One vote for pension fund capitalism.

U.S. legislators will continue to closely examine the interplay between pension fund investment policy and public policy. With pension funds now controlling $2.5 trillion in assets and owning shares worth almost $1 trillion (28.2 percent of all U.S. equity), policymakers are beginning to view this pool of assets as a potential source of funds to address a variety of social ills.

Harbingers of things to come include California Governor Pete Wilson's recent attempted "hostile takeover" of the California Public Employees Retirement System and Ohio Congressman Visclosky's failed attempt to impose joint labor/management trusteeship on pension plans nationwide.

The pooling phenomenon (labeled by Peter Drucker as "pension fund socialism") has continued to grow at a remarkable rate over the past five years-7 percent per year for private pension funds and 12.7 percent for public-sector funds. Overall, institutional shareholders including mutual funds, insurance companies, etc.) now control assets worth $6.5 trillion-more than the GNP of the United States-and account for some 20 percent of all financial assets and 53 percent of all outstanding equities, according to Carolyn Brancato, executive director of Columbia University's Institutional Investor Project.

The 20 largest pension funds (13 of which are public funds) control assets worth more than $600 billion. The top 20 funds (plus the 10 largest money managers) already hold some 16 percent of the equity of the 10 largest U.S. corporations, and could own as much as 30 percent within the next 10 years.

Not since the robber baron era of primitive capitalism has so much economic power been concentrated in so few hands. Only the naive believe that this rapidly evolving change in the nation's ownership structure will not come under closer political scrutiny.

To forestall the enactment of legislation that may prove harmful not only to pensioners and plan sponsors but also to the economy at large, plan sponsors and their financial managers should begin the search for potential common ground between pension plan investment policy and public policy.

One particularly promising area involves investing those funds so as to create a broad base of private-sector capital owners, including employee stock owners. in fact, the best antidote to pension fund socialism may just turn out to be pension fund capitalism.

Economic empowerment investment criteria

As an initial screening process, pension fund investment strategists could begin by asking who is economically empowered by those investments. Under today's pension fund socialism, it doesn't matter whether those investments finance capital ownership for a small or a large number of U.S. households.

For example, public pension funds were the primary investors in the leveraged buy-out funds established by New York's Kohlberg, Kravis, and Roberts. Those investments generated historically high short-term returns-which meant smaller contributions by state and local taxpayers, short-term.

However, the long-term result of such investments was to create a very small class of very wealthy individuals. For example, the Forbes 400 list of wealthiest Americans added 18 new billionaires in 1989 alone; most were LBO organizers.

Even where pension funds do not invest through such leveraged pools, shouldn't it make a difference what type of capital ownership pattern is created through these tax-exempt, quasi-public investments? Even though a particular investment's financial returns are extraordinary, shouldn't pension sponsors look beyond their short-term return expectations in evaluating the ownership impact of such an investment?

For example, in the case of top-performing Wal-mart Stores, inc., one key area of potential public concern is not now reflected in fund investment criteria: the capital-concentrating effect of such an investment, which is otherwise attractive. With the help of pension fund capital, WalMart's Sam Walton and his family recently edged out Saudi Arabia's oil-rich King Fahd to seize second place to the Sultan of Brunei in Fortune's fifth annual list of the world's billionaires. Why should pension funds (many of which help finance Wal-mart malls) add to Walton's $21.1 billion?

Fiscal foresight investment criteria

Looking back over the 1980s, wouldn't employees' pension benefits have been better protected if their retirement funds had been invested to encourage widespread rather than concentrated capital ownership? For example, 1988 witnessed $766.5 billion in capital financing nationwide, comprised of $455.5 billion in new plant and equipment and $311 billion in mergers and acquisitions via 3,637 transactions (including LBOs).

With the assistance of potent pension fund financiers, those investments could have been structured to promote widespread capital ownership-for example, by insisting that employee stock ownership plans (ESOPs) be included as a component of LBOs. Or they could have become an element in the pension fund-facilitated financing of capital expansion; nationwide, expenditures on new plant and equipment totaled $4,349 billion from 1980 to 1990.

That could have contributed to a capital accumulation trend line helpful in relieving the fiscal strains that now seem likely to emerge as today's baby boomers otherwise become asset-poor senior boomers.

"Pension fund capitalism" Suggests that, whenever possible, investments should be structured to support broadbased economic self-sufficiency as an antidote to the principle threat facing both public--and private-sector retirees; that they may retire amidst a population that is not economically self-sufficient and, thus, must use its political clout to press for more transfer payments.

Those transfer payments, of course, are already the nation's largest (and most intractable) fiscal problem. Any increase only further erodes the value of projected pension benefits. Today's highly regressive Social Security tax is already the largest single tax paid by a majority of U.S. taxpayers, and Social Security entitlements now represent the most significant "asset" for a majority of U.S. households.

The prospects for widespread economic self-sufficiency are not hopeful. A 1988 U.S. Census Bureau survey found that the median white household net worth (absent modest home equity and an equally modest pension) is approximately $10,800. Hispanic household net worth is one-eighth that amount; African-American, one-tenth.

Thus, those pension fund managers who choose to invest without the fiscal foresight to do their part in addressing the emerging demographics of dependency are jeopardizing their beneficiaries' retirement security.

Similarly, those who worry about the use to which these pools of capital may be put by elected officials had best elect tO put those pools to work creating widespread economic self-sufficiency. Continuing to invest without creating a voting populace widely populated with capitalists is a guaranteed recipe for inviting the socialization of these funds.

This capitalist-creation strategy must be distinguished from social investment. Social investment is an attempt to direct pension funds into investments that are non-market worthy or that subsidize non-pension goals.

Rather than favor particular investments, pension fund capitalism suggests that, regardless which investments are made, those investments should be structured to economically empower a broad rather than a narrow group of households--for example, Wal-mart's employees, not just Sam Walton.

Why does capitalism create so few capitalists?

Traditional corporate financing techniques have proven themselves incapable of populating capitalism with individual capitalists. According to Federal Reserve Board research, nearly 60 percent of all personally held U.S. equities are owned by only 1 percent of U.S. households, while over 45 percent are owned by just 0.5 percent.

Thus, any investment strategy favoring widespread capital ownership must confront the tendency of corporate finance (fueled, in part, by pension fund investments) to further concentrate capital ownership. This rich-get-richer financial legacy stems from the fact that practically all corporate funds are provided through only three sources:

* Reinvested earnings and profits--which create no new capital owners,

* Tax benefits (primarily depreciation reserves)-which, when reinvested, create no new owners, and

* Debt-which is repaid for existing owners with the limited exception of ownership--concentrating LBO debt and ownership-expanding ESOP debt).

The U.S. General Accounting Office labeled this phenomenon a "closed system of finance" in explaining why the U.S. economy's capital base continues to expand while its capital ownership base does not (or, indeed, contracts).

What about the sale of stocks? Wall Street's public relations efforts to the contrary, never in recent history has the sale of new equities been a significant source of new capital owners-for three obvious reasons: (1) New stock issues are not a significant net source of capital nationwide typically only 2 to 5 percent); (2) Since 1984, equities have been substantially negative due to the large volume of stock buybacks, including mergers, acquisitions, and LBOs ($130 billion in 1988 alone); and (3) It is primarily current participants in this closed system who have the discretionary income (typically from their capital) to buy those few new stock issues.

Using tax policies to subsidize investment-as we did throughout the 1980s with deficit-financed tax expenditures used to cut corporate tax rates and accelerate depreciation rates-only exacerbates this closed system's natural tendency to further concentrate capital ownership.

For example, between 1982 and 1986 (as taxpayer debt was growing from $1,137 billion to $2,120 billion), the average wealth of the Forbes 400 richest Americans was also growing-from $200 million to $550 million.

Financing both capital and capitalists

With the sole exception of ESOP financing, current techniques of capital finance (now fueled, in large part, by institutional capital) are not designed to create more capitalists; rather, they are designed to finance more capital. The question for pension fund investment strategists is simple: Should the capitalism of tomorrow be designed to do both?

For example, should funds prefer investments that create larger numbers of individual shareholders, whether through ESOPS, through small businesses (generally excluded from this source of capital by "indexed" funds), or by other means? Should funds prefer the equities of banks that have ESOPS over those that don't, or banks that maintain a portfolio of ownership-expanding ESOP loans? Or insurance companies whose portfolios of debt securities support ownership-broadening financing techniques?

Current pension fund socialism unwittingly supports today's tightly closed system of finance. in turn, this system's ownership-concentrating tendency undermines the value of pension benefits for future beneficiaries-by contributing to the likelihood that they will retire into a population (like the current one, only much larger) lacking in widespread economic autonomy.

Herein lies a key dilemma that confronts institutional investors of every type: Because this particular consequence of their actions lies in a distant part of the larger economic system, they have no way to learn from that consequence. The system feedback is beyond both their learning horizon and their investment horizon. For this very reason, public policy initiatives loom ever more likely in the absence of a change in investment policy initiated by institutional investors.

Pension fund capitalism suggests the inclusion of more fiscal foresight as a component of investment strategy, recognizing that today's ownership-concentrating closed system of finance will not change until pension fund financiers actively foster ownership-expanding investment strategies.

Developing an institutional owner's voice

This capitalist-creation strategy could also help address other issues of pressing concern to fund managers. With institutional trading now accounting for some 51 percent of daily market trades, simply selling is no longer an effective strategy for conveying shareholder dissatisfaction. And for funds (such as New York's public funds) that have adopted stock index buy-and-hold strategies, exiting is largely irrelevant. When you can't leave, you must begin to care.

Thus began the institutional investor's search for means to enhance corporate responsibility and responsiveness. With taking the "Wall Street walk" now an ineffective corporate accountability mechanism, how do pension funds develop and exercise their ownership voice in a way that is both effective and politically acceptable?

One common strategy involves developing a surrogate voice of active, focused, motivated, on-site owners who, in theory, will positively affect corporate decision making on behalf of typically passive institutional owners-who often lack the skills, the information, and even the motivation to press for accountability.

Thus far, such surrogate ownership strategies have been largely limited to promoting ownership among managers and directors and investing with core investors" (such as LBO or patient capital funds).

While this provides a partial solution, a pension fund capitalism investment strategy suggests that companies would perform better if rank-and-file employees also had both something at risk and something to gain.

As New York State Comptroller Edward V. Regan phrases it, "The widest distribution of active ownership results from ESOPs employee stock ownership plans). The idea is very appealing, for employee ownership both closely aligns workers' self-interest with that of the corporation and provides the company with probably the ultimate source of patient capital. When managers and workers are owners, accountability pervades the company with beneficial results."

Investing for excellence

One potential impact of such an employee-capitalist investment strategy is to help companies create within their workforce a shared sense of values-according to management consultant Tom Peters, the most common element in the corporate culture of those companies "in search of excellence."

The Oakland-based National Center for Employee Ownership finds support for that assertion in its research documenting the positive impact that corporations report when they combine employee stock ownership with employee participation programs.

Properly implemented, such an employee-empowerment strategy can have a positive correlation with a variety of performance-related aspects of the corporation, such as job satisfaction, quality of work, turnover, and absenteeism. With employee equity sharing, accountability seems to permeate the corporation, rather than stopping at the door of the executive suites.

In addition, instead of relying on remedial corporate governance structures that act after the damage is done, pension fund capitalism suggests that investments be structured to create corporate cultures permeated from top to bottom with active owners.

That personal "at risk" stake, in turn, helps create a workplace environment more amenable to performance-enhancing management innovations such as self-managed work teams, total quality control, continuous improvement programs, and the rapidly expanding panoply of other workplace participation techniques that help to elevate constancy of corporate purpose over short-term profit.

Executive-level stock plans are simply not enough. Those employed as managers and directors already own (or have under option) some 5 percent of the stock of most major U.S. companies. That is an enormous amount of stock-yet the result is only marginal noticeable improvements in corporate performance and shareholder accountability.

Current surrogate-ownership investment strategies are not working as hoped. Plus, given current political sensitivities (fueled by the recent rash of articles on "the CEO disease"), investment strategists-especially among the public funds-must be increasingly sensitive to the social and political implications of limiting such pension fund-financed ownership strategies to a small cadre of already well-compensated employees -particularly given the yet-to-be-proven linkage between their compensation and corporate performance.

Would capitalists enhance competitiveness?

A closely related issue concerns how pension funds can invest to enhance long-term U.S. competitiveness, thereby protecting the value of future pension benefits.

In their search for investment strategies that can help companies create an entrepreneurial, motivated, dedicated workforce, fund managers have largely overlooked the potential impact on productivity and efficiency that could accompany an employee-capitalist investment strategy.

Such a strategy could improve accountability by helping companies shift from management by control to management by commitment-a key challenge facing U.S. companies as they struggle to trim costs due to the overstaffing of mid-level management.

Such an investment strategy may also help create a more flexible workplace environment better able to respond to the realities of global competition. For example, U.S. steelworkers have a large and growing portion of their members in ESOPs due largely to their recognition that, in a global marketplace for labor, U.S. workers need a capital source of income to supplement their declining labor income.

Cross-generational accountability

Pension fund capitalism recognizes that investment strategists may do great harm to fund beneficiaries unless they work to avoid the ownership-concentrating toxic byproduct of blindly investing in today's closed system of finance. To do otherwise seems certain to create a population whose governmental dependency can only erode the future value of pensioners' benefits.

Happily, the positive correlation among the three themes of economic empowerment, voice, and competitiveness suggests an investment strategy that can contribute to long-term wealth creation while also creating a broad-based capitalist constituency capable of resisting political interference in the investment process. Encouraging the wider use of ESOP financing offers one obvious place to begin.

Despite their stake in these huge pools of capital assets, those within the voting public (including most in today's workforce) do not now think of themselves as capitalists. For the most part, they think of themselves as employees, or managers, or neighbors, or consumers, but certainly not as shareholders.

The best way for institutional investors to promote corporate accountability is to invest so that more people have a direct stake in ensuring that those corporations are accountable. That will require a much broader base of active, long-term shareholders, including rank-and-file "inside" shareholders with enough shop-floor savvy (and motivation) to contribute to day-to-day improvements in quality and efficiency.

This capitalist investment strategy also recognizes that successful corporations are institutions that must be built over decades, and that pension fund investment strategies are essentially a covenant across generations. Thus, those in whose hands these investment decisions lie must begin to recognize their cross-generational accountability for the foreseeable outcomes of their investment choices.

The recent emergence of this new type of institutional owner represents a profound change not only in social economic power and structure but in the political structure of civil society as well. Very similar systems are emerging in developed countries worldwide.

The farsighted investment strategist will begin now the search for ways to correlate the goals of pension fund management with the larger public interest of building long-term economic growth for the benefit of a broad range of citizens. In the end, pension fund investment strategies must reflect a vision of what constitutes a just and sustainable society.

Jeffrey R. Gates

Mr. Gates is a partner in the Washington, D.C., office of Powell, Goldstein, Frazer & Murphy. He previously served as counsel to the U.S. Senate Committee on Finance (1980-87), where his responsibilities included pension issues.