center for the management of a considerable amount of capital. All in all, Lukomnik oversees $75 bn in five large funds, not to mention 23 other smaller funds. The biggest, $32.4 bn amassed, is the New York City Employees Retirement System (Nycers) – the tenth largest pension fund and the largest municipal fund in the US. Then there’s the Teachers Retirement Fund with $20.3 bn, the Police Department Pension Fund with $14.25 bn, the Fire Department Pension Fund with $5.62 bn and the Board of Education Pension Fund with $1.38 bn.
With all NYC pension assets managed externally, and around 80 percent of equities passively invested, many investor relations professionals might be surprised to learn these funds are shareholders. Yet the typical US company can count on them owning 0.5 to 1 percent of its shares. Increasingly, overseas companies can also expect to find the NYC funds as owners. After a hard fought battle with state legislators, the city is upping its proportion of foreign equities from 12 percent to between 15 and 20 percent.
Any one of those thousands of companies could suddenly find themselves very aware of the NYC funds as stakeholders, and not disinterested ones at that. As a pioneer of the shareholder activist movement, New York’s comptroller’s office carefully screens the portfolios for financial underperformers and social offenders. Then these scofflaws are targeted for change. But where once the funds were known as aggressive proxy tacticians, they have in recent years become masters of quiet diplomacy.
No Slouch
Just because it farms out the pension fund management duties doesn’t mean New York’s comptroller’s office is any slouch when it comes to investment acumen. In October it was given the Alexander Hamilton award by the National Association of Corporate Treasurers – the first time the award for excellence in treasury management was awarded to a public office.
Actually Lukomnik, asset management bureau chief William Paolino and chief investment officer Donna Anderson have to be astute fiduciaries. Among their duties are recommending asset allocation and investment structures, performing manager searches, handing down manager guidelines, and monitoring performance.
The resulting performance is imp-ressive, even compared with more aggressive mutual funds. NYC’s score card shows one year returns around 22 percent, topping 18.67 percent recorded for the Callan median of 108 public pension funds. For the three-and-a-half years since comptroller Alan Hevesi took office, the funds have earned $4 bn more than if they had been median performers. Those numbers are feathers in Hevesi’s cap as he runs for re-election in November.
Perhaps more impressive is that such performance can come out of the Byzantine architecture of the NYC pension system. Each different fund has its own board made up of labor and management – 70 trustees for the five main funds. Just counting regular board meetings, that’s 86 meetings a year. Add in budget meetings, proxy meetings, tobacco committee meetings and so on, the number of planning sessions tops 125.
‘We are not flexible, we are not nimble,’ Lukomnik acknowledges. ‘Therefore we practice ‘investment jujitsu’: we take our weakness and make it a strength by becoming very strategic.’ The result is a top-down decision-making process with a great deal of attention paid both to asset allocation and risk management.
A benefit of the NYC funds’ somewhat ponderous, ‘slow study’ decision-making is that it has managed to avoid some of the major investing debacles of the past decade. They examined the high-yield bond market at length before taking the plunge in the early 1990s – after the asset class crashed. And emerging markets made their debut in NYC’s portfolios in 1995 when Mexico’s peso crisis had already passed. ‘We missed the big blow-offs,’ says Lukomnik. ‘We weren’t the first ones in, but we weren’t the first ones burnt.’
Social Headliners
The NYC pension funds have been among shareholder activism’s pioneers and most active players. For instance, former NYC comptroller Harrison Goldin helped found the Council of Institutional Investors, and the city’s record of corporate governance proposals goes back to 1988.
‘We strongly believe that good corporate governance adds value,’ states Lukomnik. ‘That’s why we’re activists: to make money.’
The NYC funds are currently active on the social issues of discrimination and environment under the direction of Ken Sylvester, pension policy director. Again, Lukomnik says the funds are focused firmly on the bottom line: ‘If a company discriminates, then it is choosing from less than the full available talent pool. It’s putting our capital at risk because its competitors are hiring from the whole pool.’
The effects of change on these issues are termed ‘social’, Lukomnik says, because they aren’t quantifiable from quarter to quarter. ‘But as a pension fund, we don’t care about the next quarter. We’re long-term, patient capital, and what we need is a corporation that will give us a real return at about the rate of inflation forever. Discrimination is a forever issue: over the long-term it has a bottom-line effect.’
According to the Investor Responsibility Research Center in Washington, DC, the last few years have seen the NYC funds adopt ‘kinder, gentler personas’ and the traditional barrage of shareholder proposals has now largely been replaced by quiet talks behind closed doors. Only when talks fail are resolutions filed or the targets made public. Hevesi led the effort to focus more on companies which underperform their peers as well as those likely to be easily swayed by corporate governance activism. The result was a performance-based screening system used to target ten to 15 underperforming companies a year.
All in all, the NYC funds use eight quantitative and qualitative criteria to select activism targets. The most important compares company performance against industry-specific average returns for one, three and five-year periods. By using industry standards, the funds aim to minimize biases against certain industries and zero in on companies with real underperformance compared to their peers.
The three screens used to judge the susceptibility of the company to change are institutional ownership (the higher the better for effecting change), corporate governance structures, and how the company is perceived by the public and the business press (the worse its image, the easier it is to pressure the company). The final screening step is quality control: resorting to fundamental analysis, the funds identify companies that are already in a turnaround, or which were inadvertently singled out because of extraordinary events like a big restructuring write-down.
1994 was the first year the NYC funds pegged underperformers for action. Within six months, two targets had been taken over and another had a hostile takeover. ‘Clearly, the combined focus of discovering undervalued corporations and examining their susceptibility to change was validated by the market’s merger and takeover specialists,’ Lukomnik says. ‘Ironically, performing the selection analysis with an eye toward future intervention often means that intervention is not necessary.’
Where shareholder activism once meant ‘in your face’ techniques, it now entails a fair amount of tact. The next step after security selection is deciding whether to approach management, and when. NYC funds usually waste no time in firing off a letter requesting a one-on-one meeting with company management.
Such a meeting is usually with top management – the CEO and general counsel, and often the CFO or COO. Meanwhile NYC is represented by one of the funds’ proxy committees – investment staff as well as trustees.
The two-hour meeting has three parts: a usual IR presentation, just like the one sell- side analysts see, along with a longer-term overview of the company’s strategic plan; a discussion of corporate governance, focusing on the board’s role; and finally, the pension funds’ recommendations for change.
Lukomnik explains that as long-term passive investors, the NYC funds have to focus on whether board mechanisms designed to ‘enhance shareholder value’ are in place and working. That means board independence, director skill sets, director and management incentive compensation plans, and interaction of the board and management.
Lukomnik believes that just shining the spotlight on companies has a positive effect – ‘People tend to work better when they know someone is watching what they’re doing.’ He quotes Lens Fund’s Nell Minow: ‘Board members are like subatomic particles: they act differently when observed.’
Dialogue, it seems, works better than confrontation in the new enlightened corporate governance environment. Over half of the NYC funds’ planned resolutions are dropped or never filed in the first place.
Final Solution
Only when discussion breaks down do Lukomnik and his team look to their proxy arsenal. Their most common weapon is a proposal to adopt confidential voting, with 82 brought to vote during 1988-1995. Another common proposal is to create an independent nominating committee.
Lukomnik is never disheartened by the low vote counts usually garnered by shareholder proposals. He says many companies correctly interpret even minority votes as a sign of discontent among owners. Tenneco, for example, was hit by a resolution calling for an independent nominating committee in 1995. It only got 32.8 percent of the vote, but the company nonetheless complied.
A new tool plied by the NYC funds in the last few years is a direct outreach to Wall Street. For instance, in 1995 Nycers managed to spark the interest of a Salomon Brothers analyst over corporate governance issues at Ethyl Corporation. The result was a published research report on creating an independent board at the company.
The new look of the NYC pension funds, then, is that of a socially responsible investor with its eye firmly glued to the bottom line. It walks more softly now, and it has discarded its big stick, but don’t test its patience. After all, the funds have the whole weight of New York’s police, firemen, teachers and city employees behind them.
Allocation Equation
It’s been three long years of hard lobbying to get the legislation passed. Now New York City pension funds have shrugged off the legalistic constraints of government and gained more flexibility in allocating their assets.
Deputy comptroller for pensions Jon Lukomnik says the NYC funds are remaining highly invested in equities – about 70 percent in total. But those equities will be better diversified among US, international, private and emerging markets companies. The proportion of international equities should rise to 15-20 percent.
The NYC funds always study carefully the proportion of assets invested passively and actively. About 85 percent of US investments are passively managed (by Bankers Trust), while 40 percent of assets invested in developed overseas markets are passively managed. Emerging markets investments are all actively managed.
On the fixed-income side of the NYC funds, Lukomnik and his team carefully apportion funds among different classes of debt. Enhanced yield bonds, from almost-investment grade companies, have turned out to be stellar performers for the fund.
Campaign for Change
Pre-dating New York City pension funds’ corporate governance concerns is a strong track record of ‘social’ activism. As far back as 1984, the trustees began a campaign against apartheid through shareholder resolutions and sometimes divestment, and they have become well known for their work against discrimination in Northern Ireland. In fact the MacBride principles against religious discrimination in the workplace reached their final form under onetime city comptroller Harrison Goldin.
Discrimination also played a part in the debate when Nycers targeted Cracker Barrel Old Country Store for discrimination against gay workers in 1992. Reversing the SEC’s subsequent no-action letter to the company – which let it ignore the substance of the proposal – has been a cause cJlPbre for the NYC funds and other shareholder activists ever since.
In a letter to the SEC this year, comptroller Hevesi noted the very real effect on investors caused by employment practice lawsuit settlements by Texaco, Shoney’s, Denny’s and Chevron. Of Texaco, Hevesi said, ‘The precipitous loss of $800 mn in stock value, the $176 mn settlement of the case, and the widespread negative image of the company cumulatively diminished shareholder value.’
The NYC funds have also turned their attention toward other social issues including the Ceres principles environmental code and tobacco advertising. With other US pension funds like the Florida retirement system divesting its tobacco stakes, the NYC funds are undertaking a review of their $310 mn in holdings.
This year the NYC funds took their social responsibility to the world stage. Hevesi is spearheading a group of pension fund officials monitoring Switzerland’s handling of billions of dollars belonging to Holocaust victims. For months he has been hounding Swiss companies in which the NYC funds hold shares, demanding details about how much they’re contributing to a special fund for Holocaust survivors.
In a letter to Swiss executives this summer, Hevesi wrote: ‘A company’s public image is one of its most valuable assets. Similarly we have found that contingent liabilities – such as potential boycotts or even the expense of lobbying against such boycotts – are often undervalued. As investors in many Swiss companies, we do not want to see their values diminished.’ne
