Index Fund Proxy Voting and Fiduciary Liability

A recent report from Wintergreen Advisers argues there is a critical flaw underlying the current trend of plan sponsors pushing more and more assets into lower-fee index funds—a flaw that could be construed as a fiduciary violation.

The report’s title doesn’t mince words: “How the Votes of Big Index Funds Feed CEO Greed and Put Americans’ Retirement Savings in Peril.” Neither do David Winters, CEO of Wintergreen Advisers, and Liz Cohernour, chief operating officer (COO) of Wintergreen, in discussing what they see as major failures on the part of the big index fund providers to ensure individual investors are treated fairly.

Winters tells PLANSPONSOR that passive U.S. equity funds gathered an impressive $167 billion in assets in 2014, ending the year with about $2.2 trillion in assets under management (AUM). He suggests the growth has been fueled by “huge advertising and PR budgets” among some of the largest and well-known index fund providers—whom are well aware that sponsors running plans under the Employee Retirement Income Security Act (ERISA) are highly sensitive to fee issues.

This fee sensitivity has continued to increase with the prevalence of ERISA lawsuits and class action challenges around higher-priced investments, Cohernour notes, and with the reintroduction of the Department of Labor’s new fiduciary rule. As a result, sponsors feel a huge amount of pressure to use passive index funds that have lower stated fees than more active investments.

It’s a familiar story to most working in the ERISA domain—but Cohernour and Winters feel there is a key theme that has so far gone unnoticed by most industry practitioners. As Winters puts it, “The problem is simply that the big index fund providers have adopted a pattern of rubberstamping the compensation packages of executives across indexes such as the S&P 500, and this has led to truly runaway compensation and has actually damaged the returns of the end investors routing money into these major index funds.”

The Wintergreen report reviews voting histories of the largest S&P 500 index funds run by Vanguard, BlackRock and State Street, for example, and finds that over the past five years for the 25 largest companies in the S&P 500, these firms’ funds cast their votes in favor of management equity compensation plans 89% of the time, and actively opposed executives’ pay packages less than 4% of the time.

“If you take a step back, this really does not jive with ERISA and the fiduciary duty that sponsors have to ensure fees paid either directly or indirectly from plan assets are reasonable,” Cohernour suggests. “As you know, it’s a basic duty for all fiduciaries dealing with retirement money to look at the value of a security in a few ways. There is the basic price value—the cost of the stock itself. And then in addition to this there is the proxy voting value of the stock, which also has real value and must be considered by fiduciaries making investment decisions.”

This thinking is touched on in a 2008 interpret bulletin from DOL, which sets forth the department’s interpretation of Sections 402, 403 and 404 of ERISA, as those sections apply to voting of proxies on securities held in employee benefit plan investment portfolios. The guidance also touches on the maintenance of and compliance with statements of investment policy, including proxy voting policy.

Cohernous adds that, despite this guidance, “over time it has become very unclear whether the courts and the federal government take seriously the obligation for people controlling retirement dollars to use their proxy votes solely in the interest of the end investor.”

Winters notes that Wintergreen got serious about this issue just a year or two ago, when it was doing some analysis of Coca-Cola stock that it holds in its work as a long-term global value investor. At the time, Winters sent letters to Coca-Cola’s shareholders criticizing the company’s proposed 2014 equity plan, which Winters and Cohernour believe “would have significantly eroded the per-share value of Coca-Cola Shares, by as much as 14% or more per share.”

“The company expected that the 2014 plan would result in the issuance of approximately 340 million new Coca-Cola shares,” Winters explains. “Considering the share price at the time, these shares would have been worth approximately $13 billion. In effect, the board was asking shareholders for approval to transfer approximately $13 billion from all of our pockets to the company's management over the next four years. This would have materially diluted the value of shares held by ERISA participants, no doubt.”

While Coca-Cola at the time suggested Winters’ campaign was misinformed and over-simplified the compensation packages at issue, the company did bow to increasing shareholder pressure and made some changes to how it makes disclosures and ties executive compensation to performance goals.

“We saw that there was excessive compensation being asked for at a time when revenues were not jumping and there were no major accomplishments for management to point to in order to justify the increases they were asking for,” Winters continues. “So we decided to step up and do something about it, and we’re proud to say a lot of that has been rolled back at Coca-Cola.” 

Winters says the process made the firm think about the wider compensation practices taking place across companies included in indexes such as the S&P 500, which gets the lion’s share of new dollars being routed into index funds. “The whole situation really raised our eyebrow on the fact that the big index companies hold so much ownership and power in these really large companies—it’s not a bad thing per se, but they have failed to practice proper governance in this area,” he suggests.

The Wintergreen report goes on to argue this effect gets magnified across the entire indexing marketplace—leading to huge amounts of wealth being siphoned off every year from gross index fund returns and going into the pockets of a select group of executive managers.

As Cohernour puts it, “When we talk about this fee story, and the fact that all these proxy votes are just rubberstamping these unreasonable increases in executive management compensation, it amounts to the investment manager saying, ‘Yes the performance of your company’s stock has lagged in the last year, and the last several years, but we’re going to increase your paycheck anyway.’ That’s doesn’t exactly seem like the reasonable and well-thought-out investment process demanded by ERISA.”

Both Winters and Cohernour are quick to add there are certainly executives and members of upper and lower management among these companies “doing a terrific job and deserving to be handsomely rewarded for their work.”

“But right now it’s practically automatic that, just because management is asking for more stock, more options, more cash and more benefits, that it will get a yes vote from the shareholders,” Cohernour continues. “The pattern of index fund voting appears to be a virtual automatic response—it’s less than a 4% rejection rate when these executives are asking for more compensation. That either means these executives are only asking for appropriate increases—or the mechanism is flawed.”